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Pabrai Smokes Cohibas

December 04, 2007 | About:
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Evan Vanderveer

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Mohnish Pabrai asks himself one question that has produced stunning returns since his fund’s inception. Is the company he is considering investing in a great business?

Value Investors did not always care about the quality of the company. In 1934, when Benjamin Graham first wrote about value investing, he was buying companies below net working capital, as calculated by current assets minus current liabilities. Generally, the quality of the company mattered little if at all.

As the value-investing concept spread and became increasingly popular, the methods remained intact. One of the investors who picked up Graham’s teachings was Warren Buffett, in a class at Columbia University. From that point through his days working at Graham-Newman, till the later existence of the Buffett Partnership in the 1960’s, Buffett continued to practice what he calls “cigar-butt investing”, or buying cheap companies as prescribed by Benjamin Graham, and taking one last puff before having to throw them away.

All of that changed with just one introduction. Buffett was invited to dinner at a friend’s home to meet a man named Charles Munger. Munger was also an investor and the two men began to increasingly collaborate on investments. Munger brought one important concept to the table that would forever change value investing. He stressed that great companies should be bought at a fair price instead of buying fair companies at a cheap price.

Buffett began to incorporate Munger’s concept into his own work. The first identifiable investment Buffett made involving a good company was American Express. In 1964, Buffett placed about 40% of his partnerships asset base in the credit card company. He had thrown away the “cigar-butt” philosophy and picked up Munger’s framework.

Soon after, Buffett started writing and speaking about the change in his philosophy. He has continued to buy great companies at fair prices for the last 40 years. It would be these investments that would become his most famous.

Nearly four decades after the shift in Buffett’s framework, Mohnish Pabrai started a fund that “shamelessly cloned” everything about the structure and general investment concepts of the original Buffett Partnership, except for one. Pabrai buys and smokes Cohibas instead of old wet cigar butts.

Rather than buying any cheap company, Pabrai only buys great companies at a cheap price. The average market cap for these companies is around $500 million, though that number has recently become larger because of his increasing asset base. Pabrai has created a hybrid value investing methodology; buy great small companies at a major discount to intrinsic value and wait.

So how does Pabrai define a great company? He believes they have at least one of four defining characteristics.

* “Recurring Revenue Streams (GEICO)”

* “Ability to raise prices ahead of inflation (The Washington Post)”

* “Some sort of Monopoly or Oligopy type market positioning (American Express)”

* “Strong franchise/brand that gives it insulation from most competitors (Coca Cola)”

CompuCredit is in a different business than GEICO, but has a similar recurring revenue stream. The company has five different business segments, the largest of which is the credit card operation. CompuCredit is the countries largest marketer and servicer of credit cards solely dedicated to the subprime market. The cards they offer come in two types, fee-based and standard cards. The fee-based cards have an annual fee and a small monthly maintenance fee. The standard cards have only an annual fee because they are for customers with a slightly higher FICO score.

Besides the fees charged for the utilization of the cards, CompuCredit collects high interest rates from its subprime customers. Similar high rates are charged to the company’s customers in two of the other business segments. While surely CompuCredit is no GEICO, the company sells a variety of products that often result in recurring revenue and customer attachment.

CompuCredit’s management team owns 60% of the company and the CEO David Hanna controls a large portion of those shares. Large insider ownership may be another “great company” indicator. Pabrai began buying in the second quarter of 2007 and added to his position in the third quarter. The company appears to have one of the four defining characteristics that Pabrai believes defines great companies.

The ability to raise prices ahead of inflation is a unique characteristic, one that does not appear to be associated with any of the companies Pabrai has purchased in the last eight years. While some such as Stewart Enterprises, one of the largest providers of death care services in the US, do have the ability to raise prices, a comparison to a company such as the Washington Post is a stretch. One could argue the ability to raise process on a regular basis comes in conjunction with a strong brand name, something unlikely to be found in the small cap category.

Lear Corp. is a leading provider of automotive components. The company’s main product is car seating and interiors used by manufacturers such as GM and Ford. Lear has an “oligopoly-type business” in the seating segment. The relationship held with the carmakers and the reliance on a company such as Lear makes a switch quite difficult.

