The Dhandho Investor - Mohnish Pabrai

[petekoch]

A while back, I posed a question about Delta Financial (DFC) -- probably in the Value Trail thread. I asked if anyone knew of a reason to buy this issue, other than the fact that Pabrai had bought @20% of the company. The response was no, no easily determined reason. But because Mohnish was such a big buyer, I ventured in with a small (1000 share) speculative position at just under $5/shr. As the price dropped, I remember my thinking while reading A Mathematician Plays The Stock Market by Prof. John Allen Paulos. Paulos lost money with WorldCom, buying all the way down. After reading the book, I remember thinking that the reason he lost all his money was because he never considered what his risk was. That got me to thinking that I was in the same boat with DFC. I didn't really know the company's business nor did I understand the risk involved. I was just in because Pabrai made such a big play. So I sold for a loss at under $3.70/shr.

Today, Delta announced it was filing for bankruptcy and stated that it was probably no longer a going concern. Last I looked, the shares were trading for about 16 cents. I lost a few hundred dollars, but Pabrai owned over 4.6 Million shares. He bought some at $5/shr, but he also bought quite a bit at $10-15. Delta represented almost 6% of his portfolio.

So much for HEADS I WIN, TAILS I DON'T LOSE MUCH.

Fortunately, since I knew I hadn't done my due diligence, I limited my stake in DFC to a small position. I have moved into large, full positions in USG, CSE and USB. I might actually buy more USB -- I don't know of a sounder, more conservative big US bank. I'm also looking at the SNV/TSS spinoff, which is scheduled for the end of the month. I know the details of the spinoff. Does anyone have an opinion on this deal?

[npg]

They all had nice losses. This one will go down as a monumental loss for Pabrai. Buffett tanked quite a bit of money too. I believe that it was with an airline....

The way I see it is that I don't have the acumen that a guy like Buffett or Lampart possess. I cannot unpick the balance sheet of a financial institution like DFC. It's just not transparent enough. But I know quality and although the quality stocks won't give me young Buffett-like returns, I do achieve superior returns than on a savings account and that is what matters to me. There is also the insignificant fact that I am not a young Buffett either...

All that searching for the mega-big returns in the order of 50% has ever done for me was prompt me to make silly bets resulting in big losses. I know that I don't have the training nor the wiring to be another Buffett. But I don't have to be. I can patiently wait for the quality stuff to become well priced and then take my stake. Arguably, I won't make returns in the order of 20%+, but so far this nets a quite satisfactory return for me. Regularly.

Interesting to see what happens to his stake during liquidation of the business...

WFC, BCS, LYG, AIB, EIRE and WB are all top notch banks that are flirting with very attractive price levels for buyers. They all had a little run-up lately, but that can well move into rock-bottom territory again, as the next act of the sub-prime story unfolds.

I'd just sit tight and let the nice regular returns of sound investments compound.

[Roger Jones]

I have a question for NPG about cash flow vs. earnings. I ran across a site that explains valuation. This is the site :Investment Valuation: A Little Theory

The paragraph that got me thinking was this:

"Purists would say that a company is worth the present value of its future free cash flows rather than its earnings. The trouble is that you would have to know a lot about the company (and use fancier calculators!) to find values with FCF. So we'll assume that earnings and free cash flow are equivalent in the long run, and that both approximate real cash profits."

Is the above paragraph true? If it is then are earnings just as reliable as cash flow?
Peter Lynch says that in the long run stocks follow earnings.

Do stocks follow cash flow in the long run too?

Any help would be great.

Roger

[npg]

Apart from the sheer joy dedicating 12 hours or more a day to your business, what's the most important factor?

Cash.

In essence, you run a business to get cash. That makes sense, doesn't it?

The difference between earnings and cash is that the earnings don't account for the overheads of your business. This is for tax reasons. The inland revenue needs to know how much tax they expect. Overheads are then claimed apart. They are tax deductions (in a nutshell). Earnings are very important for the tax office, and are important to the investor too, but not to the same extent since capital exenditures (overheads) are a very substantial factor in how much cash you get out of the business.

