The Dhandho Investor: Chapter 10

Mohnish Pabrai is an Indian-American businessman and investor. For a number of years, he turned heads with the performance of Pabrai Investment Funds since its inception in 1999. Pabrai has high regards for Warren Buffett and admits that his investment style is copied from Buffett and others. Over the next few weeks, we'll be exploring the topics in his book about value investing.

The basic idea underlying this chapter is that when opportunities exist, it's important to bet big. Pabrai is not an advocat of investing frequently, with amounts of money that won't significantly move the needle. Instead, he suggests disproportionate amounts should be invested when the odds are significantly in one's favour.

To calculate how much an investor should bet on a given opportunity, Pabrai suggests using the Kelly Formula, which he discusses in detail. A major weakness of using this formula, however, is that it requires the payout and odds to be known in advance. This knowledge is available in gambling games (where the Kelly Formula is perhaps more relevant), but stock returns are not calculated with assurance so easily. To better understand how investor's should think about how much to invest in a particular opportunity and why, Pabrai recommends William Poundstone's book, Fortune Formula.

Though the motel-buying Patels described in earlier chapters of the book had likely never heard of the Kelly Formula, Pabrai argues that they nevertheless recognized the fundamental concept behind it, and that's why they were so successful: when a great opportunity presents itself, bet big. Pabrai also analyzes the statements and writings of Warren Buffett and Charlie Munger and concludes that they employ the very same credo. Said Charlie Munger in a speech at the USC business school:

"The wise ones bet heavily when the world offers them that opportunity. They bet big when they have the odds. And the rest of the time, they don’t. It’s just that simple."

And wrote Warren Buffett in his partnership letters from 1964 to 1967:

"We might invest up to 40% of our net worth in a single security under conditions coupling an extremely high probability that our facts and reasoning are correct with a very low probability that anything could change the underlying value of the investment."

In light of the above, Pabrai finds it puzzling that the average mutual fund holds 77 positions, and that the top 10 holdings represent just 25% of assets. Dhandho, on the other hand, as Pabrai describes it, is "about making few bets, big bets, infrequent bets".

The Dhandho Investor: Chapter 9

Mohnish Pabrai is an Indian-American businessman and investor. For a number of years, he turned heads with the performance of Pabrai Investment Funds since its inception in 1999. Pabrai has high regards for Warren Buffett and admits that his investment style is copied from Buffett and others. Over the next few weeks, we'll be exploring the topics in his book about value investing.

While no moat can last forever, Pabrai suggests readers invest in businesses with competitive advantages that can last for several years. There is an endless list of businesses with durable moats, and Pabrai goes on to name some including: Chipotle, American Express, Coca-Cola, H&R Block, Citigroup, BMW, Harley-Davidson, and WD-40.

Pabrai also lists a few companies with no moat at all: Delta Airlines, General Motors, Cooper Tires, Encyclopedia Britannica, and Gateway Computers.

Sometimes the moat is not so clear. The example of Tesoro Corporation, an oil refiner, is highlighted. While Tesoro has no control over the price of its supplies (crude oil) or the price of its principal product (gasoline), it does have an advantage: refineries on the west coast. While the number of refineries has declined over the years, Tesoro holds a growing advantage due to environmental regulations for gasoline products that are specific to the West Coast.

While a business' moat is often hidden, whether a company has one is usually clear from its financial statements: good businesses generate high returns on invested capital. For example, if opening a Chipotle store costs $700,000 and it generates $250,000 per year in free cash flow, in Pabrai's words "it's a damn good business."

While some moats are more durable than others (e.g. American Express was founded 150 years ago, and still has a strong moat.), it's important to note that all moats erode over time. As noted by Charlie Munger, "Of the fifty most important stocks on the NYSE in 1911, today only one, General Electric, remains in business...". Even seemingly invincible businesses today such as eBay, Google, Microsoft, Toyota and American Express will all eventually decline and then disappear. Pabrai notes the results of Arie de Geus' study that showed the average life of a Fortune 500 company is just 40 to 50 years (and it takes about 25 to 30 years from inception for the typical company to get to the Fortune 500, meaning the typical company ceases to exist after spending less than 20 years on the list). The implication of this is that discounted cash flow estimates into the future should be kept to relatively short timeframes.

The Dhandho Investor: Chapter 8

Mohnish Pabrai is an Indian-American businessman and investor. For a number of years, he turned heads with the performance of Pabrai Investment Funds since its inception in 1999. Pabrai has high regards for Warren Buffett and admits that his investment style is copied from Buffett and others. Over the next few weeks, we'll be exploring the topics in his book about value investing.