When commodity prices began to rise and SUV sales began to fall in 2005, Lear’s stock crumbled. GM and Ford were hit especially hard because of their large SUV product line. But Lear’s market position ensured that when the storm passed, the company and its stock would recover. Pabrai began purchasing the stock in August of 2006 and sold in April of 2007 with a 60% gain or an annualized return of about 144%.

The importance of holding a great company is plainly visible here. When an industry becomes distressed to the point of causing bankruptcies, only the “best of breed” are left standing. Pabrai looks for distressed companies in distressed industries, one of the components of a “Dhando” investment. To protect from permanent capital loss and to ensure large returns, the company usually must have one of these four defining qualities.

Like the ability to raise prices ahead of inflation, a strong brand name such as Coca-Cola is rarely found to be associated with a small company. Industry specific brand names however are at times plentiful. A primary example is Embraer, the aircraft manufacturer, a name widely known in the aircraft-manufacturing field. Pabrai began buying the stock a month after September 11th and held the company for over four years with annualized returns of about 43%. The brand name was sure to allow the company to rebound when the airline industry began to recover and that is just what happened.

Value investing comes in many different shapes and colors. Pabrai has beautifully balanced Graham’s dirt-cheap method with Munger’s great company concept. The result is the ability to buy great companies that for some reason have become distressed, resulting in bargain basement prices. Next time you go shopping, look to see if the company has already been smoked or rather if a brand new Cohiba has been pushed to the way side.

About the author:

Evan Vanderveer
GuruFocus - Stock Picks and Market Insight of Gurus

Rating: 2.7/5 (69 votes)

Comments

DaveinHackensack
DaveinHackensack - 7 years ago
How could you write an essay about Pabrai today and not mention DFC?

Embraer in 2001 was a great buy though. A friend of my father's cleaned up on that one too.
vooch
Vooch - 7 years ago
Evan,

You must be smokin' some wacky tobbacky to write an article like that in this quarter. Your timeliness is untimely, imo.

- Vooch

P.S. Btw, there's two types of Cohibas: red band (the fake ones), and yellow band (the real deal).

brady56
Brady56 - 7 years ago
Mohnish is a very shrewd and value-oriented investor. However, some of his picks do not have wide moats as WEB usually wanted. Pinnacle, ABXA, DFC... very commodity type of business with no distinguishing brand equity and the one with lowest cost is the winner. So, if the picks are wrong. They can turn real ugly in an accelerated way.
fk
Fk - 7 years ago
What is compu-credit's liabilities if their subprime credit card holders default on payments? And what of the liabilities of their 4 other divisions?

Evan, I'd like to hear your comments on DFC as well. Thanks.

herbertj
Herbertj - 7 years ago
I think any article that talks about Buffett's move to focusing on great companies should reference Philip Fisher.
valueorama
Valueorama - 7 years ago
people seem to give too much importance to short-term performance. Most value investors are happy if they get 51 good calls out of 100.
tkervin
Tkervin - 7 years ago
HNR does not seem to fit this template either. While I have made money on in I consider it to be a speculative play. The geopolitical risk was, in my view, higher that Buffett would ever agree to.
cprause
Cprause - 7 years ago
Vooch - hit it on the head. Most of Pabrai's picks have been smoked by the market. CRYP is down in the quarter, CCRT ia around $12 and I think he bought in the mid to high $30's. DFC... most of us know what has happened. BRK/B is the only one that I can think of that has held up well. I bought some CCRT in the low $20's after I saw that Pabrai paid way more and I am down 50%. Mohnish must be down 70-80% on that pick. I am a fan of Pabrai's investment style but buying the most dirstressed companies in the most distressed sector (or in other words "low quality") has severely backfired over the last several months.
commodity
Commodity - 7 years ago
Buy a basket of cheap stocks and average out.

This is what Ben Graham did.

The Stingy Investor, Ben Graham screen, has returned 30% a year.

It is only 5 stocks.

Never put it all in one stock .

