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Collection: Mohnish Pabrai - #92 'Low Risk High Uncertainty'



The third kind is the ones which have shown up the most in my portfolio. I have never had the good fortune of having the first kind of business which is huge tailwinds and idiots for management, I've never had that. If I ever get that in my portfolio we're never going to sell those, we're going to keep those forever.

Now, the third one is when the market gets confused between risk and uncertainty. And so what I wanted to do here, I want to go through some examples from my own portfolio in the past. In some cases I was able to capture the upside, in other cases, I was too stupid and I missed the upside. I made some money but I didn't make a lot of money.

So the first company I want to talk about – And sorry these are not businesses you may have heard of but that's the nature of this game. The ones that are going to be 100-baggers are not going to be the biggest names around that you’ve heard of.

In 2005, I invested in a steel company which was based in Canada. They were created in the U.S. called Ipsco. So Ipsco made two types of steel. They made plate steel and they made tubular steel, you know, kind of like pipelines, and drilling for drilling oil wells and all that.

So they made these kind of like specialized steel which are in pipe form or plate form. And the company had the following characteristics when I invested in it: the market cap was $2.5 billion; they had $900 million of extra cash on the balance sheet; and the company had contracts on the book. There were these pipelines that were going to buy their steel for the next couple of years.

So they had a two-year backlog where they knew that their earnings for the next two years were going to be $650 million each year. So you had a $2.5 billion market cap, and you had $2.2 billion between cash they already had and cash that was coming in the next two years. And so you would collect about 90% of the market cap in cash in two years, and after two years you still had all the plants and equipment and people and all the know how, everything was still there. But after two years there was no visibility into earnings, and we know the steel business can go up and down.

So the way I looked at it I said, "You know what? What we're going to do is I'm going to make a bet, I'm going to put 10% of my assets into this. I'm going to just sit there for two years and if it doesn't work we probably get back 90% or the company’s completely gone. But I don't think it's completely gone. I think it's a real business."

So what happened is a year later they made the $650 million, and that year later they had visibility for one more year. And now they said that they would make $650 million for the third year. So now they had three years of $650 million which was almost $2 billion plus the $900 million.

So now we were above my purchase price. So the stock that I bought at $45 a year later was sitting at $70. So I said, "Well, we were above what we paid, but we still don't know what the business does after three years. Why don't we just wait for another couple of years, see what happens? Okay?"

So in 2007 I waited one more year and by now the stock had gone to maybe $100-$105. And they got a buyout offer. Another company came and bought them for $160 a share. And when the deal was announced at $157 something, I sold the stock. And so we ended up with almost a 4x in about two and a half year. Okay, and we captured the entire 4x right?

And this was a situation where it's a highly, highly cyclical business and markets hate uncertainty. It's a highly uncertain business, but the risk for this business was very low. So it is what I call very low risk and very high uncertainty. So when you find a combination of low risk and high uncertainty, usually that combination is going to give you a high reward because markets are not very good at pricing in uncertainty. They hate uncertainty.

And so we get some benefit from that and in fact, there's a business like this in my portfolio currently. And I don't talk much about my portfolio but I'll just make an exception because I love you guys so much. I own a company called Fiat Chrysler, which is based partially in Italy and partially in Detroit.

And Fiat Chrysler's very similar to Ipsco so the stock is at $6. The management of the company says that in the year 2018, their earnings are going to be around $5. And so if the management is correct about the future prospects of the business then basically the business has been priced at 1.2 times earnings for one year.

And so my answer to that is, "Okay, we'll hold the stock to 2018." If it's completely worthless of a business, I mean – they have $130 billion in sales of cars. They just started manufacturing Jeep in China. The Chinese love their Jeeps. Raise your hand if you think Chinese love Jeeps. All right, at least a few Chinese love their Jeeps. That's great. So their Jeep sales are going up like 5 times in the next three years in China.

But anyways so I happen to think that what they're saying makes sense. The market thinks it doesn't make sense. So no problem, just like Ipsco we put the stock in the portfolio and forget about it. And I'll wake up in January 2019 and see what happened. And if you invite me back in 2019, I'll tell you what happened to Fiat. Between us girls, we may end up with five times our money if it trades at five times earnings, or seven times our money if it trades at seven times earnings and such.

There's another company, Tesoro Petroleum. And this is one which we did not capture but we should have but we didn't, so Tesoro – You know, Ipsco is in the steel business, Tesoro is in the oil refining business. They have oil refineries in the United States.

