This article is Part 2 of a three-part series. The first part can be accessed here.
At the Pabrai Investment Funds annual meeting of 2004, Mohnish Pabrai described his evolution as a focused “special situations” based value investor with the following key points:
- Contemplating on “The Warren Buffett Way” in 1994 led Pabrai to develop the core constructs for his funds from which he has not faltered since then – concentrated portfolio, buy value, circle of competence, and buying a business not a stock.
- Pondering over Tim Vick’s “Wall Street on Sale” and “How to Pick Stocks like Warren Buffett” in 2000, was pivotal in pointing him towards “special situations” investing.
- Buffet’s essays on the 17 year market cycles and the prediction the 1999-2016 timeframe will provide 3-5% in real annual returns motivated him further to be “special situations” based value investor.
Indeed credit for the outstanding performance of his portfolio can be attributed equally to the “special situations” investing decisions, idea of concentrated bets, and his expertise in valuing businesses. The highlights from the early years include:
- Stewart Enterprises (STEI): Pabrai Investment Funds bought Stewart Enterprises in the 3rd and 4th quarters of 2000 when the stock was trading at less than thrice the cash-flow. The company was leveraged and had $500 million in debt due in 2002. When most everyone else assumed the company would declare bankruptcy, Pabrai anticipated that the debt could be handled by selling back some of its funeral homes back to previous owners. The scenario unfolded as envisioned with the company selling a number of international funeral homes and the stock price rebounded to $4 in the 1st quarter of 2001. Pabrai exited the position with over a 100% return in less than nine months.
- Level 3 (LVLT) Convertible Bonds: Pabrai Investment Funds invested in Level 3 convertible bonds (2002) on recognizing the market had mispriced the bond – in spite of having $2.1 billion in cash, Level 3 was cash-flow negative. However management had no plans on spending cap ex, unless revenue justified expansion. That meant, interest payments for three years would be met with the cash reserve. As the bond was priced at 20 cents on the dollar, in this timeframe the investor could recover his investment in interest payments alone. Remarkably, Warren Buffett employed the same strategy independently.
- Frontline (FRO): The Frontline investment came upon recognizing the company was trading at a significant discount compared to the scrap value of its ships in 2002.
- Tesoro Petroleum (TSO): Tesoro Petroleum, an investment made in early 2002 at an average buy price of $7.52 per share, was sold two years later at an average sell price of $15 for an almost 100% return. Pabrai’s normalized cash flow and sum of parts analysis of the company indicated equity was trading at a discount of more than 50% mainly due to high debt levels. As management was selling non-core assets, Pabrai figured some refineries could be easily sold in a cash-crunch. The stock went on to lose more than 80% in the following six months, trading at $1.33 (October). Pabrai steadfastly held on to that position and exited 18 months later after doubling the value of his original investment. For individual investors, this is a great lesson on the virtues of patience and conviction in choosing and sticking to one’s bets in the face of a market assault.
- Fremont General (OTC:FMMH): Fremont General, an investment made in late 2002 at an average buy price of $4.57, was sold in early 2004 at an average sell price of $25.10 for a return of almost 300% in less than thirteen months. Pabrai recognized the mistake the otherwise good management at FMT had made by delving into worker’s compensation insurance. The problem was fixed by discontinuing and selling businesses, but the market was still mispricing the firm. The heavily shorted stock rode the mortgage boom very well and the stock of the company advanced.
