I'm an infrequent investor. I try and buy shares in a company I like, with management I like, at a price that I like and then sit back and wait. If my entry price is attractive and the management team is good then I don't need to do much else.
One of my favorite quotes is this one from Jesse Livermore:
"After spending many years in Wall Street and after making and losing millions of dollars I want to tell you this: it never was my thinking that made the big money for me. It was always my sitting"
That sounds good to me, I'm a much better sitter than a thinker.
Because I seldom buy or sell anything I end up spending quite a bit of time reading. This week I found myself reading an interview with one of my favorite investors, hedge fund manager Monish Pabrai.
The interview covered one of Pabrai's main investing concepts that he incorporates into an investing style he calls "Dhandho Investing."
As I read the article I had to wonder why in the world does Pabrai have Chesapeake Energy (CHK) as one of his core holdings?
The key concept I'm talking about is that rule number one is "don't lose money." In the interview, Pabrai described it as follows:
When I'm looking at an investment, I now look at it like the way I looked at my first business, which is, the first thing I'm looking at is, how can I lose money on this? And can I absolutely minimize my downside?
The upsides will take care of themselves. It's the downsides that one needs to worry about, which is why even the checklist becomes important. But so the important thing that value investors focus on is downside protection. And that's exactly what entrepreneurs focus on--what is my downside? So that is the, I would say, the crossover between entrepreneurship in investing, and value investing especially, is protecting your downside.
According to Pabrai priority number one is only investing in situations where there is little chance of losing money.
Pabrai runs a concentrated portfolio. He makes very few investments and according to him is interested in only opportunities where the risk is skewed heavily in his favor. He wants opportunities where there is little chance of losing money, but a also offers a chance of making a lot of money.
Those opportunities are rare, and Pabrai views them as being "low risk, and high uncertainty." The actual chance of losing money is slim, but the even so the investment is offered at a very attractive price because there is considerable uncertainty surrounding the company for one reason or another.
The market hates uncertainty and often mistakes it for risk.
I love the concept and think it is a terrific way to invest.
What I don't quite understand is how Chesapeake Energy fits with into the area "low risk and high uncertainty." I view it more as having plenty of upside if things go right, but enough debt and exposure to commodity prices to create a significant chance of losing money.
Here are Pabrai's current holdings according to his most recent filing:
Bank of America
I believe that Pabrai has almost 20% of his fund in cash and may have some positions in some foreign equities which aren't disclosed in the SEC filing so the above weightings are a bit misleading. Nonetheless he clearly has a lot of his fund's cash exposed to Chesapeake.
I don't disagree with the idea that Chesapeake could be a good investment, but how is it a low downside opportunity?
The company is very heavily leveraged and is exposed to the volatile world of commodity prices. Surely that could create a situation with considerable downside couldn't it?
Chesapeake is a company that has been on a long term spending spree, with annual cash outflows far in excess of the cash coming in.
In 2010, 2011 and 2012 Chesapeake spent over $10 billion each year while operating cash flow has been only $5.1 billion, $5.8 billion and $2.8 billion in those three years respectively.
Chesapeake has bridged a considerable chunk of that spending gap by selling off parts of its excellent unconventional asset portfolio, but it has also rung up a big debt bill.
All of that spending helped build a great set of assets, it also bit a bit of a wobbly balance sheet.
The slide above (from the Chesapeake investor presentation) shows Chesapeake's long term debt and working capital deficit. Combined they total almost $17 billion.
Last year's with a seriously depressed natural gas price cash flow from operations was all of $2.8 billion. That ratio of cash flow to debt makes the company incredibly leveraged.
Thankfully natural gas prices have improved from disastrous levels to something more manageable.
The slide below shows that cash flow for 2013 with a recovery in natural gas prices and production that is more weighted to liquids is expected to improve to the $5 billion range. That is better than 2012 to be sure but still very leveraged at more than 3 times cash flow.
Chesapeake has a wonderful portfolio of acreage in the various unconventional oil and gas plays situated in the United States. The company is continuing to sell off pieces of that portfolio to bring down debt and fund drilling.
That is a strategy that will work well until it doesn't. If we go into another global recession or financial panic that kills commodity prices and basically closes the capital markets Chesapeake would lose the ability to sell assets any sort of reasonable price.
I'm not saying such a situation is likely, just that it is possible. This is a company that is relying on the fact that third parties are going to be interested in buying assets from them.
That puts Chesapeake in a position where it might not be in control of its own destiny.
And that is what makes me wonder how Pabrai (one of my very favorite investors) views Chesapeake as a "low downside, high uncertainty" situation.
I don't dispute the fact that Chesapeake could make for a great investment, I love the assets the company has and think the debt overhang creates a real discount in how the market values them. I'm also very aware that Mr. Pabrai is much, much smarter than I.
I'm just not sure that Chesapeake fits with the "Dhandho" philosophy.