What One Tough Hedgie Is Buying

• ByTim Melvin, RealMoney.com Contributor
• On Friday December 5, 2008, 8:01 am EST

It has been an interesting year so far if you are a hedge fund manager. Some of the best in the business over the last decade have had a disastrous year. After years of being able to lever up just about any trade to exploit the smallest of anomalies and record huge profits, managers were caught in 2008 and had to furiously dump stock. This massive deleveraging caused stocks that were heavily owned by the funds to tumble an unprecedented amount in a very short period of time.

It seems that every day we hear of another hedge fund closing its doors. With losses in excess for 50%, it just doesn't make sense for them to stay in business. They face the likelihood of having to work without incentive for several years before they can even begin to approach their high-water mark. Hedge fund investors have had it as well. They are pulling money out by the tens of billions. Many funds have simply stopped allowing redemptions.

In the midst of all this, some hedge funds have actually done well this year. I believe it is worth taking a look at what they are doing, to see if we can gain an advantage in this difficult market. One of the biggest winners of the past two years has been John Paulson of Paulson Capital. Last year his fund was up over 500% as his fund bet against toxic mortgage-related securities.

It appears that he is now buying some mortgage-related securities. Several news reports have suggested that mortgage-backeds have now fallen to the point that the fund manager considers them to be cheap enough to begin accumulating a position at these levels. This could bode well for mortgage-related REITs such as Redwood Trust and Doug Kass' favorite, Hatteras Financial.

A look at the firm's 13HF filing shows large holdings in some interesting stocks as well. The company has been increasing its position in Mirant. Shares of the electricity generator are down about 50% so far this year, and apparently Mr. Paulson feels they are cheap. The company recently reported third-quarter earnings that were more than double those of the year-ago period. Most of those earnings, however, were the result of successful hedging transactions, not operations. Operating income was actually down slightly, and the company guided lower for the fourth quarter of the year. Earlier this year, Mirant had suspended its stock buyback program to conserve cash during what the company saw as a difficult economy.

The fund continues to hold a substantial position in Boston Scientific as well. Shares of the medical device company have shrunk by over 80% in the five years since it was a market darling. Boston Scientific remains the market leader in cardiac stents, but increasing competition from Medtronic and Abbott Labs has pressured prices and margins in that market.

The cardiac rhythm management business has been improving. The division posted double-digit sales gains this year and has gained several new product approvals from the FDA this year. The weak stock price has led to one unfortunate consequence that has weighed heavily on the shares: The company co-founders had borrowed to buy stock and have had to sell over 55 million shares to meet margin calls. The stock now sells at around the 2001 lows.

Pauslon's funds recently announced a 14% position in Cheniere Energy as well. Cheniere is developing and constructing liquid natural gas plants. The debt-laden energy concern has seen its stock price fall over 90% in the past 52 weeks. The Sabine Pass will be the largest LNG plant in North America when it opens in the coming months. There is some question as to how fast LNG demand will grow in the U.S., and that has weighed heavily on the stock.

The fund has several positions in companies that are viewed as recession-proof, such as Dr. Pepper Snapple and Phillip Morris.

Paulson has also attributed much of his 28% gain in 2008 to being hedged. He has said several times that for every stock he is long, he likes to be short another one. While he does not have to reveal his short positions, he was said to be short banks in the U.K. earlier this year. With a risk arbitrage background, hedging is as natural as breathing. The firm still has substantial merger arbitrage positions in announced deals.

Even in horrific markets like we have now, some people do well. Observing what they do can help us uncover ideas and strategies that can smooth the ride. The best thing investors can take away from Mr. Paulson's approach is to be cautiously aggressive and contrarian in nature and to stay hedged. It seems to me that I have heard that somewhere else!