November 22, 2012


I modeled the essence of my thoughts about my investment in Provectus when writing blog posts on the essence of story behind a book by Gregory Zuckerman, a reporter at The Wall Street Journalnew book, entitled The Greatest Trade Ever, which narrates how John Paulson, his assistant Paolo Pellegrini and a few other investors saw what nearly everyone else initially and for some time did not see, went against conventional wisdom, and saw through the U.S. housing bubble (I have borrowed liberally from a 2009 article by The Daily Beast's Daniel Gross).

While Paulson wound up making the so-called greatest trade in financial history, he was neither a mortgage expert nor a real estate one. He also did not have much background in the derivatives he used to make his bets, like credit-default swaps. Paulson and Pellegrini really never had a eureka moment and essentially backed into their trade, initially having a vague worry in 2005 about the state of the economy and housing market. They wanted to buy puts on the S&P 500 but found them too expensive, so they began buying CDS contracts because they were much cheaper. Paulson knew nothing about this stuff and Pellegrini knew a little more. They had a tough time convincing people. Paulson wanted to raise a specific hedge fund dedicated to betting against housing. His audiences had interesting arguments why Paulson was wrong: the contracts are illiquid and hard to trade, the government would act to stop any collapse, etc. Paulson ended up with a fund of about $147 million, but at the time hedge funds were raising billions of dollars for different funds. Timing is important. Paulson started out making his initial trades in 2006 by buying certain CDS contracts, and later expanded his trades in 2007 and 2008 to include CDS contracts on financial institutions involved in peddling subprime mortgages.

Paulson and others identified a market dislocation that most people did not initially see, including many directly involved in the housing industry. The dislocation later included certain aspects or parts of the financial services industry and its activities that overlapped or were involved with housing. Paulson et al. were not experts, but employed a process of thoughtful analysis and intelligent conclusion drawing to arrive at their respective investment theses. Their timing, implementation, discipline and patience varied to greater or lesser degrees when compared to each other and how the situation ultimately played itself out.

This narrative -- identifying a dislocation (market) or disruption (technology), not necessarily being an expert in order to do so, utilizing thoughtful process and intelligent decision-making to arrive at the starting point and along the way, getting the timing [somewhat] right, and ultimately monetizing the opportunity -- is what I hope to draw out further in subsequent posts related to this thread.

While I certainly am cognizant, however, that the Paulson example is the exception that proves the rule, I still use his story as a useful exemplar. To me, it was not just that Paulson had the greatest trade in investing history by virtue of how much money he made and the total return of it, I also was struck by the monstrous size of the dislocation he and others identified and then played (and the process by which he thought about and did it).

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