Saturday, September 19, 2009

The Dhandho Investor: Chapter 13

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 theme of this chapter is that high uncertainty does not equal high risk. Wall Street will often shun companies with uncertain outlooks, but this is exactly what allows value investors to swoop in and make outsized profits. Pabrai walks the reader through three examples of Pabrai fund purchases, and how excellent returns were realized.

Stewart Enterprises was an over-leveraged funeral home operator that traded at 50% discount to its tangible book value. Wall Street punished the stock because its debt was coming due; but in Pabrai's estimation, the chances of bankruptcy were slim. The company was earnings and cash flow positive, and was comprised of several businesses. Stewart was able to sell off businesses that were not cash positive and thus pay off its debt without hurting cash flows.

Despite the fact that Level 3 had cash of $2.1 billion, some of its debt was selling for under 20 cents on the dollar, as the company was cash flow negative and the industry outlook was uncertain. Careful analysis of management's plan, however, indicated that cap ex would not be spent unless revenues justified expansion. This meant that the company's cash reserve could continue to meet interest payments for another three years. Due to the low bond price, the investor could recover his initial investment in interest payments alone!

Frontline, and shipping company, sold at a massive discount to the scrap value of its ships in 2002. Furthermore, Pabrai argues it had enough liquidity to last several months at the depressed shipping prices that prevailed in the market at the time. Needless to say, the company outlasted the downturn and Pabrai was rewarded for his investment.

While all of the above companies were in different industries and with different surrounding circumstances, each investment represented an investment in a highly uncertain but still low-risk position. Due to Wall Street's opposition to high uncertainty, value investors can profit by finding investments that fall within this group.

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