Pabrai Smokes Cohibas
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.