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Dhandho 402: Invest in Low-Risk, High-Uncertainty Businesses
The theme of this chapter is that high uncertainty does not mean high risk. Wall Street will often elude companies with uncertain prospects, but this is what allows value investors to jump in and earn excessive profits. The author takes the reader through three examples of Pabrai fund purchases and the excellent returns that were realized.
Stewart Enterprises, an over-leveraged funeral home operator, traded at a 50% discount to its actual book value. Wall Street penalized the stock because its debt was coming due; but according to the author’s estimation, the probabilities of bankruptcy were slim. The company had positive earnings and cash flows and consisted of several businesses. Stewart was able to sell off businesses that were not cash positive and consequently pay off its debt without harming cash flows.
Even though Level 3 Communication, a telecommunication giant had cash of $2.1 billion, some of the company's debt sold for 20 cents on the dollar due to the company’s negative cash flow and uncertain industry outlook. A thorough analysis of management's plans, however, indicated that capital expenditure would not be spent unless earnings justified expansion. This meant that the company's cash reserve could continue to cover interest payments for another three years. Due to the low bond prices, the investors could recover their initial investment in interest payments alone!
Frontline, a commodity shipping company, sold at a steep discount to the scrap value of its ships in 2002. In addition, Pabrai asserts it had adequate liquidity to last several months at the miserable shipping prices that persisted in the market at the time. Needless to say, the company outlived the downturn, and Pabrai was rewarded for his investment.
Although all of the above companies were in different industries and different circumstances, each investment symbolized an investment in a highly uncertain yet low-risk position. Because of Wall Street's resistance to high uncertainty, value investors can profit by discovering investments that fall within this group.
