The Rude Awakening
Laguna Beach, California
Friday, March 10, 2007 ------------------------- - Heads you win, tales you don't lose much - Understanding the Pabrai approach,
- Front and center for the Value Investing Conference,
- Mojito-soaked cellphones and plenty more…
------------------------- Eric Fry, reporting from Laguna Beach, California… Last week, I met up with my colleagues, Chris Mayer and Dan Amoss, at a rooftop bar in Hollywood. Neither one of them was wearing sunglasses, or jabbering away on a cell phone about a movie script, or drinking a mojito. In short, they looked like tourists. That's because they WERE tourists. But these two East Coast boys did not fly across the country to examine the hand prints at Gromin's Chinese Theatre or to take a spin along Mulholland Drive…or even to peer over the hedge at Cameron Diaz' house. They rolled into town to attend the
Value Investing Congress. Now this event might not seem particularly scintillating to most folks, but Chris and Dan loved every minute of it. (In fact, Chris had attended the very same event last year). The two gushed on and on about highlights from the Congress. And I have to admit that their excitement was infectious. At one point, I nearly dropped my cellpone into my mojito. "The gathering features some of the most successful cheapskates of the investment world," Chris explained after returning from last year's Congress. "These are the guys who don't like to pay much for anything, who are usually bearish on most things and who like digging around in the dumpsters and sewers of finance, trolling around for overlooked goodies." Chris pursues a very similar investment discipline, both in his investment letter, Capital & Crisis, and in his investment service, Mayer's Special Situations. (In fact, one of this year's speakers highlighted a stock that Chris had recently recommended in Mayer's Special Situations). "I loved getting that endorsement," he beamed, while sipping a beer on that Hollywood rooftop. "It's always a good feeling when one of the world's best investors recommends a stock you have already recommended." "Yeah, that's a nice confirmation," I replied. "But you're not going to these conferences to get confirmation, you go to get ideas. So did you get any?" "Yep," Chris nodded, "a couple of really good ideas." "So who was your favorite speaker?" I asked. "Probably Mohnish Pabrai, just like last year," Chris replied. Upon returning from last year's Congress, Chris wrote two columns for the Rude Awakening highlighting two specific presentations at the event. In the Rude Awakening edition of June 23, 2006, Chris revealed some of the "dos" and "don'ts" of short-selling, according to the accomplished
hedge fund manager, Carlo Cannell. Click here to read L.A. Confidential And in the Rude Awakening edition of June 22, 2006, Chris explored the investment strategy of his "favorite speaker," Mohnish Pabrai - a strategy that Pabrai describes as "dhando." To read this column, click here "Dhando!" Pabrai wowed the crowd again this year, according to firsthand reports from both Chris and Dan. But this year, it was Dan's turn to shine a light on Pabrai's investment genius. In a guest column earlier this week for our sister publication, Whiskey and Gunpowder, Dan penned a wonderful column about Mr. Pabrai's presentation. We found the column so insightful that we decided to republish a streamlined version of it right here in the Rude Awakening. We hope you enjoy it… --- Special Housing Report ---
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By Dan Amoss Mohnish Pabrai, a popular speaker at the Value Investing Congress and portfolio manager of Pabrai Investment Funds, reminds me of a young Warren Buffett. He's delivered roughly 30% annualized returns to his investors since launching his partnership in 1999, similar to the return Buffett earned for his partners in the early years of his career. Pabrai delivered a great presentation about the dilemmas that often face value investors. I've just read his book, The Dhandho Investor: The Low-Risk Value Method to High Returns. Value Investing Congress attendees received a copy of Pabrai's book at registration. It's still available on Amazon, but perhaps not for very long. Pabrai's last book, Mosaic, which I received at last year's Congress, must be out of print. It was selling for $475 on Amazon. I recommend Pabrai's books for anyone who wants to learn how the world's top value investors think about risk. Literally translated, "Dhandho" means "endeavors that create wealth." But for Pabrai, the word means something like, "Heads, I win; tails, I don't lose much." Dhandho investors seek to minimize the size of the losses they can potentially suffer. The best way to minimize the size of losses in the stock market is to minimize the price you're willing to pay for shares in a business. Low-Cost Production: The Commodity Company's Moat Pabrai writes about how Lakshmi Mittal, one of the richest men in the world, has achieved remarkable success in the steel business, a business most ignore, for many good reasons. His company, Arcelor Mittal, is now a leading steel producer listed on the NYSE under the ticker "MT." Using a "heads, I win; tails, I don't lose much" approach, Mittal's strategy relies on paying low prices for undesirable steel mills, implementing disciplined cost controls and expanding market opportunities: "When Mittal picks up assets for pennies on the dollar and then streamlines operations, he has an unassailable low-cost producer advantage. Over the years, he has developed a second enduring advantage -- global arbitrage on labor, raw materials, energy costs, and the best-selling price. And now, his tremendous scale and brand gets him a third enduring advantage. His volumes and capacity allow him to negotiate better prices than his competitors with both buyers and suppliers -- driving his costs even lower." Mittal has definitely established a very valuable "moat" of low-cost steel production that can continue growing as long as cost discipline remains a focus.
