Pabrai’s Take On Sub-Liquidation Value Investing

(If you didn’t know, Pabrai’s the guy to the extreme left. )

Mohnish Pabrai had always been an inspiration to me. For one, he did not really have a background in finance. Rather, he was engineer trained and eventually started out a business called Transtech, an IT consulting company. After selling his company to Kurt Salmon Associates for $20 million, he turned his sights to investing.

Although not many people speak about Pabrai’s ideas from a mathematical standpoint, his ideas are very much risk-reward driven. And of course, he mentions all too elegantly the idea of “Heads I win, Tails I don’t lose much”. This is nothing more than a payoff with a positive expected return. In this little statement about, if you have read some of Pabrai’s writings, you will understand that it is really the large payoffs that Pabrai guns for. Because us humans are not conditioned to think in a fermat-pascal framework, we readily confuse risk with uncertainty and there can be huge opportunity costs involved as an investor. While there may have been some big blow ups in Pabrai’s portfolio, there were also some tremendous winners and that has nudged him closer towards investment greatness. So the idea is to come up with different scenarios and place probabilities on each scenario materialising. Then, if the company has a positive expected returns, that company is worth a further look. This is the realm of probabilistic thinking and probability theory.

So just to give you an example of the above. Suppose a company is priced at $1 per share right now and it is trading at one-fifth of its tangible book value. Suppose that when conditions normalise, it would trade at its tangible book value of $5 per share, which is a 400% return. It looks distressed and perhaps rightly so for it has some upcoming debt that will mature and needs refinancing. As such, there is a fair amount of refinancing risk. In the case of a credit crunch, refinancing can seem difficult. So if an investor thinks  that there is a 40% chance of the company going bankrupt, he also seems to think that the company has a 60% chance of being worth $5 sometime in the future.

The expected return is : 0.4 X -100% + 0.6 X 400% = 200%

And that you see is a positive expected return my dear friends.

On the other hand,  let’s look at a company that has the same accounting data as the one above with a tangible book value of $5 per  share, but, this time, it trades at $4 per share. Again, there is a 40% chance of it going to $0 and a 60% chance of it going to $5.

In this case, the expected return is 0.4 X -100% + 0.6 X 25% = – 25%

It is negative in an instance like this.

So let me break this down for you. In an instance like this, the expected return is negative and immediately you discard it. If you did not already notice, the price you pay makes a huge huge difference in expected returns. It can result in a huge payoff of 400% if things play out correctly. But if you pay the wrong price, it would lead to disaster with only a minute possibility of a a pay off of 25%. Hence, that is the reason why value investing works. The price you pay must have a margin of safety. Failing which, all other factors are pretty irrelevant. The margin of safety is bar far one of those critical concepts that investors must embrace to have consistent market beating returns over the long run.

This is critical. And yet, I feel, may investors fail to see it and appreciate it. Anyway, back to Mohnish Pabrai. This is what Mohnish is trying to do. The simplistic term for this is to have a favorable risk-reward ratio. But Pabrai had a volatile portfolio of I am not wrong. Pabrai believed in few, infrequent large bets. This would have caused a lot of gyrations to his portfolio which I think can upset the majority of investors. But that is perhaps an article for another day.

But surely, you can see what Pabrai is trying to do now. Anyway, once upon a time Mohnish invested in a company called Frontline. The company had been severely hit with an industry downturn. In around 2001, Pabrai was screening for companies with a high dividend yield. Companies with a high dividend yield either have some impending doom about them or are just completely unappreciated by the markets. This was a good place to search out for seemingly distressed companies which may not be distressed. The dividend yield is based on historical data and hence, markets often react by selling off companies with an impending industry downturn.

Frontline was a company that owned the largest oil tanker fleet in the world and rates for its tankers were in free fall. The rates for its tankers typically was around $6000 a day or more. The breakeneven rates at which the company operated at was around $18000 a day. That means that if rates fell below that number, the company’s free cash flows would be negative. If rates went above  that number, free cash flows would tend to increase. Since the company have previously given such high dividends, there was a possibility that Pabrai was at the low end of the down cycle of the industry. This is my conjecture at this point because I don’t have enough information as I write this.

There was a lot of uncertainty in the industry but one thing was for sure. The value of the tankers did not go down as much and the company Frontline, had a considerable amount of cash balance. This is where the sort of second level thinking comes into play as spoken about by Howard Marks. Pabrai considered that the company could easily sell a few tankers at around  $60 – $70 million  per tanker to pay down its interest and debt. The annual interest payments amount to about $150 million. The company’s stock price was in distress. The company however, was not. That was the general conclusion then.

Apart from that, the company had about 60 to 70 ships which implied that the company had a liquidation value per share of $16.50. Even at fire sale prices, the liquidation value per share would have been worth around $11 per share. ( I am recounting the case study he told here. But I have to say that I am not in agreement with everything written. In a fire sale, tankers, ships and vessels can go at a third of the recorded book value. So I am not sure if I would have come to the same conclusion that he did.)

Anyway, Pabrai decided to buy shares at around $5.90 according to morningstar and then promptly sold out his stake when the company reached $10 per share. So this is Pabrai’s take on calculating the liquidation value. If anything at all, a great story. And this brings me to the point that some long term assets can be calculated as part of the liquidation value. These long term assets such as land and freehold buildings have as much value as inventory and receivables.

More on these in another article.

Thank you for reading. May you be blessed with prosperity, health and happiness!

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I have been an investor for 15 years now and my journey has meandered from Warren Buffett to Ben Graham. My start, like many, really was the naive idea that Buffett's skills could be replicated in some fashion. I was proven wrong when some of the supposed stock picks that I chose had dismal performances. Then, I learnt that it is no point trying to be someone I am not. Gradually, through failure and some success in deep value investing, my approach towards stocks gradually shifted to an approach based around Graham's techniques. So, I give credit where credit is due and to Ben Graham, I and many other investors around the world, owe him a great deal. So, if you want to read up on biographies, read about Ben Graham. His seminal work, Security Analysis is a gem. My books are just rich interpretations of what he has taught.

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