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John Paulson had an awful year in 2011. As of the third quarter, the flagship Paulson Advantage Plus fund was down 47%. ValueWalk exclusively obtained the letter, which can be found here.

The Advantage plus fund had a loss in Q4 2011, and was down 52% for the year. Despite the poor performance,  since inception, the fund has returned 23% annually gross, and 14% net of fees.

ValueWalk has recently obtained highlights from a recent letter, which totals 102 pages.

Below are some of our exclusive highlights:

The Paulson Merger Fund was down -10%, Paulson Gold Fund was down -10.5%, Paulson Credit Opportunities was down -18%, Paulson Recovery was down -28%, and the Paulson Advantage Funds were down the most with Advantage ending the year down -36% and Plus down -52% net.

Paulson had total aum of $22.7billion at the end of 2011, down from approximately $35billion at the peak.

The rest of the highlights are from January and February  2012.

The mistakes responsible for the bad performance were due to the following four reasons:

(1) overweighting long event equity, (2) underestimating the
recurrence of Europe’s sovereign credit issues, (3) overestimating the U.S. economy, and (4) some individual security selection.

Paulson has reduced his equity exposure at the end of 2011 and began 2012 with a more balanced and hedged portfolio. We noted in a recent post, that John Burbank who also had a bad 2011,  has employed a similar strategy for 2012.

Paulson noted:

“While we have seen a reasonable recovery in the U.S. with leading indicators in early 2012 trending positive and equity valuations well below historic norms, the European sovereign debt crisis remains the overriding risk in the markets. A potential collapse of the Euro triggered by a Greek default or other event could throw the world into recession and serious financial disorder.

Unfortunately, after considerable analysis, we concluded that the Euro, a fixed exchange rate system shared by 17 different countries, is structurally flawed and will likely eventually unravel. While the ECB has calmed markets by providing massive liquidity to the banking system via its Long Term Refinancing Operation (“LTRO”), an indirect form of quantitative easing, such liquidity operations do not address the structural imbalances inherent in a fixed exchange rate system and may only push the problems into the future. While the timing of events precipitating a breakdown are difficult to predict, we believe the consequences are significant enough that we have reduced exposure across all our funds and operate with additional hedges.”

On the US, Paulson believes that 2012 S&P earnings will be $104.52. That would put the market at a forward price earnings of 13.

Net exposure went down from 82% to 32%. Paulson is concerned about the Euro-Zone and has largely reduced his exposure for fear of a severe recession in Europe. The biggest problem is that unit labor costs are now close to 50%
higher in Greece, 38% higher in Portugal, 35% higher in Italy and 30% higher in Spain relative to Germany. With one single currency and a fixed exchange rate, there is little flexibility to solve the economic problems in Europe.

A trigger event for even bigger problems in Europe could be a default by Greece or the need for further bailouts of Portugal, and possible bailouts of Italy and Spain. European banks have a tremendous amount of exposure to Greek sovereign debt, which would make a default a contagion event.

2012 Positioning:

Paulson notes the increasing volatility in the markets, which is great for Paulson’s original background in special situations.

A merger arbitrage purchase which he made is Motorola Mobility (MMI).  Paulson expects to earn an 8% plus annualized return when Google (GOOG) completes the $12.4billion purchase on March 31st.

Spin-Off/ Restructuring of Ralcorp (NYSE: RAH): ConAgra (NYSE: CAG) made an offer in 2011 for $82 for Ralcorp. The company rejected the offer and announced a tax-free spin-off of Post Cereal in July. Applying an EBITDA multiple of 11 to both Post and Ralcorp, the companies have a 30% plus upside.

Paulson also likes AMC Networks (NASDAQ: AMCX), which was spun-off of Cablevision (CVC) in July 2011. Compared to competitors, which are trading at EBITDA multiples of 12-12.5%, the company has a 25-30% upside.

Delphi (NYSE: DLPH) Bankruptcy Exchange offer is another position which Paulson likes.

Delphi, the largest U.S.-based automotive parts supplier, emerged from bankruptcy in late 2009. Paulson believes that the bankruptcy reorganization transformed this previously troubled manufacturer into one of the auto parts industry’s most efficient companies. All the liabilities were eliminated in the bankruptcy process.

Upon emergence from bankruptcy, Delphi’s defaulted secured debt was exchanged for privately traded partnership units. Paulson believes that the security was unlisted, illiquid, and complicated, it was little understood by the market and therefore traded at a wide discount to Delphi’s public equity comparables. A confidentiality agreement was signed to receive more financial information.

Stay tuned for more coverage…