Makes sense?

To me that is a lot of common sense, actually. I was very surprised when I learned about the difference between earnings and free cash flow. Current valuation dogma quasi dictates since William J Burr's book, The Theory of Investment Value, that the intrinsic value of a business is the cash you expect to receive over the lifetime of the business.

Looking at earnings alone, a business that needs to invest 10$ in order to earn 12$ is considered the same as a business that needs to invest 5$ in order to earn 12$ --wheareas clearly the profits are substantially more for the business with the lower capital expenditures.

Irrationality in markets happens when price is substantially out of sync with the cash that a business throws off. This occurs more often than you think, especially when a lot of people value a business according to its earnings without taking capital expenditure and other expenses into account. This makes for a real breeding ground for irrationality.

Note that in Phil's approach the sticker price does not take into account capital expenditures. It's too earnings centric. This is one of my main criticisms on his book.

[PrivateInvestor]

Originally Posted by npg

Note that in Phil's approach the sticker price does not take into account capital expenditures. It's too earnings centric. This is one of my main criticisms on his book.

Actually, Phil does take capital expenditures into account, but he uses other numbers for his sticker price calculation because capital expenditures are too hard to break into their maintenance and investment components when looking at the financial statements (this is a limitation of GAAP). He also maintains that the ideal Rule #1 business doesn't spend a lot of cash to maintain its operations (page 233 of the hardcopy book).

He says that free cashflow each year adds to equity each year and that free cashflow is net bottom-line earnings less maintenance capital expenditures (so far, so good). He then assumes that maintenance capital expenditures are roughly the same small percentage of earnings each year (which may or may not be exactly true, but it's probably close enough for many businesses).

He calculates sticker price by using the future growth rate of earnings as a proxy for the future growth rate of equity. He assumes that the future growth rate of earnings (subject to any adjustments by analysts) is the same as the past growth rate of equity, which is a number that can be obtained by analyzing the financial statements.

A business meeting the 4Ms should have a consistent long-term growth record, so the past equity growth rate should be roughly equal to the future equity growth rate, which in turn should be roughly equal to the future earnings growth rate when maintenance capital expenditures are roughly the same small percentage of earnings each year.

Phil also covers himself by giving himself a 50% margin of safety in case these assumptions are off.

[bovverd]

[quote=PrivateInvestor;11220]A business meeting the 4Ms should have a consistent long-term growth record, so the past equity growth rate should be roughly equal to the future equity growth rate, which in turn should be roughly equal to the future earnings growth rate when maintenance capital expenditures are roughly the same small percentage of earnings each year.
quote]

The problem I have with Rule 1 is the assumption of future earnings being roughly equal to earnings of the past. I believe this is a very dangerous assumption to make, particularly if you take into account the market trend or cycle for the last ten years.

To illustrate my point, heres a chart of the Dow for the last ten years:



As you can see we sitting at the very top of a bullish market cycle which apart from a period in 2002/03 has been heading steadily upwards from 1996.

So as we know from all the hundreds of business's which everyone has on their watchlists, there are a very large number of companies displaying fantastic growth rates for the last ten years which comply with 'Rule 1' requirements.

But my question is this: How many of these business's would continue to display the same or similar growth if the market cycle began to trend DOWN??

I believe a very large number of these so called growth business only appear to be growth business's because of the bullish market trend which we have been experiencing for the last ten years, rather than any durable competitive advantage which exists.

Its very dangerous to assume the growth of individual stocks will continue if the current market trend is expected to change.

So I would recommend anyone to revisit their watchlists and remove any companies regardless of growth which do not appear to have any competitive advantages or who are not selling recession proof products or services because WHEN the trend changes, so too will most of those growth rates.

Choosing ten previously bullish years to predict future growth can only be considered a predictable exercise if the same bullish conditions are expected to continue, and with the recent economic news and market volativity, this now does not seem very likely.