It could be DCF.

equityguy
Equityguy - 7 years ago
"Moat" is a somewhat subjective term, so your mileage may vary. Pabrai's recent presentation at the Value Investing Congress actually touched on this topic. He discussed "hidden moats" and used PNCL as an example. As he wrote about in his Dhando Investor book, he identifies moats by looking at the firm's financials. According to Pabrai, sustainable high ROEs = moats. Other value investors define moat differently, but usually there are similarities.

ABXA, PNCL, and HNR all have very wide moats under normalized business conditions. (So do DFC and CCRT, but it is debatable as to whether or not they'll be around by the time conditions "normalize".)

Valueorama said "people seem to give too much importance to short-term performance. Most value investors are happy if they get 51 good calls out of 100." Right on. Michael Mauboussin has written extensively on how much more important the MAGNITUDE of an investor's correctness is over the FREQUENCY of their correctness. Lynch/Buffett/Munger have all touched on this subject in the past. It is an important concept for an investor to understand (and practice) IMO.

TKervin said "HNR does not seem to fit this template either. While I have made money on in I consider it to be a speculative play. The geopolitical risk was, in my view, higher that Buffett would ever agree to." I can't say I agree with you. HNR fits the template according to Pabrai's definition of moat. BTW, in his early years Buffett lost 100% on an investment in Cuba -- so the geopolitical risk is clearly not beyond Buffett's standards.

Ravinsu had some good thoughts on HNR. The actual value of their assets could be as much as 4 times their current market cap (under optomistic assumptions with recovery rates and oil prices) and that could even grow substantially if they have much success with their exploration activities. The stock market typically doesn't confer value to oil & gas companies until reserves, production etc are "proven". In the next 2 to 3 years it is highly likely that HNRs #'s will increase drastically IMO. Of all Pabrai's picks, I like HNR the best despite the political risk.

All my opinions, which sometimes aren't worth much. Do your own due diligence.
commodity
Commodity - 7 years ago
If they have little competition they have a moat .

Few have moats.

Get info at Value Line - WEB Does

Charlie Munger came up with moat investing.

Stocks you can buy and hold.

Ben did not buy and hold.
mrubsam
Mrubsam - 7 years ago
You guys are living in economic fantasy land if you think these are good companies with wide moats.

Procter and Gamble has a wide moat.

Cryptologic does not.

Coca Cola has a wide moat.

ABX Air does not.

I'd say Pabrai's stocks are more in the "Phillies Blunt" category. They can do pretty well in bull markets. He's been a good performer in a huge small cap rally.

Let's see how he does if and when the Russell 2K is at 500.

Pabrai has made all his money in highly abnormal economic conditions. What we are witnessing now is a reversion to normal economic conditions.
Evolution
Evolution - 7 years ago
This article repeats certain ideas about Buffett/Munger which are misleading.

Buffett moved into better established companies for one main reason - too much capital to allocate. You can't take a billion dollars and through it into a bunch of "cigar butt" companies. He was able to do that when he had his partnership, valued at around 100 million when he closed it, but not with Berkshire.

Pabrai is essentially doing what Buffett did with his partnerships. These are "cigar butt" companies he is buying - they do not dominate their markets, but they are fairly valued, with limited downside and decent upside potential (yes, not every company meets this criteria, such as DFC, but at least that is his intention).

When Pabrai starts managing 1-2 billion dollars or more, you'll see him investing in larger cap, better known, companies.

It's also one of the reason Greenblatt states his Magic Formula is ideal for individual investors. The larger players cannot appropriately allocate capital to the majority of these companies, which are not large cap.

Pabrai, even though he calls himself a humble disciple of WEB, is known to be much more of a strict Grahamsian investor.


buffetteer17
Buffetteer17 premium member - 7 years ago
At the last annual meeting, Pabrai stated his intention to close his fund when they reach $1B. Of course, that won't stop them from growing, just not as fast.
yhlbb
Yhlbb - 7 years ago
"You only find out who is swimming naked when the tide goes out." -- Warren Edward Buffett

WEB writes well, so does Mr. Pabrai. I put Mr. Pabrai's picks in the "for-further-study" pile, like the others gurus featured here.

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