In this chapter, Pabrai extolls the virtues of investing in distressed businesses in distressed industries. While he believes the market is mostly efficient, he believes that investors paying close attention can find the situations where it is not. When a business (or its industry) is distressed, it can often sell at large discounts to its intrinsic value due to the fear that is prevalent in the market. It is precisely this phenomenon that offers investors the opportunity to buy stocks at large discounts.

For those who believe the market is always efficient, Pabrai offers the following Warren Buffet quotes:

"I'd be a bum on the street with a tin cup if the markets were always efficient"

"Investing in a market where people believe in efficiency is like playing bridge with someone who has been told it doesn't do any good to look at the cards."

"It has been helpful to me to have tens of thousands [of students] turned out of business schools taught that it didn't do any good to think."

Pabrai discusses several ways for investors to find distressed industries/businesses. For one thing, business headlines are often filled with negative news and outlooks for particular businesses and industries. Examples include Tyco's stock during the Kozlowski scandal, Martha Stewart's stock following her prison sentence, and H&R Block's stock following Elliot Spitzer's investigations.

Another useful place to find distress is Value Line's weekly summary of the stocks that have lost the most value. It also publishes a list of the stocks with the lowest P/E and P/B values. Pabrai also recommends looking at 13-F disclosures to see what other value investors are buying, and using Value Investor's Club. Pabrai also recommends that investors read Greenblatt's The Little Book That Beats The Market for help in this area.

From the above sources, a plethora of troubled industries and businesses can be identified. From this group, Pabrai recommends investors eliminate those businesses which are not simple to understand or which fall outside the investor's circle of competence. For the remaining stocks, the Dhandho framework (as discussed in the rest of the book) should be followed to determine which of these stocks should be purchased.

Being Wary Of Retailers

The financial statements of various retailers can look very clean in some cases: decent cash balances, low debt levels, and dropping inventory levels acting as a source of cash in this tepid retail environment. In many cases, the stock prices of these retailers can seem like veritable bargains in relation to their financial statements. After all, what value investor wouldn't want to buy a company for half of what it owns in inventories alone?

However, when valuing company assets, retailers should not be placed on the same playing field as companies operating in a different space, even if the financial statements suggest two companies are identical. This is because of an accounting standard that does not require retailers to include on their financial statements a most material of liabilities: their operating leases.

Consider Trans World Entertainment (TWMC), a retailer with about 700 stores across the US. The company trades for just $30 million, even though it has current assets (mostly inventory) of around $360 million, and total liabilities of under $200 million, for a net current asset value of around $160 million.

If a manufacturing company had the types of numbers depicted above (and some do have similar), it would likely be a straight up steal, as the company could cut costs (reduce output/headcount/facilities) while sourcing cash from its inventory. Retailers, on the other hand, are burdened with fixed operating leases that in some cases don't expire for years, reducing the ability to cut costs. While manufacturers can also have operating leases, the magnitude of these leases are normally not nearly as material as they are for retailers.

For example, Trans World has operating lease obligations of $220 million over the next five years or so. (Compare this to the company's market cap of $30 million!) Trans World lost $17 million last quarter, and it will likely continue to lose money (eating into its current assets) as its cost structure is not flexible enough to allow for a quick turnaround, thanks to these leases.

Not all retailers have such daunting operating leases, however. Some, like Office Depot (ODP), own land and buildings outright, which provided ODP some much-needed flexibility during a cash crunch earlier this year. Furthermore, the expiration of operating leases can empower management with the ability to reduce costs: companies can cherry-pick which leases to renew based on store-by-store profitability, thus improving overall results. Finally, we've also seen how some companies (e.g. Build-A-Bear as described here) have been able to re-negotiate their lease requirements lower as the lessors would rather work with them rather than lose a valued client.

Nevertheless, when viewing the financials of a retailer, alarm bells should go off because of the fixed-cost nature of this industry: what is this company contractually obligated to pay in the future, and does it have the ability to make those payments? While a company may trade at a discount to its net current assets, that is no good to investors if it will continue to lose money. To avoid falling into the trap of buying such companies, it's important to consider the company's cost structure thoroughly, no matter what the financial statements say.

From The Mailbag: Brinx Resources

Brinx Resources (BNXR) is an oil exploration and development company. The discount the company trades at to its cash balance (about 25%) prompted a reader to ask about its suitability as a value investment. Personally, I would stay away.

