- By Stepan Lavrouk
After Mohnish Pabrai (Trades, Portfolio) found an old and forgotten stock certificate of an Indian company, he discovered that in the 21 years since he invested in it, it had gone up 60 times. This prompted him to identify the characteristics that define truly exceptional investments that have the potential to grow to such an extent.
In the first part of this short series, we looked at the first category - businesses with strong tailwinds. These are the types of companies beloved by Warren Buffett (Trades, Portfolio) - strong, cash flow generative businesses with little debt and durable competitive advantages. We are now going to look at two more categories identified by Pabrai in a talk at Peking University in 2016.
Category 2: Complex but quality businesses
Buffett likes to say that his favorite companies "could be run by an idiot" and still be excellent businesses. That was the first category identified above. The second category includes companies that have all of the great tailwinds of the first one, but with the added caveat that they cannot be run by idiots. Pabrai named a few examples: Amazon (NASDAQ:AMZN), Costco (NASDAQ:COST) and Geico (owned by Berkshire Hathaway (NYSE:BRK.A)(NYSE:BRK.B)). For all of these companies, management is a very important piece of the puzzle that adds a lot of value.
Category 3: When markets get confused
These aren't necessarily world-beating businesses. Here, the potential for profit comes from the mismatch between the risk inherent in the investment and the potential reward. The example given by Pabrai is Ipsco - a steel manufacturing company. When he invested, it was trading at a market cap of $2.5 billion, and had $900 million in cash and cash equivalents.
On top of this, it had contracts that locked in an additional $650 million annually for the next two years. In total, that amounts to $2.2 billion in cash in two years time on a $2.5 billion market cap. An investor would recoup the entirety of their capital in just two years. Pabrai took a big position in business, and was rewarded when it announced that it had secured $650 million in cash for a third year.
The reason that the business was trading at such a discount was because steel manufacturing is a cyclical, uncertain business. Markets hate uncertainty, but anyone who took the time to examine the numbers would have seen that the risk-reward was clearly in favour of the investor. Uncertainty might be uncomfortable to stomach, but the best investors are able to think in terms of probability and allow uncertainty to be their friend.
Disclosure: The author owns no stocks mentioned.
Read more here:
Mohnish Pabrai on How He Stumbled Into Owning a 60-Bagger Stock, Part 1
Seth Klarman: Short Selling Should Not Be Banned
Howard Marks and Seth Klarman: The Difference Between Cycles and Timing the Market
Not a Premium Member of GuruFocus? Sign up for a free 7-day trial here.
This article first appeared on GuruFocus.