Pabrai on Managing Risk and hitting 100% returns

“I talk in the book(Dhandho Investor) about this concept of low risk, high uncertainty. So there’s a perception that entrepreneurs are risk takers. Well, in reality entrepreneurs avoid risk. They try to minimise risk… They do absolutely everything to absolutely minimise the downside. But they are also humans that are very comfortable with uncertainty. So they can believe a wide range of outcomes and be very comfortable.”

“You don’t try and buy businesses worth $83 million for $80 million. You leave yourself an enormous margin. When you build a bridge, you insist it can carry 30,000 pounds, but you only drive 10,000 pound trucks across it. And the same principle works in investing”

 

Pabrai believes that buying at a low enough price will help to mitigate the risk.We shall look into the Stewart Entreprise case study to get a better glimpse of his thought process.

Stewart Enterprises (STEI) is the second largest company in the “death care” industry worldwide. Stewart has about $700 million in annual revenues and owns about 700 cemeteries and funeral homes in nine countries, with the bulk of them in the United States.

• Stewart was trading at about $2/share for several months during Q3 and Q4 of 2000.
• At the time, Stewart had a book value of $8.50/share. It was thus trading at less than ¼ of book value.
• At the time, Stewart’s free cash flow was about $0.72 cents/share. The stock was trading at less than 3 times cash flow
• In a business with predictable cash flows

Risk

Highly leveraged company with 500 in debt due in 2002

Wall Street assumed company would default and market forces drove the stock down to $2

Possible scenarios

Over the next 2 yrs

1.Management decides to sell off the numerous family owned funeral homes it had acquired over the years. The company would raise enough capital to meet debt obligations

2. Based on the predictable solid cashflows the business was generating, it could ask bankers/ /lenders for loan extensions

3.Stewart Entreprises goes into bankruptcy and is forced by courts to restructure ( e.g. selling off assets to raise capital )

Pabrai believed that the stock was mispriced at $2/share and calculated an intrinsic value of at about $4/share based on higher P/FCF multiple (from 3x FCF to 5-7 x FCF) .He bought shares at $2/share in Q3 and Q4 of 2000 In Q4 2000, Stewart Enterprises announced plans to sell off the funeral homes and this drove the share price higher to $4/share by Q1 2001

Pabrai had made an almost 100% gain in Steward Enterprises(<9mths)

Conclusion

1.Understanding the business model is crucial
2.Distinguish between risk and uncertainty. There was high uncertainty surrounding Stewart Enterprises but it was a low risk to shareholders (i.e. Stock was trading at 3x FCF and ¼ of book value)
3.High uncertainty but low risk events such as Stewart Enterprises can provide v high returns (i.e. 100% gain <9mths)>

Singapore’s Stock Guru on making millions

Here are some excerpts from an article on Peter Lim who is well known in Singapore for his investing prowess. Some of his better investing bests were FJ Benjamin and Wilmar International.The last part of the excerpt bears a striking resemblance to a key Buffett tenet which is invest in honest and excellent management.

1.An investment in fashion retailer FJ Benjamin, has grown from about $13 million to $60 million SGD over five years

2.An initial stake of $10 million SGD in Wilmar International(ard 1991) has grown to over 1 billion SGD

What Peter Lim Says:

“I can’t say I invested in the right company, because at that time, there was only a vision. The potential palm oil plantations were just swamplands,’ he said.

‘It was at the Equatorial Hotel. I spent a few hours with Mr Kuok(Wilmar’s founder). This man made me feel very inadequate. He had a vision, and could explain, step by step, how to attain this vision.’

But that ‘quality face time’ is in a nutshell how Mr Lim decides on all his investments.

‘I must see his face. The person should be master of his trade, and should be honest.”

Regards,
Manpreet

Buffett explains how to hit 50% returns

Found an excellent post on Buffett and how he can generate 50% returns on smaller sums.Once again, one does not need any fancy finance theories to generate market beating returns but rather patience and a little bit of detective work.

