Low Risk and High Uncertainty Bets in Uncertain Times
In times of market volatility, investors should be aware of the difference between risk and uncertainty. Risk and uncertainty are two different concepts, but investors often confuse the two.
However, the difference between risk and uncertainty is not clear-cut, which is why so many investors tend to make a mistake when trying to distinguish between them.
In investing, risk can be defined as being the chance of permanent capital impairment. Meanwhile, uncertainty can be defined as not knowing what the future holds, i.e., a wide range of possible outcomes.
A company can have a lot of uncertainty, but little risk. For example, a business with lots of cash on the balance sheet but little or no revenue has low risk but lots of uncertainty.
These are the kinds of investments that interest Mohnish Pabrai (Trades, Portfolio). In his book, "The Dandho Investor," Pabrai says that low risk and high uncertainty are a wonderful combination.
Low risk, high uncertainty
What sort of qualities do these businesses have, and how do investors identify these low risk, high uncertainty opportunities?
In a lecture he gave at the Guanghua School of Management as part of the first value investing course ever to be held in China several years ago, Pabrai presented three case studies of his process in action.
First, he presented shipping company Frontline (NYSE:FRO):
"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...The daily charter rate for these ships can vary from $5,000 a day to $300,000 a day...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 about $6 a share...Then it went from $6 to $9 in a short time. I wanted just to capture that spread. It was above the liquidation value. I sold the company."
He also presented Tesoro (TSXV:TES):
"What happened with Tesoro is that there was another merger taking place with two large oil refiners... Tesoro bought that refinery, they leveraged the balance sheet to buy the refinery...The markets looked at the debt, and they saw a lot of uncertainty because it is very hard to predict the crack spread...I looked at the company, the balance sheet, the debt, and so on...I bought 10% of assets at $7.5...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!'"
And finally, Fiat Chrysler (NYSE:FCAU):
"The management of the company says that in the year 2018, their earnings are going to be around $5. If the management is correct about the prospects of the business then basically the business has been priced at 1.2 times earnings for one year. My answer to that is, 'Okay, we'll hold the stock to 2018.' 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. Their Jeep sales are going up 5x in the next three years in China. I happen to think that what they're saying makes sense. The market thinks it doesn't make sense."
Pabrai has made several times his money back on his Fiat position so far. You could argue that these trades weren't investments, but rather speculations. That is true to a certain extent, but all of these businesses were low-risk opportunities. Pabrai believed that in each case, the risk of the company going out of business was low. Therefore, he could afford to sit and wait for the recovery.
Another thing to note is the risk/reward ratio on these trades. In all but one of the deals, Pabrai made a return of more than 100%. Frontline was the only trade that didn't make a return of 100%. However, the stock later hit $30. This suggests that even with a 50% failure ratio, Pabrai would have still come out on top.
Disclosure: The author owns no share mentioned.
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This article first appeared on GuruFocus.
