Dhandho Investing in Commodity Companies

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 great book, The Dhandho Investor: The Low-Risk Value Method to High Returns . I want to share my thoughts and a few quotes. 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.” Pabrai tells interesting stories about entrepreneurs that built empires following the time-tested principles of hard work and frugal living. But what makes Dhandho investors unique is their intelligent use of outside capital to invest in ventures where risk and reward can be boiled down to the phrase “Heads, I win; tails, I don’t lose much.”

The world is a very uncertain place and this uncertainty can ruin the best-laid plans of brilliant entrepreneurs. Dhandho investors realize this and 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. With plants in a wide range of geographies, he optimizes the type and quantity of steel produced by geography to maximize this advantage. 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.”

Perhaps Lakshmi Mittal is a fan of John D. Rockefeller. Whiskey & Gunpowder colleague Byron King (also editor of Outstanding Investments ), wrote a great piece on the Rockefeller era of the oil industry. You can find “John D. Rockefeller and the Age of Oil” at this link. “By the early 1870s, Rockefeller was certain that the refining business was on the verge of a massive shakeout. Thus, he was consumed with a focus on efficiency in his operations,” Byron writes.

Both Mittal and Rockefeller sought to buy assets on the cheap and constantly wring costs out of the steel business and the oil business. They knew that low-cost commodity producers survive — and even thrive by consolidating the industry at low prices — when commodity prices weaken. Commodity companies are not playing a zero-sum game. There are clear long-term winners, mediocre players, and unfortunately, many outright frauds — Mark Twain’s proverbial “hole in the ground owned by a liar.”

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.” This is generally true in a world where 10% or 15% of the world’s population has a virtual monopoly on consumption of its natural resources; this was the world of the 20th century. This is not true in today’s world, where natural resources must be shared among a larger consuming population and it’s not cheap or easy to scale production quickly enough to meet demand.

What does this mean for commodity companies like BHP Billiton (BHP) and Companhia Vale do Rio Doce (RIO)? Should we assume that they have “no moat”? 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

As investors, we must not remain psychologically anchored to the past. The world is changing and investors need to adjust their perspective. Commodity companies, indeed, have strong moats. If you don’t agree, try starting your own iron ore mining business and 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.

Countries like China, India, and Brazil have sprinted out of the gates in the 21st-century economic race. We should assume that they are not going to squander another century of progress on idiotic socialist or communist projects that turn back the clock on living standards. We should not assume that we are the only ones that can think for a living and that everyone outside the Western world should sweat for a living (to paraphrase the GaveKal argument).

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.

Good investing,
Dan Amoss, CFA

May 16, 2007