Link

Enjoy,

Manpreet

Buffett on Managing Risk

Buffett on Managing Risks

Came across this excerpt from Buffett about managing risk and i feel it gives us an exceptional look into how Buffett views risk when buying stocks

“We bought all of our WPC holdings in mid-1973 at a price of not more than one-fourth of the then per-share business value of the enterprise. Calculating the price/value ratio required no unusual insights. Most security analysts, media brokers, and media executives would have estimated WPC’s intrinsic business value at $400 to $500 million just as we did. And its $100 million stock market valuation was published daily for all to see . Our advantage, rather, was attitude: we had learned from Ben Graham that the key to successful investing was the purchase of shares in good businesses when market prices were at a large discount from underlying business values“

Buying a stock/business at a huge margin of safety helps mitigate losses.Moreover, with the case of Washington Post,he had an excellent management running the business that had a local monopoly in where it was based.So by understanding the business well and buying at a huge margin of safety when the markets were bearish helped Buffett manage his risks and carve out his investment record.Indeed, the man is a genius!!

Regards,
Manpreet

Eddie Lampert on Managing Risk

As investors, risk management is an essential tool.However, the problems of modern portfolio theory and the use of Beta to determine WACC, make us uncomfortable.Beta as a measure of a stock’s past volatility does not equate to anything substantial and is a poor indicator of risk.So how does one manage risk? While rereading Lampert’s shareholder letter 2006, i came across this interesting paragraph

“Indeed, business is about managing risk. When these risks come in other forms, they are not always accompanied by the same level of detailed disclosure in public filings. Doing business in California will always carry “earthquake risk” and doing apparel business in winter clothing will carry “weather risk.” Investors and executives focus on some of these risks and tend to overlook others. If a company’s risk-management process is a robust one, the level of focus will be proportionate to the amount of risk and the probability of the risk occurring, as well as whether or not the risk can be effectively managed. At Sears Holdings, we try to manage risk in an effective way whether it is in our investment decisions, our real estate decisions, or our product line decisions and we are prepared to take risks where we believe the probability of success justifies the investment.We will not always be successful, but if we do a good job of evaluating opportunities and executing on them, we believe that our shareholders will be well rewarded”

Here, Lampert suggests that as investors ,we intend to overlook some risks while focusing on others.So for Lampert, risk management means being prepared for unexpected risks that may appear from nowhere.Another key point is the probability of success needs to be high enough to justify the investment.For Lampert who often buys larges stakes in companies and usually forces management to heavily buyback shares or allocate capital,this means one needs to be conservative with his capital and ensure the probability of success is very high.With the case of Autozone, he forced management to aggressively buy back stock .A share buyback would reward existing shareholders and be an excellent yet conservative way of allocating capital.After all,management is basically increasing the stake of its existing shareholders and not chasing risky acquisitions for growth.Once the stock rebounds, shareholders can then cash out and realise their returns ,provided they had bought it when it was relatively undervalued.What an excellent way to manage risk!

Regards,
Manpreet

Dell Updates

I wouldn’t say that Dell has been performing off late but it is undergoing an overhaul as led by founder and CEO , Michael Dell right now and is sure worth a second look.

The most recent announcement states that it will cut approximately 10% of their work force. 10% of the workforce would amount to 8800 jobs. Based on 8800 jobs, assuming each job pays USD 2000 a month, the jobs cut will effect a savings of $211,200,000 a year. Do take note that this is just a proxy to how much they can save. $2000 per month may be either too high or low a figure and may not be accurate. Despite this, some analyst have done some figures and claim that the 8800 job cuts can help the company save approximately 600 million per year. Based on such claims, the assumption is that each worker in Dell earns on average $5681.81 per month.
Whatever the assumption, i am sure you do get the picture, Dell’s restructuting efforts will lead to cost savings which in turn will lead to better profit after tax figures asumming other factors constant.

Using 2006 fiscal year financial statements, Dell had an EBIT of 4.3 billion approximately. Projecting a growth of 15%(I am being ultra conservative as 22% is the CAGR for the last 3 years) from 2006, 2008’s EBIT would be approximately 4.9 billion and with a 200 million savings and 1 billion in taxes would produce a net income of approximately 4.1 billion compared to 2006 income of and its eps will be approximately $1.80 with 2.27 billion shares outstanding.

