The Dhandho Investor: Chapter 13-14
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.
Many companies are devoted to innovating of some sort, and many investors are looking to find the next big innovation that will generate superior returns on investment. Pabrai argues, however, that investors should focus not on companies that innovate but rather on companies that excel at copying and scaling.
Pabrai goes through a couple of case studies to illustrate his point. Ray Kroc purchased McDonald's restaurant from a pair of brothers. He didn't invent the concept, but saw its potential and expanded it. Furthermore, many of the menu items and processes that made McDonald's into the restaurant we see now did not come from corporate headquarters, but rather from its franchisees and other restaurants. McDonald's is successful because it has been able to scale up the innovations of others.
Microsoft is another company Pabrai describes as a non-innovator that is excellent at scaling up the successful innovations of others. Microsoft's own inventions have often failed, but when it has taken a competitor's existing idea and applied Microsoft's know-how is when it has been at its most successful. It took the idea of the computer mouse and graphical user interface from Apple, Excel from Lotus, Word from Word Perfect, networking from Novell, Internet Explorer from Netscape, XBOX from Playstation and the list goes on. In these cases, Microsoft waited for a product/service to demonstrate a certain acceptance by customers, and then went after this now proven market.
Pabrai Funds is also a copy of Warren Buffett's funds to a large extent. From the fee structure, to the philosophy on identifying good investments, to the reporting scheme, to the investor profiles, to the personnel structure, Pabrai has tried to emulate the partnerships of Buffett's past.
Too many investors make the mistake of looking for innovators in the public equity markets. Instead, Pabrai advises to focus on companies run by people who have repeatedly shown they can lift and scale existing ideas.