As we've seen before, it's not enough that a company trade at a discount to its cash balance in order to qualify as a suitable investment. Outside of its cash balance, Brinx does not have any other material current assets. On the other hand, it does have some liabilities which reduce its net current assets to a value barely above its market cap.

The company is also looking to use that cash to buy oil properties. This is a note from their latest quarterly report:

We are attempting to expand our property base by locating other resources properties. Accordingly, we have hired consultants to gather data on properties that may be of interest to us. As of the date of this filing, we have not found a suitable acquisition.

In the meantime, the company does not currently generate enough revenue to meet its costs (having sold some of its assets), which acts as another drain on its cash. Furthermore, as the company is heavily reliant on the price of oil, the value of its resource properties (which have already been impaired to some extent due to the reductions in the expected future cash flows of these resources) could fluctutate dramatically.

As such, the assets of this company just don't provide enough of a margin of safety. When buying a company this small and this illiquid, buying net current assets, even if predominantly cash, at a small discount just doesn't cut it. The price of oil could go up or Brinx could discover a great oil resource on its land, either of which would serve to reward shareholders. In both cases, however, the investor needs something positive to happen in order to realize a large upside, making this a speculative play rather than a value investment. Before investing in a company such as Brinx, value investors should look for a massive margin of safety, not a small discount, in order to ensure both upside potential and downside protection.

Disclosure: None

Reward vs Risk

Orsus Xelent (ORS) is a Chinese cell phone maker that trades for $22 million on the AMEX. The company has a ton of risks:

• Almost all of its sales are to one distributor. Having one customer is always a risk, though this risk is somewhat tempered by the fact that many consumers purchase Orsus' phones.
• This distributor owes Orsus $76 million, or more than three quarters worth of sales at the current pace!
• As a foreign-owned entity in China, its taxes are about to double.
• The company prides itself on being innovative and meeting end-user needs, yet its R&D budget was about $11,000 in the latest quarter.
• It has guaranteed a $17 million bank loan to one of its suppliers.

In many cases, these risks would be enough to turn a value investor away from a company like this. But as Mohnish Pabrai notes, value investing is about investing in companies with upside potentials larger than the downside risks. Clearly, there is some risk with Orsus Xelent, so what possible upside is there that can trump these risks? The answer is the company's low price on several levels.

First of all, Orsus trades for a P/E of around 2! Companies normally trade at such levels if earnings are expected to fall drastically. For Orsus, however, earnings and revenue this year are expected to be even higher than they were last year, as the company continues to supply more and more of rural China with mobile phones.

The company also trades for about half of its liquid assets. While those assets do include a ridiculously large sum due from its main distributor, that number has come down in the last quarter. Furthermore, the company has taken out a 3rd party insurance policy on the overdue receivables, which should provide some protection. The distributor is also guaranteeing a portion of Orsus' outstanding loan, whatever that's worth.

Orsus can hardly be considered a risk-free stock. Nevertheless, despite a huge number of risks, the upside potential of this company was too high for this value investor to ignore. This penny stock trades at a massive discount to its earnings and to its assets. Time will tell if that discount is justified.

Disclosure: Author has a long position in shares of ORS

When Bad Times Are Good

Demand for goods and services generally drops during recessions. It is for this reason that value investors prefer companies structured to withstand such drops. When incomes fall, certain industries suffer disproportionately. For example, we saw that for every 1% drop in US incomes, airlines actually lose about 6% of their revenue!

But on the other side of the coin, it should be noted that there are actually products for which demand increases as incomes drop! These products/services are referred to as inferior goods, since people buy these instead of buying a product they actually want but can't afford! Tutor2u classifies frozen veggies, processed cheese and tinned meat among this group of inferiors.

With US job losses climbing to local highs and continually rising unemployment, companies that provide such products may actually find themselves in boom times! Such companies tend to be non-cyclical, and can therefore take on more debt and still remain safe, thus offering shareholders a tax break. For example, consider Kraft (KFT). Although Kraft provides a wide variety of products, one could argue that many of their processed and packaged foods are precisely the inferior goods which see demand increases when incomes drop.

Indeed, Kraft's stock is only down about 20% from its 2007 high, as it continues to post increases in operating income. But as a largely followed, well-covered stock, it doesn't offer the same value as many smaller businesses that also benefit from recessions but that have seen their stock prices get pummeled. What small companies appear poised to see increases in revenue and earnings in this environment thanks to the types of products they sell?