With a current PE of approximately 20, it should trade at a price of conservatively $36 in 2008.

With the more aggressive assumption of 600 million in cost savings a year, its 2008 net income would be 4.9 billion + 600 million – 1 billion in taxes = 4.5 billion in net profit after tax and its eps would be approximately $2.

Currently trading at a PE of 20, it should trade at $40 in 2008.

However, i do have to disclaim myself that these figures are ball park figures and will not be accurate and this is the quick and dirty method of calculating target prices. If you want figures with greater accuracy, do try to work it out on a spread sheet.The most important thing is that when it comes to financial modelling, do try as best as possible to be conservative. In my opinion, using a dcf analysis, it should trade at around $35 – $42. And Manpreet and I agree that barring any unforseen circumstances, the catalyst is Michael Dell and his new found strategies.

And finally, one point to note is that Mason Hawkins a value manager is a substantial shareholder holding greater than 5% of the company.

Do your own homework ladies and gentlemen. You might find yourself disagreeing with me.

Remember Apollo???

Dear readers!

Remember Apollo???!!! The article i wrote a while back. Do refer to my previous article on Apollo.

For the recent quater, they have beaten analyst estimates. And what i did not expect was the stock shooting up till $58 . I woke up one morning in Hong Kong amazed to find out that the price has shot up and it made me tremendously happy to know that my hypothesis was right. Usually, when there is lots of pessimism surrounding a stock, analysts will place over conservative estimates on the company. But this time the analysts were wrong and the market responded enthusiastically.

No one’s valuation is ever correct. That being said, i am prepared to sell it when it reaches my intrinsic value of around $70.

On hindsight though, do allow me to critique my investing skills and be completely honest with everyone. I feel that compared to strayer education, this company generally has a poorer set of management. They are trying right now to diversify into other companies which i feel may not be aligned to their main business as online educators and may be willing to over pay for an acquisition. Clearly, management lacks a certain focus in their directions.

Online education in my opinion is set to grow in the years to come. The world needs to reach out to such an audience and Apollo is well positioned to do just that. However, with its recent options back dating woes and its inability to read the market, management just does not seem to know their real growth potential and despite its excellent cash flow, may be allocating capital in the wrong manner.

On hindsight, i know i did buy the wrong company as there were better candidates around.

Oh well, everyone learns don’t they?? 🙂

Better and better,
Lucas

Summary of Charlie Munger USC 2007 Speech

Charlie Munger USC Law Commencement 2007

Accounts and Attitudes that have worked for me

Core Ideas

1. Safest way to get what you want is to deserve what you want

2. No love that is so right that is admiration based love and that love should include the instructive dead

3. Wisdom Acquisition is a moral duty
a. Warren Buffett is a continuous learning machine
b. The skill that got Berkshire through one decade would not have sufficed to get it through the next decade

4. Rapid advance of civilization came only when men invented the method of invention

a. You can progress only when you learn the methods of learning
b. Learning should be continuous
c. Half of Warren’s time is sitting on his ass and reading the other half is spent talking on the phone or in person to highly gifted person that he trusts and trust him

5. Learning all the big ideas in the big disciplines
a. Not good if you don’t practice it
b. Multi disciplinary approach can be dangerous – it works so well – that you can be in front of an expert and you will see a correct answer that he has missed and must be tactful to avoid causing offense
c. Cicero famous for saying (my paraphrase): a man who doesn’t know what happens before he is born is doomed to go through life like a child
d. Learn them in such a way that they form a mental latticework in your head that you can use in everyday life situations

6. Work Problems in Reverse
a. Inversion will help you solve problems that otherwise couldn’t be solved

7. Avoid sloth and unreliability

8. Avoid really dead ideology
a. I tell myself I’m not entitled to have an opinion on a subject unless I can state the arguments against the position better than the people who are supporting

9. Avoid self serving bias
a. You should not believe that you are entitled to do whatever you want to do
b. Live below your means – Mozart was mostly miserable because of this

10. Avoid Self Pity
a. Disastrous behavior
b. Avoid it in yourself but allow for it in others
c. When encounter it try to reflect it by appealing to the interests of that person, do it of lofty motives
d. Never improves any situation

For the complete summary

Link

Buy Quality says China’s Warren Buffett

Here is an article on an investor who has made a fortune in the chinese stock market by buying quality companies.It always amazes me how the principles of value investing are able to work so well in capital markets other than the US despite different regulatory climate.Somehow , the principles of value investing are universal and allow one to profit handsomely provided one does his due dilligence.

