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Collection: Mohnish Pabrai - #142 'How to Profit from Uncertainty & Risk'



Hi, my name is Lisa, I’m also an undergraduate here and I noticed that one of your investing principles is that to invest high uncertainty companies and notice that in market people often interpret high uncertainty as high risk. I’m just wondering how would you differentiate or how would you interpret idea of high uncertainty and high risk.


Sure, that’s the good question. So risk and uncertainty are two different things and markets money can get confused between the two things.

So for example, if I were to let’s say look at a funeral services company, you know, company focus on either cremating or burying the dead. And let say they’re in certain geographies, we don’t know who’s is going to die in Peoria Illinois next year, but we know how many are going to die.

Okay, so if you want a predictable business there is probably no more predictable business than a funeral services business in Peoria. Okay, I can tell you 10 years from now their cash flow are going to be, even 20 years from now the cash flows are going to be. Right so, a business like that exhibits no uncertainty, right?

It’s a very low uncertainty business and generally speaking businesses with low uncertainty tend to be fully priced, they almost become like bonds, you know, because I mean if you have a real estate investment trust, it has a set of class A properties in prime locations, 95% lease, economy is doing well, you can see those cash flows for a while and you know it’s got a lot of stability to that.

On the other hand, there are businesses which by their very nature are subject to very high uncertainty. So for example, let’s say they were an oil company, right, where the revenues and cash flows are very dependent on the price of oil – they haven't hedged or anything – or let say they’re the shipping company which is – got an entire fleet on daily charters if you will.

And again, in some cases those charters can vary so much that you can get very high deltas in what the cash flows can be. So one of the cues in investing is that one should look for situations where you get the combination of the two, where you get a combination of very low risk and very high uncertainty. So when you see an example of the two together, the odds are very high that you can make a lot of money.

So I’ll give you an example, I think this was in 2001, there’s a company I invested in, it was called Frontline. It was a shipping company and what they did is they transported crude oil, so they had this VLCCs, very large crude carriers which are transporting oil between let’s say Saudi Arabia and the US and so on.

And these crude carriers are huge ships, you know, at that time they cost about $70-80 million dollars a piece and there’re two ways that people use these ships, they either do leases, you know, kind of time charters or they are on the spot market. So in the case of Frontline, they had something like 40% of the global fleet of VLCCs and they were all on the spot market.

So the spot market – VLCCs is range of daily rates varies from something like $10,000 a day to a quarter million dollars a day, it’s a huge variance. And breakeven price for these ships was at that time about there to make at least $20,000 to $25,000 a day to break even.

So what had happened in 2001, I think in 2001-2002 when I was looking at Frontline is the – there was a glut of ships, too many ships and not enough crude being shipped around and so as a result shipping rates had collapsed. And at that time shipping rates were around $10,000 or $12,000 a day, so Frontline’s fleet was losing money and the stock price went down to something like $3 a share.

So these ships also have active market of being bought and sold, so I could look in for example, Clarksons for the publication, I could look at what the distressed selling price of the ships were at that time and in the entire company just sold everything at a distressed price they would get something like $11 a share.

So it was trading at, you know, huge 60-70% discount to liquidation value mainly because there was fear, right, I mean this is like, there is – this kind of the midnight of the oil shipping business if you will.

And now the other nuance, you know, we talked about mental models since we have some time, I’ll just make this a little bit more detailed.

There’s a friend of mine who is in the real estate business, and you know, he was telling me that Class A office towers in major urban areas normally take 3-5 years from the time someone thinks about them to the time they’re ready, takes a long time.

And usually what happens in the real estate business is that when occupancy gets really high and vacancies are very low in these Class A towers, everyone and their brother plans to build them, but the thing is it takes 3-5 years to build it by the time they get built, they all hit the market at the same time and then everything collapses.

So in these real estate tower, you have this boom and bust cycle going on because they’re like lemmings, you know, when everything is jamming, everyone and their brother is building and they all come on the market at the same time.

The VLCCs are very similar in the sense that it takes a couple of years, two years, three years to get a VLCCs built in our Korean shipyard and usually when the rates are really high, you know, $80,000-$100,000 a day, everyone and their brother places orders.

And what happens is that on a $70 million VLCC, you can place an order by giving them $2 million or a million, you know, you don’t put up a lot of money, it’s like ordering model 3, thousand dollars gets you the model 3.

And so on the other side, when rates go to $10,000, nobody wants to place orders, you know, there’re no orders been placed, just like there’re no tower been built. And so what happened in the VLCC market when these rates go to like $10,000 scrapping increases because they can scrap the ships – the old ships – and get a lot of instant cash from the steel value.

So what happened in the VLCC market is that when these ships – there's a glut of these ships, there’s excessive scrapping taking place. But when those ships get scrapped and then the demand comes back up, you cannot instantly have more ships and so the only thing that happens is the price changes.

So I bought Frontline, I just want to capture the liquidation value spread, so I bought at $3-4 dollars and it you know, eventually got up to as the rate started going up, got up $8 or $9 dollars, it was still below liquidation value, I sold the stock. I think in 6 months I double my money whatever else.

But then the second part which I missed came to bear which is there weren’t enough ships, rates went to a quarter million. They’re sitting there with 40 ships and eventually the stock was a 200 to 1. You know, so if I had been like Sanjay and I just put my $5000 there and just, you know, gone away that would be the thing to do and such.

So I think that was the case of very low risk and very high uncertainty because of those dynamics. And so if one is kind of a student of these things, you can find these kind of weird things in different industries and it’s a fun hunt when you find them to look at that and such. So that’s what I would suggest. Yeah, go ahead.


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