Mohnish Pabrai on Debt Discipline

Pabrai Investment Funds Assets Under Management (In Millions of $) 1999 2000 2001 June-02 Assets Under Management The diligent reader will notice that PIFI is at a historical high and has delivered exceptional results since inception. I would like to make a few comments at this juncture on PIFI: 1. I have stated earlier that PIFI has a few disadvantages versus PIF2 which are likely to hinder performance when compared to PIF2. The first is that there is no new money coming into PIFI. This means that when I have an idea that PIF2 invests in, PIFI may not be able to make the investment – or if it does, it means there are likely to be tax consequences as I have to sell something in PIFI to buy. The flip side of this is that there was an investment PIF2 made a few months ago that PIFI could buy a very small position in. As it turned out, it has so far resulted in a unrealized loss and PIFI’s exposure was proportionally far lower than PIF2. Time will tell if this eventually turns into a realized gain or loss. The second disadvantage is that the allowable leverage % is lower (30% vs. 50%). I’d like PIFI partners to be fully aware of these facts and their impact on performance. 2. It is harder to manage PIFI than PIF2 because of the bigger struggle with which ideas are the best. I try to do my best and so far the overwhelming number of decisions on idea selection have been good ones – hence our performance versus the broad market. 3.

As you are aware, the funds are allowed to employ leverage. PIFI can leverage upto 30% and the other funds can go upto 50%. When Buffett ran his partnerships in the 1950s and 60s, he almost always had more ideas than money and the funds were nearly fully leveraged (50%) during most of the period. Buffett’s use of leverage was focused on workout and special situation investments. Today Buffett’s vehicle for leverage is insurance float – which is simply brilliant since that float is subdivided into a myriad of risk classes being covered that are very very unlikely to have any sort of aggregation ever. As an example, after 9/11, some of Berkshire’s Insurance units saw big claims, but its GEICO auto insurance unit with about 15% of the float was untouched by the events of 9/11. Many partners and potential partners have voiced concerns about the use of leverage in the funds to me from time to time. I have always been very careful with leverage – only using it for special situations. However, after a great deal of reflection, I have come to the conclusion that there are really no limits to the short-term irrationality of markets. I don’t believe 1929 represents the extreme to which markets can go. If fact, until 1987 common wisdom was that big market drops were a thing of the past. So while we are probably protected against a 50 or 100 year flood, I don’t think we’re protected against a 1000 year flood.

October 1, 2001 was an especially good window because of the market drop after the tragic events of 9/11. Thoughts on Merging PIFI and PIF2 A few of the PIFI partners met with me a few months ago to voice their displeasure and discomfort with the infrequent reporting. At the conclusion of the meeting, a plausible solution was arrived at. If the two funds were merged into one, it is likely that the merged fund would have atleast one partner (old or new) adding funds every 2 months and thus there would be 7 to 8 datapoints a year for PIFI investors. I liked the idea of merging the funds as it would simplify my task (easier to manage 1 fund vs. 2), reduce accounting, audit and administrative costs and I would no longer have less-than-happy partners. We’d also have a larger asset pool to amortize expenses over. The negatives are that the guarantee of principal etc. in PIFI would be eliminated (I see this as a positive). The leverage ratio would go up to 50%. I don’t see this as an issue as I am exceedingly careful with leverage, but some of you might. Finally, we’d have higher accounting and legal fees for 1 year as the funds merge to handle all the tax, accounting and legal issues. I only want to pursue a merge if the overwhelming number of partners want it. At this point, I’d like to get a pulse on your thoughts. Just call me or send me an email letting me know if you’re in favor or against the merger.

If the market were to drop 50+% in a course of 2 to 3 days and if it happened while we were fully leveraged, we’d have a problem. We’d be forced to sell positions at the exact opposite time that we’d like to sell. As an example, the Nasdaq has seen over 75% of its capitalization disappear over the last 2 years. There is nothing that prevents such drops from occurring over a matter of days versus a matter of years. While I don’t believe we will ever see the type of drops I’m alluding to, I would not want to bet on it – especially with your hard-earned money. If we are totally unleveraged and the market dropped 50%, there is no real problem. We can just wait out the storm and eventually the underlying businesses will get priced around their intrinsic value. Indeed, if we ever saw such big drops with no change in portfolio fundamentals, I’d be asking partners to add funds and we’d go shopping selectively. I started thinking hard about the leverage issue last year when Charlie Munger made the following comment at the 2001 Berkshire Hathaway meeting alluding to the “Monopoly” board game when speaking on the subject of use of leverage. “I don’t want to go back to Go! I’ve been a Go once and have no desire to see it again.” t I thought a lot about the appropriate percentage of leverage (while still being able to withstand a 1000 year flood) and concluded that it should be zero.