And in the United States, in the last 30 years, not even one new oil refinery has been built because of NIMBY. You guys know what NIMBY is? Not In My BackYard.

Nobody wants the oil refinery near them. So in the entire U.S. for anyone who wants to build an oil refinery, they never get the permits. So the oil refineries that we've had for 30 years – 30 years ago – are the same ones we have today. And they keep trying to tweak the oil refineries in the U.S. to get more and more capacity, but they are not able to build new ones.

And so anyways, Tesoro had a bunch – So the oil refining business in the U.S. actually is a pretty good business. The reason it's pretty good is because all the different states have different requirements for how the gasoline or petroleum is to be produced, and the amount of emissions and all that.

So you need different refineries for different states to meet the standards, which makes it difficult for other competitors to come in. So even though oil refining maybe a commodity business, it's not really a commodity business because it's got these kind of local aspects to it.

So anyways what happened with Tesoro is that there was another merger taking place with two large oil refiners. And in order to make that merger happen, they were forced to sell one of the oil refineries to make the merger happen.

Tesoro bought that refinery, they leveraged the balance sheet to buy the refinery, and after they leveraged the balance sheet the crack spread which is the spread that refiners get to make crude oil into gasoline. The crack spread narrowed to almost nothing, so their profits went to next to nothing. At the same time they had a huge amount of debt.

And so markets looked at the debt and they saw a lot of uncertainty because it is very hard to predict the crack spread. So just like the uncertainty of steel prices, the refining margins are always uncertain. And markets project present circumstances to infinity.

So market said, "Hey, the crack spread is small. It'll always be small. They have all this debt. They will not be able to pay their debt.” What happens if they don't pay the debt? Well, what happens if they don't pay the debt is they have many refineries. They can just sell a refinery, they don't need to go bankrupt they can just sell some assets, and they can get out of the jam on their end. So I looked at the company, the balance sheet, the debt, and so on.

And the stock was at $7.5 – it had gone down a lot. It used to be at almost $30. It had gone down to 25% of the price so I bought 10% of assets at $7.5. Three months after I bought the stock it was trading at $1.33. So the 10% of assets I put in just this alone took my portfolio down by 8%. This one position.

One of the things that always happens to me, only happens to me, it doesn't happen to you, is that every stock I buy goes down first and it always goes down. I don't know why it doesn't go down before I buy, but they all go down after I buy. Somehow it knows. And, you know, Bruce Berkowitz is a fund manager, and he calls it premature accumulation. So I always have premature accumulation.

Anyway, so $7.50 went down to $1.33. We're used to that, we're not going to sell anything. We sit there and then a few months later the crack spread widens and they're paying down debt, and the stocks at $15. And I said, "Hallelujah!" From $1.33 to $15 10 times, from $7.50 to $15 double less than three years, still on track for 26%, we are out of here. Or like Arnold Schwartzenegger would say, "Hasta la vista, baby." I sold the stock and moved on.

Now, what I didn't realize is that Tesoro had a phenomenal manager, Bruce Smith. Just a kickass manager. And he was a master at extracting value from these refineries. He bought pipelines and refineries when the financial crisis took place. And if I had kept Tesoro from the bottom tick of $1.33, it went up 200 times till today. Okay, so from the time I bought, it went up about 40 times. So I only captured a double, okay? But the rest of the ride I completely missed.

What this guy was able to do was – He was master at buying these assets, you know, extracting more value, getting more assets. They spun off a pipeline company. A lot of things they did, he de-levered the balance sheet and all of that. And it just – even now I think it's done really well.

So that was an example of a low risk, high uncertainty business where I already knew in the period I owned the stock that I was dealing with an exceptional manager because in the conference calls I was in love with Bruce Smith. He was just a great guy, he was doing all the right things. But we missed that 40x, and there was a chance to get 200x.

And then we were going to go to another one which is a shipping company, all these wonderful businesses – steel business, refining business, shipping... And you thought you can only make the money on Alibaba and Baidu. No, you can make the money without Alibaba and Baidu. You can make it in other places.

So for example, Frontline was a shipping company and this company focused on transporting crude oil. They had something known as VLCCs, Very Large Crude Carriers that they owned. And the global [Inaudible] that's the time I invested, I haven't looked at the shipping business lately but this was an investment I made I think in around 2002. There were about 400 VLCCs in the world and Frontline was the largest amongst all of them. They had about 70 of them in their fleet.