Different Types of Moats What other kinds of moats can companies use to defend their businesses? In the wake of the euphoria about the proposed Alcoa-Alcan merger, one of the speakers at the Value Investing Congress warned the audience that "commodity companies have no moat." Pabrai does not agree. Commodity companies, indeed, have strong moats. If you don't agree, try starting your own iron ore mining business? Or competing with CVRD or BHP Billiton on price? Their expertise, managerial talent, and, most importantly, massive cumulative past capital investments in mines make
these companies irreplaceable. And steel companies must now pay these dominant producers an arm and a leg for what they all need -- critical steel ingredients like iron ore and nickel. The term "no moat" may apply for small-fry commodity companies, but not for those like BHP Billiton, whose management still assumes very low future base metal prices when they decide whether or not to invest in a new mine. BHP has learned to survive in a low commodity price environment and should continue thriving as long as management remains disciplined in their decisions. The statement "commodity companies have no moat" also doesn't apply to CVRD. Based in Brazil, CVRD is the most dominant miner of iron ore in the world. CVRD controls 35% of the seaborne iron ore trade, followed by Rio Tinto and BHP Billiton, with 25% and 20% market share, respectively. The fragmented steel industry has to write awfully big checks to these players for their crucial raw material. There's really nowhere else to get reliable supply. Not only has this Brazilian giant done a great job keeping production costs low, but it's also long held the luxury of being able to force price increases onto its customers -- including the formidable Arcelor Mittal. Its growth in earnings and cash flow resembles its chart below, which covers the time frame it's been on the SI recommendation list (since August 2004 -- when it was originally recommended by former editor Dan Denning): 
When CVRD acquired nickel miner Inco last summer, most media sources considered it a sign of a top in the commodities market. Commenting on the Inco acquisition, I wrote the following in the Aug. 14, 2006, SI update: "Billions in startup capital may not be very hard to come by in today's hyper-liquid credit environment, but securing a scalable, high-grade reserve base in a stable country, a team of geologists, and a fleet of heavy equipment is no small feat (particularly at a reasonable ROI)." In hindsight, it now appears that CVRD not only made a great strategic move, but got a real bargain. Earnings from Inco's operations are soaring. In the March 12 SI update, I wrote that CVRD "is successfully integrating last year's acquisition of Canadian nickel miner Inco and now controls four out of the six major new nickel projects coming online over the next three years. Even if the price of nickel consolidates after its breathtaking 2006 rally, it will still be an enormously profitable metal to mine." So I'd argue that CVRD's competitive moat holds two qualities: access to world-class, low-cost metals in the ground and a management team with great foresight. This moat can keep growing, provided humans keep fashioning iron ore into steel. Technology Moats Can Shrink Using the example of Google, Pabrai does a great job illustrating how this old economy/new economy concept should be applied to fundamental stock analysis: "If we were to look at a business like Google, it starts getting very complicated. Google has undergone spectacular growth in revenues and cash flow over the past few years. If we extrapolate that into the future, the business appears to be trading at a big discount to its underlying intrinsic value. If we assume that not only is its growth rate likely to taper off, but that its core search business monopoly may be successfully challenged -- by Microsoft, Yahoo, or some upstart -- the picture is quite different. In that scenario, the current valuation of Google might well be many times its underlying intrinsic value. "The Dhandho way to deal with this dilemma is painfully simple: Only invest in businesses that are simple -- ones where conservative assumptions about future cash flows are easy to figure out." This is why I tend to avoid technology stocks. It's not that you can't make money in technology; you've just got to be extremely confident that the technology you're investing in isn't made obsolete within a couple of years. Who knows if Google or Yahoo -- or Baidu -- will dominate the search engine business during the 21st century? What separates all-star investors from mediocre investors? It's the accuracy of the assumptions in their valuation models. Emerging economies are growing. They need copper, iron ore, nickel, oil, gas, coal, and other building blocks of Western living standards. You don't have to make heroic assumptions about what technology will look like in 10 years to make money in leading commodity companies -- companies that have wide moats. To lower your risk while investing in commodity companies, follow the "Dhandho" principle of paying the lowest possible price. Maybe you'll get a shot at lower prices the next time the media mistakenly calls the end of the commodities bull market. Joel's Note: Dan's insights appear regularly in Whiskey & Gunpowder, the only newsletter of its kind to cover geopolitics, macroeconomics and peak oil all with an unashamed libertarian bent. Oh, and it's also free of charge. Get your own Whiskey shot here: Whiskey & Gunpowder --- Free Market Investor --- The World's Greatest Retirement Stock Double-digit returns and income checks…from a secret "pension-payout plan" that's otherwise off-limits to everyday Americans… Want to grab your share? Click here for the full report: The Free Market Investor | 