Our current leverage is small and, over the next few weeks, I will be completely eliminating use of leverage in all the funds. We have a couple of appreciated positions that are near intrinsic value and would prefer to get long term capital gains treatment since we’re under 8 weeks away from it. The impact of being fully unleveraged is significant from a performance perspective.9

employed leverage. We still expect to continue to beat the indices and 90+% of mutual funds, but this is now one more reason future performance will be less spectacular than the past. The good news is that we have far more control over our destiny and have a substantially lower risk profile. I’ve recently had conversations with some partners on this change and nearly all are enthusiastic about it. I’d welcome your thoughts and comments. Finally, in the highly unlikely event, that I ever change my mind on leverage use, I’ll be giving partners a heads up and a chance to exit the fund before employing leverage again. Merging PIFI and PIF2 Michael J. Liccar & Co. are researching some of the nuances of merging the funds. It appears that it is fairly straightforward with no negative tax impact on anyone. I’ll be proposing an amendment to the PIFI and PIF2 on 1/1/03 after we’ve gotten a handle on all legal, tax and accounting issues. Assuming 2/3 or more of partner units vote in favor, we will proceed with the merger. We’ll also allow any PIFI or PIF2 partners opposed to the merger to exit the fund on 12/31/02, so no one has the merger forced on them if they disagree with it. I see this as a big positive with the reduction in fees and a single larger fund with is easier to manage and amortize the reduced fees over a larger pool of assets. Stay tuned. I’ll email you before any of the amendment docs get sent out so you can watch for them.

The name was maintained (as these small funeral homes had tremendous brand equity in their communities), but the back-end, merchandizing, selling pre-paid funerals etc. was streamlined and corporatized. The mistake all three made was that most of the acquisitions were done for cash rather than stock and they freely borrowed money to support their acquisition binge. Then the music stopped. The street lost its excitement for the funeral business and their stocks started to come down. Bankers and lenders weren’t interested in further lending and wanted balance sheets deleveraged. With no additional acquisitions, sales went flat. This is not a growth business. Stewart found itself in 2000 with $930 Million of long-term debt with about $500 Million coming due in 2002. The company had said to the street that they had excellent relations with their bankers, had never violated a bank covenant and were confident that their bankers would extend the loan. They also said that they had begun to explore the sale of international funeral homes and cemeteries in Europe, Mexico etc. International assets comprised about 20% of revenues and assets, but weren’t generating much cash flow. Thus Stewart has about $460 Million in assets outside the US. Despite this data, the stock was at $2/share. I figured that there were two possible scenarios – the company would either be forced into bankruptcy by lenders or they would refinance/eliminate debt and continue as usual.6

If the company liquidated, at the “store” level, each store was very profitable, so they’d be sold off as going concerns. Stores would not be sold for 3 times cash flow. Buyers would bid them up to 6-10 times cash flow. Presumably, worst case, the previous owners would buy them back for less than they sold them for. So under a 2002 bankruptcy, I figured the worst-case liquidation value was $4-5/share. If they indeed did sell off international operations, than would generate $300-500 Million in cash, which would eliminate the 2002 issue with the lenders. Thinking back to the Tribune article, while I allowed for bankruptcy as an option, I thought it was very unlikely given the nature of the business. This qualified as a Buffett-style workout or special situation. It was a play to get $4-5/share within a maximum of 2 years and exit (a 50% annual rate of return). I like all aspects of Stewart’s business except the leverage in the balance sheet. If I could buy Stewart with no debt at 3 times cash flow, I’d do it in a heartbeat and hold it for much longer – till it got to 8-10 times cash flow. But with the leveraged balance sheet this was simply a special situation play. The final piece of the research was to kick the tires. I met a friend of mine who had known Stewart for years and mentioned that their properties and services were the best in the business. They were at the high-end and very committed to service.

Per the terms of our agreement, PIFI has the ability to buy securities on margin upto 30% of the total assets under management. This would allow me to invest another $260,000 before I hit the maximum. I do not want to leverage PIFI to that extent. I’d like to bring in another $500,000 at this time to eliminate our margin position and have money ready to go to work as I see opportunities.2