The last five years saw a number of investments returning well over 100% but there were also some duds. Below is a chart that shows his five biggest bets in each of the last five years: Below are some observations:
- Ternium (TX): The Ternium stake was acquired in the 2nd quarter of 2007 when price per share ranged between $25 and $40. At purchase time the stake accounted for more than 15% of the total portfolio value. By year end, the share price was at $40 and the stake accounted for 18.5% of the portfolio. The share price dipped to $5.54 the following year but Pabrai held steady until the 4th quarter of 2009 when the share price climbed up to between $25 and $37. The Average Buy Price was $26.98 and the Average Sell Price was $28.40 giving ~5.2% in profit in the 2+ years of ownership. Mohnish Pabrai’s investment thesis on Ternium included an intrinsic value estimate of $55 per share. The company, a low-cost producer with dominant market share in Mexico and Argentina, was controlled and managed by Rocca family whom he considered “world-class folks”. The stock was depressed due to the uncertainty surrounding the nationalization of its Venezuelan subsidiary. The recession followed by nationalization resulted in the extreme drop in stock price at the end of 2008. Ultimately, Rocca negotiated and collected from President Chavez resulting in volume and cash flow rebound which translated to an 8-fold increase in the share price in the following 18 months.
- Sears (SHLD): The Sears Holdings stake initiated in the 4th quarter of 2007 was sold-off completely by the 2nd quarter of 2009. The Average Buy Price was $133.12 and the Average Sell Price $53.56 - a whopping 60% loss in less than two years. Sears was an unusual investment in that it was against his conviction “retailers aren’t worth the risk”. The primary argument of the investment was how impressed Pabrai was with Eddie Lampert and how low the valuation of Sears was, when looked at as a collection of assets. He failed to grasp Sears had 324,000 employees standing in the way of monetizing those assets. In the 2009 annual meeting, he discussed this investment and concluded with the following quote from Buffett: “When a management with a reputation for brilliance tackles a business with a reputation for poor fundamental economics, it is the reputation of the business that remains intact.”.
- Fairfax Financial (OTCQB:FRFHF): Fairfax Financial was an unusual holding too - a long-term holding present in the first 13F filing (12/2004) was sent on its way completely by the third quarter of 2010. Fairfax Financial and Harvest Natural Resources are the only stocks that survived till 2010. Also atypical was the size fluctuation of the position. It varied from a low a 58,000 in 2008 to a high 314,000 in 2007. It is likely that Pabrai used the holding as a store of value and liquidated the position as needed on an ongoing basis.
- Teck Cominco (TCK): TCK, a stake initiated in the 4th quarter of 2008, was sold in the 1st quarter of 2010. The Average Buy Price was $4.33 and the Average Sell Price was $37.08 bringing the realized gain to 763% including dividends over a period of 13 months. TCK is the best performing exited position in the history of Pabrai Funds. The investment theory was based on the stock price mismatch due to a combination of high debt financed partly through a bridge loan and uncertain free cash flow due to a precipitous drop in commodity prices. Further, if TCK were to file for bankruptcy, the common stock would still have value and options existed to handle debt: cancel dividend, asset sales, extending term loans, etc. Ultimately, the commodity prices improved, some loans were extended, and cash was raised by selling assets, issuing bonds, and equity. The clarity resulted in the stock price bouncing eight times in the space of 13 months.
- Harvest Natural Resources (HNR): HNR was a large 10% holding, per the first 13F filing (12/2004). The stake was tripled in 2005 and was increased by another two-thirds in 2007. It remained steady through 2009 but was disposed off completely by the 1st quarter of 2011. Oddly, a small stake was re-initiated as of the latest filing. Again, Pabrai may be using the holding as a store of value.
- Pinnacle Airlines (PNCL): PNCL is a small (2.5%) stake initiated in 2005. The stake was increased by four-fold by 2007 and the stock price went up from a low of ~ $5 to ~ $19. By 2007 end, PNCL was the fifth largest position accounting for around 12% of the portfolio. By 2009, as the share price tumbled, the stake was trimmed by a third. Since then, the stake has remained steady (~2 million shares) in spite of the stock price trending down. The investment rationale revolved around the fact PNCL had $10 in cash per share on the balance sheet and the free cash-flow was estimated to be in the $3 to $6 per share range within the next few years. The thesis is yet to play out completely and at the moment the funds are sitting on sizable losses.
- Brookfield Infrastructure Partners (BIP), Brookfield Properties (BPO), and Potash (POT): BPO, BIP, and POT are very large investments accounting for more than 50% of the portfolio per the latest filing. The funds have sizable unrealized gains on those investments.