Link

Blast from the Past

Firstly,apologies for the lack of recent posts.I came across this interview and just wanted to share with the rest of the value investing community.Here is an old message board post dated Feb 24,1996.An old stockbroker recounts a chance meeting with the legendary Benjamin Graham.

You asked me to elaborate on a meeting I had some years ago with the late Benjamin Graham and to make this information available to this discussion group.
In order to make my discussion of the meeting meaningful, it is necessary to briefly discuss what had led up to my meeting. On September 23, 1974 Barrons had published an interview with Mr. Graham under the title, Renaissance of Value. In that discussion Mr. Graham described how he and others had made money in the stock market for many years.

He had formed a small hedge fund (assets $5 million) to invest in undervalued stocks. They mostly bought shares in companies which were selling below net net working capital. To determine net net working capital, current liabilities, long term debt (if any) and any preferred stock are subtracted from current assets. The remainder is net net working capital. Let’s say that net net working capital per share is $20. If you can buy the stock at, say, $15 you almost certainly have a bargain. If you bought an entire company at that price you would get the
fixed assets free, the fact that it was going business free and the use of the company name (if it is valuable) free. That is what his fund, the Graham-Newman fund did. They also were involved in arbitrage. Remember that this was before many people had access to computers. Let’s say the
same company shares trade in London and New York. If there was a price difference they would lock that difference in hoping to perhaps earn 15% on their money with no risk. For example, if Imperial Chemical sold at $21.50 in London and for $20 in New York you could short the London stock and go long the U.S. stock and make the spread.

I understood instantly how they had made a lot of money and began investing in net net working capital stocks myself. The difference was immediately apparent. I had winners and some which didn’t do much but I didn’t have any serious losses in the companies which did poorly after
purchase. For the first time, I began to make quite a lot of money in the stock market. We had just come through a two year drop which did not hurt either. I contacted Mr. Graham through Forbes and flew out to meet with him in La Jolla in the spring of 1976 (he died later that year).

I was a stock broker at the time and was full of the usual questions.
When do you sell? Can you predict the stock market? How many stocks should you own etc.? In each case he would cite their experience. He thought it a waste of time to try to predict the stock market and found such questions foolish (his pupil, Warren Buffet and Peter Lynch would agree). He advised selling if a stock went up 50% or at the end of two years. His reasoning was that a depressed stock ought to rise in a couple of years or perhaps the company problems were insoluable. If is important to note that net net working capital purchases tended to be in companies with lots of problems that were not suitable to long term holding. When Warren Buffet bought Berkshire Hathaway he was following in Mr. Graham’s footsteps but later, apparently under the influence of Charles Munger, he began buying better companies and holding. Mr. Munger and Mr. Buffet had the better idea. Finally, he thought ought to buy
shares in at least 15 companies. Some of his followers bought shares in dozens of companies and still earned great returns. Charley Munger, on the other hand, when he ran his partnership owned shares in very few companies.

All of his ideas were mechanistic by which I mean he had mechanical rules for buying and selling, etc. The reason was that he feared emotion overruling an investor’s judgement. The rules forced the investor to act rationally. Warren Buffet’s method of investing is much more flexible. You may know that Warren Buffet studied under Mr. Graham at Columbia University and worked for him at Graham-Newman for three years.

For a great picture of Benjamin Graham (and Warren Buffet), you may want to read, Supermoney by Adam Smith and the chapter, Lessons of the Master (the Master being Ben Graham). Sorry this response is so long but even this discussion is cursory. Hope this is what you had in mind.

Marshall Delano