The second installment of this series continues with  Mohnish Pabrai (Trades, Portfolio)'s third type of stocks that make the best multibaggers:
“The third kind is the ones which have shown up the most in my portfolio. I have never had the good fortune of having the first kind of business, which is huge tailwinds and idiots for management, I've never had that. If I ever get that in my portfolio, we're never going to sell those, we're going to keep those forever. The third one is when the market gets confused between risk and uncertainty."
This third bucket of companies is more of a contrarian style. The difference between risk and uncertainty is sometimes difficult to separate, but, in some cases, it is straightforward to see.
The critical difference here is the risk of a total loss. You have to ask, "What are the chances that the disaster the market is currently pricing in will actually take place?" If you conclude it is unlikely the business will fold, the challenge becomes to understand what the market is uncertain about. Why does this mispricing opportunity exist, and what do you know that the rest of the market seems to misunderstand?
The example Pabrai gives in his letter is his investment in Fiat Chrysler (FCAU, Financial). Several years ago, the market did not believe the company would be able to execute on its turnaround plan to eliminate debt and produce substantial profits by 2018. The risk of the company going bankrupt was limited, but the potential reward, if it managed to hit its output targets, was massive. Uncertainty weighed on the price, offering value investors, who were willing to bet on Fiat's success, a highly attractive risk-reward profile.
“The fourth criteria is what I call bankruptcies, reorganizations, public LBOs, and special situations. How many of you have heard of Sam Zell? Raise your hand if you've heard of Sam Zell. At least one person, the professor. I think you should extend an invitation. You should extend an invitation to Sam to come speak to your class. Sam is called the grave dancer. He dances on the graves of companies that are left for dead. If you get a chance to invest with Sam, generally speaking, it's going to go really well. Warren Buffett (Trades, Portfolio), Sam Zell, and the Pritzker's - these are some of the very best people on the U.S. tax code. They know U.S. tax code better than anyone else. Way better than Donald Trump. They really know the tax code. And I don't think Sam Zell has ever sent much of a tax bill to U.S. government because he's just so efficient with the way he runs his tax affairs.”
Investing in special situations can be an extremely lucrative style. However, I should caution this is not for everyone. It requires plenty of experience, understanding of the bankruptcy process, accounting knowledge and funds. The average investor is unlikely to have enough time or expertise to take on these situations as it may require an active approach with the company and its creditors to achieve the best results. With four other multi-bagger styles to choose from, it might be best to leave bankruptcy investing to the experts.
“The final and fifth model I want to talk about is upside without downside. I also call this playing the bubble. In the late '90s, the dot-com boom was on in a big way, and everyone thought it's going to be transformational, it's going to change everything. Companies like Pets.com, etc., had huge valuations. Even Amazon (AMZN) was a huge valuation, Yahoo - all these companies. I had spent some time in technology. I knew that the internet was important but I could not tell which company would make it, which company would not make it. I was definitely not interested in buying anything which was even trading at 10 times earnings. I like to buy things at three times earnings, or even better, like Fiat, one times earnings.”
This "playing the bubble" strategy is quite a fascinating concept. What Pabrai goes on to describe is a strategy that makes the most of a bubble environment by finding stocks or investments that are set to benefit from bubble prices, but are insulated from the crash and can achieve returns in any situation.
An example given was that of a private equity company, which was investing in the dot-com bubble through hundreds of small internet businesses.
The benefit of this model is that if the bubble bursts, the firm is so well diversified it is bound to profit. At the same time, Pabrai was able to buy in at a valuation that did not reflect the valuation of the underlying assets, therefore exposing him to plenty of bubble upside with limited downside risk.
Disclosure: The author owns no stocks mentioned.
