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Easy Street

Reporter’s Notebook: John Paulson, Quarterback

Heidi Moore Jun 23, 2011

Not to be confused with Hank Paulson, quarterback:

Let me explain.

Yesterday I talked to a few people about John Paulson’s disastrous investment in Sino-Forest. (You can read/listen to my piece here.)

Sino-Forest trades on the Toronto Stock Exchange and owns timber plantations in China. A short-selling/research firm, Muddy Waters, released a report saying that Sino-Forest doesn’t actually own all the land it claims. Paulson sold his entire investment, although he probably took some deep losses. The company denies the charges and is conducting an internal investigation.

There is a kind of strange irony here: once upon a time, before he was the big Wall Street legend he is now, John Paulson was the short-selling rabble-rouser who told everyone that subprime was a fraud. He was so adamant that he convinced Goldman Sachs to create CDOs made up solely of subprime mortgages.

Now Paulson is the established eminence grise of investing, and he ends up taking losses because of….a short-selling rabble-rouser who says that Sino-Forest is an alleged fraud.

What allowed Paulson to spot the subprime bubble was good, thorough research (some say the credit belonged to Paolo Pellegrini, Paulson’s investing partner).

It stands to reason, though, that Paulson has probably moved several steps away from personal involvement in analyzing all those investments as his firm has grown to manage $30 billion.

As Sal Arnuk from Themis Trading told me about Paulson and other mythic hedgies like Julian Robertson, “Keep in mind that they are not sitting there, these giants, picking all of these stocks individually.They have staffs. And some of those staffs are 40-year-old veterans who know a lot, and some are 28-year-olds who don’t know much. Not that there’s anything wrong with 28-year-olds.”

Which is why my basic question to my sources was this: subprime, fine. Gold, I get that. But why on earth would Paulson – or anyone – be able to trust the financial statements of a company whose only business is in an emerging-market economy?

Emerging markets aren’t evil; in fact, for a lot of fund managers they’re saviors of otherwise struggling portfolios. Some EM stocks can return as much as 5% to 6% – much more appealing than the 2% one portfolio manager said he’s lucky enough to get in the U.S.

But emerging markets are risky precisely because it’s difficult to know what executives are up to, especially when their laws are so different -and that’s assuming they’re following the laws. Yes, the returns from emerging markets can be terrific to the point of being addictive. That’s particularly true when even the U.S. looks like a mess.

Remember the 1990s, though: that was the decade of one emerging-markets crash after another. The Mexican “Tequila Crisis” of 1994-1995. The “Asian Flu” in 1997-1998. Brazil crashing. Russia’s currency collapse. Argentina shutting down its ATMs.

I asked Jim Rickards about this. He’s the former chief financial officer of Long-Term Capital Management, which bit the dust because of its bets in the emerging markets like Russia. (Rickards, who is now a senior managing director at Tangent Capital, calls Russia “a gangster economy…worse than the Sopranos.” Even Russians agree.)

Obviously there are well-run companies in emerging markets. But to find them, you have to see them – personally. Finance is still a handshake business, and even in this global world, a lot still comes down to deciding whether you can trust the person you’re buying from.

Every investing professional I asked was unanimous on one point: The key to making any investment work in the emerging markets – which means any country that is not the U.S., Canada, Europe or Japan – is being able to send people overseas to kick the tires. It’s impossible to trust the public statements and audits. One of the risks of investing in the emerging markets like China, said one investor, is “the rule of law.” That means that investors have to double-check that their companies are actually following the law.

That’s a pretty big risk.

Paulson’s statement on the Sino-Forest debacle: “Due to the uncertainty over Sino-Forest’s public disclosures and financial statements, we have sold our stock and await the results of the independent committee’s investigation.”

It shouldn’t be this way. There are usually safeguards in place to protect investors from investing in fraudulent companies, as Sal Arnuk mentioned in my piece. But those safeguards can fail.

At the same time, successful investors can start looking on the fringes for bigger returns. They can start playing in markets that they don’t completely have a handle on. That’s when losses set in. (Long-Term Capital Management is the primary example of this.)

Paulson is even getting hammered on what he does, presumably, know. The Wall Street Journal says Paulson is also getting slammed on his investment in gold mining stocks like AngloGold Ashanti Ltd. and Gold Fields.

And what do you know? Most of them do a lot of business in emerging markets.

Paulson made his name betting on whether companies would merge successfully. It’s a long jump from that world – known as merger arbitrage – to becoming a China expert. I thought Adam Bold, from the Mutual Fund Store, described the risk here best:

BOLD: It’s like saying someone is a good football player. Well, maybe they’re a great quarterback, but if you try to put them on the offensive line, they’re going to be very small and they’re not going to do very well.

UPDATE: Paulson’s expanded statement on Sino-Forest indicates that he relied mostly on public statements and did his research that way. Hat tip to the great Bess Levin at DealBreaker.

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