Mohnish Pabrai (Trades, Portfolio) is a well-known value investor, but he got his start in IT and as an entrepreneur. As a result, it is perhaps unsurprising that he likes to say that investors could stand to learn a lot from entrepreneurs. A common misconception about founders of businesses is that they are inherently risk-seeking people.
According to Pabrai, this is not so. Starting a new venture is, of course, an uncertain business; however, entrepreneurs don’t just run into a new industry without a plan. They try to look for situations where there is both an obvious and overwhelming need for a new product or service, and where the initial costs of starting a new business are low relative to the potential rewards. In other words, they look for asymmetries - situations with low risks and high rewards. Here’s how Pabrai has used the entrepreneurial mindset to benefit his investing.
IPSCO was a steal
Like all shrewd investors, Pabrai knows that forecasting the future cash flows of any company is a very difficult business. Consequently, he looks for companies where the downside risk is as small as possible. For instance, in 2003 he found a steel company called IPSCO that was selling for $45 a share. It had $15 a share in cash on the books, no debt and contractually-guaranteed cash flows of $15 a share for the next two years (it is a common practice in the commodities space to use futures and forwards contracts to lock in guaranteed prices for product to counteract volatility).
After two years, IPSCO was pretty much certain to have $45 per share of cash, meaning that all future cash flows, as well as the assets on the balance sheet, were essentially free. Pabrai says that he never modelled out what the cash flows would be beyond the two-year period - he just saw an asymmetric opportunity where the potential upside was so much bigger than the downside and pulled the trigger on it.
This story has a happy ending. After a year, IPSCO announced it would have another guaranteed year of $15 a share cash flows, which sent the stock to $90. A little while after that, another company offered to buy IPSCO out at $160 a share, which brought the price up to $152. At this point, Pabrai could see he had achieved a substantial return on his low-risk bet, and cashed in handsomely.
The big lesson to learn here is that you don’t always need to try and forecast the future perfectly. In fact, doing so will likely lead you into a lot of trouble simply because predicting the future is not possible. The more elaborate your model, the more likely it is that you are fooling yourself into believing a false picture of reality. Instead, focus your energy on figuring out what the worst-case scenario is for any given investment. Pabrai worked out that, at the very least, his $45 a share purchase would have $45 per share of cash in two years' time, which gave him the confidence to bet big on IPSCO. Look after the downside, and the upside will look after itself.
Read more here:
- Warren Buffett: Make Smarter Decisions and Think Deeply
- Berkshire Hathaway Is More Like a Bank Than You Think
- Seth Klarman: This Is Where Opportunities Are Found
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