In his book, “The Dhandho Investor: The Low-Risk Value Method to High Returns”, author and hedge fund manager Mohnish Pabrai (Trades, Portfolio) talked up businesses that offered low risk and high returns. In chapter 13, though, he discussed businesses that represent low risk and high uncertainty.
To underline that distinction, he wrote, “Wall Street sometimes gets confused between risk and uncertainty, and you can profit handsomely from that confusion.” Getting more specific, Pabrai added that Wall Street hates uncertainty and punishes companies with uncertain prospects by driving down their stock prices.
The entrepreneurs he admired and emulated all found businesses that may have had uncertain futures. But they also demanded little risk or little capital, reducing the odds of a serious loss, and they were simple businesses so some reasonable assumptions about their future could be estimated.
To illustrate the point, he turned to Stewart Enterprises (SWX, Financial), a funeral home aggregator. Typically, individual funeral homes had been highly certain thanks to demographics and lack of disruptive changes. Many aggregators, however, got into the industry in the 1990s and four of them turned into billion-dollar operations. The others were Loewen, Service Corp. (SCI, Financial) and Carriage Services (CSV, Financial).
With the competition, companies like Stewart had to pay ever-higher multiples to buy mom-and-pop funeral homes. As a result, many aggregators, including Stewart, ended up with heavy debt loads. Loewen went bankrupt and Wall Street went sour on the remaining three. The price of Stewart shares plunged from $28 to $2 in just two years.
Pabrai found Stewart and Service Corp. in late 2000—because their price-earnings ratios were less than 3. In subsequent research, he discovered that funeral homes had the lowest rate of failure for any class of business. Also, pre-need sales represented 25% of total revenue; that is, operators were often being paid many years in advance of the need to provide services—which is even more attractive than collecting annual insurance premiums in advance.
Wall Street was assuming Stewart would need to follow Loewen into bankruptcy, but by reading the financials, Pabrai realized that, at worst, the company could pay off its debt by selling 100 to 200 of its 700 funeral homes and cemeteries to eliminate its debt altogether. That, coupled with strong, ongoing cash flow from the individual funeral homes meant there was very little downside risk and a lot of upside potential.
Pabrai Funds committed 10% of its cash into Stewart at less than $2 per share. Just months later, the company announced a plan to sell its international properties, properties that were not generating much cash flow. That was expected to bring in $300 million to $500 million. By March 2001, the stock price had risen to more than $4 per share and Pabrai sold his holding. Once the proposed sale of international properties was completed, the share price roughly doubled again to $8 per share.
The big takeaway? Pabrai wrote, “Wall Street could not distinguish between risk and certainty, and it got confused between the two. Savvy investors like [Warren] Buffett and [Benjamin] Graham have been taking advantage of Mr. Market’s handicap for decades with spectacular results.”
The second case study involved Level 3 Communications (now part of CenturyLink (CTL, Financial)). While Pabrai would normally ignore tech companies because they aren’t simple, he discovered that Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial) was rumored to have bought $350 million worth of Level 3’s distressed bonds (a rumor that was later confirmed). Since Pabrai enjoyed reverse engineering Warren Buffett (Trades, Portfolio)’s investments, he made an exception in this case (Buffett, too, is normally a technophobe).
In the 1990s, the company had spent $10 billion building a fiber-optic network in the U.S., Asia and Europe. It used debt to help finance the project, and by 2001 had about $6 billion of debt outstanding. Wall Street, on shallow research, assumed the company would not be able to handle the debt. As a result, the company's unsecured bonds were trading between 18 and 50 cents on the dollar, which Pabrai said was “stunning for any business that is not in bankruptcy.”
The company insisted it would not run out of cash, that it had enough to get to breakeven, while 80% of its future capital expenditures were tied to future revenue. Wall Street analysts, though, were predicting a $500 million cash shortfall because they had not factored in potential reductions in capital expenditures if revenue was reduced.
It’s a company with which Buffett would have been familiar. It was founded in Omaha, Nebraska by his friend and associate Walter Scott Jr. Not only was Scott a member of Berkshire Hathaway’s board of directors, there were personal connections going back to Buffett’s high school days.
Pabrai committed 10% of his funds to these senior and convertible bonds, at 54 cents on the dollar. He sold his holdings in the third quarter of 2003, when the price had risen to 73 cents on the dollar, and while waiting had collected interest yields of more than 20%. He took care to sell the bonds on the 366th day after he bought them, ensuring preferential tax treatment. His average annualized gain worked out to nearly 120%.
The third case study was Frontline (FRO, Financial), a crude oil shipping company. Pabrai found it by scanning a Value Line listing of stocks with the highest dividend yields, his rationale being that sometimes companies have high dividends because their share price is deeply undervalued. In this case, he found two shipping companies yielding more than 15%. They were Frontline and Knightsbridge Tankers (no longer listed).
Again, this was a case in which a modest amount of research led to a contrarian position. Wall Street had failed to understand the nuances of the crude shipping industry’s highly volatile nature and driven down Frontline’s share price. Pabrai was able to buy in at $5.90 per share, about half of the company’s intrinsic value at the time. He sold the shares a short time later for $9 to $10.
As he wrote in his book, “Pabrai Funds had a 55 percent return on the Frontline investment and an annualized rate of return of 273 percent. Not bad for a near risk-free bet based on boning up on the nuances of oil shipping by reading a few documents. This was better than the classic Dhandho investment. Here the economics were: Heads, I win a lot; tails, I win a little!”
Pabrai’s final advice on finding such low-risk, high-uncertainty opportunities was “Read voraciously and wait patiently, and from time to time these amazing bets will present themselves.”
Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.
Read more here:
- The Dhando Investor: Margin of Safety
- The Dhando Investor: 'Investing Is Just Like Gambling'
- The Dhando Investor: Distressed Businesses and Businesses With Moats
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