Seventy out of 400 were owned by Frontline. And this is the ultimate high uncertainty business. The VLCCs are chartered two different ways. Either they are time charters or they're daily charters. The entire Frontline fleet of 70 ships was on daily charters. And the daily charter rate for these ships can vary from $5,000 a day to $300,000 a day.

It is a huge variance and at that time – I don't know what the economics are now – but in 2002, once the rates went below $12,000 or $13,000 they were not making any money; they were losing money. And once the rates went over $30,000 or $40,000 they were super, super abnormal profits, exponential profits. But the exponential profits you didn't know what would happen the next day because every day these prices fluctuate.

But there's a particular nuance in the shipping business that I understood. And I understood this because a friend of mine in the real estate business had explained this to me. He said that, you know, when you build these large office towers in the U.S. – In China, it’s probably much faster – But in the U.S. it takes three to five years to get the permits and actually build these 20, 30, 40 story buildings.

And so what happens is when office space is very tight and fully occupied, all the real estate developers rush out to build new buildings. And they all rush out to build new buildings at the same time. And the banks finance all of them at the same time because everything looks great. It's a boom business. They can see 100% occupancy, and then five years later all these buildings come on the market at the same time. And what happens is the occupancy and the rents collapse at the same time.

So in these kind of high-end office buildings you have this boom and bust cycle of, you know, very high occupancy and then low occupancy, then high occupancy and low occupancy, it just keeps going back and forth because the property developers just think whatever's happening right now is the way it's going to be forever. The people who are in the shipping business are even worse than the property developers. They believe everything that's happening right now is the way it's going to be forever.

So what happens is that when these VLCC's are trading at $200,000, $250,000 a day they all go to the Korean shipyards and place a huge number of orders for ships, okay? And they say, "Build me the ships."

Same like the building, it takes three years or four years or two years to build the ship. By the time the ships are built, all these ships get delivered at the same time and those rates collapse. And then they go scrambling again or they got a bunch of bankruptcies. So the business goes through these ups and downs.

Now, one of the things that happens is that when rates go to $5,000 a day or $10,000 a day, scrapping those ships increases a lot because they're losing money. And they – What they do is they take their old ships and just scrap them so they can make some money.

So the size of the fleet goes down at the time when the rates are low. And as the fleet size goes down it sets up the conditions for rates to go up. And then when the capacity goes down and the rates start going up, you cannot bring in more capacity because it takes three years to build a ship. So the only thing that can happen is price goes exponential.

So anyway I bought Frontline at a point when these prices were $5,000 or $10,000 a day and the stock had collapsed and it was trading at something like I think at about $6 a share. And just like with Tesoro, a few weeks after I bought it, it was trading at $4 a share – lost one-third. Not as bad as Tesoro but one-third is gone. And then it went from $6 to $9 in a short time. I wanted to just capture that spread. It was above the liquidation value of the company, I sold the company.

Anyway, because of the very high uncertainty in rates, this company if I had held the stock throughout even with all the recent collapse in shipping, it would've been a 40 times investment, from $4 to $160. I'm sorry it's not 40, it's been $6 to $160 about 35 times my money.

So another company which I just wanted to talk about is Teck Cominco. This is again, low-risk high uncertainty. So during the financial crisis, commodity prices collapsed in 2008. They went to nothing. And this company Teck Cominco is like the IBM of mining. They have huge reserves of metallurgical coal and huge reserves of iron ore, and you know, lots of trading with China and such.

But they had done an acquisition just before the financial crisis, a large acquisition. They had taken a bridge loan to close that acquisition. Then the financial crisis happened, they couldn't refinance, all the prices collapsed, and this stock went from $50 to $4. It dropped by more than 90% in seven weeks.

And when I looked at the company, it's again, like the refineries. They had all these different mines and assets all over the world. Some of them were the lowest cost mines you could imagine and the banks did not want to take over this company. The banks don't want to be in the shipping business. The banks were probably going to do what I would call “extend and protect” which is they would take some fees and penalties from them, but they would extend their loans.

And anyway – In fact, China came in as an investor in Teck Cominco, and in a few months the stock was up seven times and I sold. So we bought at $4 or $5, we sold at $30. And then it kept going, it went to $50. So we didn't capture all of it, but we captured most of it. So anyway, that was the third criteria, which is the low-risk high uncertainty.



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