In Monish Pabrai’s book, The Dhando Investor, he provides a real-life illustration of how, with third grade math, you can beat Wall Street if you’re prepared to do a little research. Here’s an excerpt from the book:
A good case study of a low-risk, high-uncertainty business is the situation with Stewart Enterprises (STEI) in 2000. Stewart is a 96-year-old company that had done a roll-up in the funeral service business through the 1990s. The funeral services industry had been highly fragmented until it became fashionable in the early 1990s to roll them up into billion-dollar enterprises. Companies like Stewart Enterprises (STEI), Loewen Service Corp. (SRV), and Carriage Services (CSV) went on rapid buying sprees of these mom-and-pop businesses at high multiples—ending up heavily debt laden.
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. The music stopped when Loewen couldn’t handle its crushing debt load and went bankrupt. Wall Street lost its excitement for the funeral business, and their stocks started to come down—way 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. Wall Street began to doubt the debt-servicing ability of all of these funeral service behemoths and priced their equities as if they were all going to go bankrupt. Due to this overhang, Stewart saw its stock go from $28 per share to under $2 per share in two years.
At the time, Stewart had about $700 million in annual revenues and owned about 700 cemeteries and funeral homes in nine countries, with the bulk of them in the United States. Stewart’s tangible book value was $4 per share. It was thus trading at half of book value. Since book value included hard assets like land at cost, it was likely understated.
Stewart’s earnings and operating cash flow for the six months ended April 30, 2000, was about $38 million, or about $0.36 per share. On an annualized basis, it was producing free cash flow of about $0.72 per share. The stock was trading at less than three times cash flow. It was also trading at about one-quarter of annual revenue. On the exterior, there was no visible change after these hundreds of mom-and-pop funeral homes were acquired.
The names were maintained since these small funeral homes had tremendous brand equity in their communities, but the back end, merchandising, selling pre-paid funerals, and such were streamlined and corporatized. Each underlying funeral home was an excellent business with lucrative and predictable free cash flow characteristics. The weak balance sheet of the parent company was the culprit.
By the time the debt came due, the company would generate over $155 million in free cash flow, leaving a deficit of under $350 million. I concluded that there were five possible scenarios for Stewart over the next 24 months:
1. Each individual funeral home is a distinct standalone business. Stewart was a roll-up that had bought hundreds of family-owned funeral homes. Each had kept the same name. Most customers did not know that ownership had even changed hands. Thus, to raise cash, Stewart could elect to sell some of its funeral homes which you can probably find more here. Presumably, many of the previous owners might buy them back. The company had typically paid eight or more times cash flow for each funeral home. I figured that it should be able to sell boatloads of these back to the original owners for at least four to eight times cash flow. Thus, 100 to 200 homes might be sold to take care of the debt.
Odds I ascribed to this scenario playing out 25 percent
Equity value in 24 months if this scenario played out >$4 per share
2. Stewart’s lenders or bankers could look at the company’s solid cash flow and predictable business model and extend the loan maturities or refinance the debt—especially if the company offered to pay a higher interest rate (e.g., 200 basis points higher than present).
Odds I ascribed to this scenario playing out 35 percent
Equity value in 24 months if this scenario played out >$4 per share
3. Stewart could look for another lender. With the robust cash flows, it was likely to find many takers—especially if it offered 100 or 200 basis points more than it was presently being charged.
Odds I ascribed to this scenario playing out 20 percent
Equity value in 24 months if this scenario played out >$4 per share
4. Stewart goes into bankruptcy. In a bankruptcy reorganization like Stewart, the judge would order that some of the businesses be sold and cash proceeds be used to repay defaulted debt. In a distress sale, these funeral homes should still go for at least five to seven times cash flow due to competition among buyers. A few hundred businesses (at most) get sold and the company emerges clean from bankruptcy.
Odds I ascribed to this scenario playing out 19 percent
Equity value in 24 months if this scenario played out >$2 per share
5. A 50 mile meteor comes in or Yellowstone blows or some other extreme event takes place that takes Stewart’s equity value to zero.
Odds I ascribed to this scenario playing out 1 percent
Equity value in 24 months if this scenario plays out $0 per share
It is clear that there is much uncertainty about how this might play out. The risk of a permanent loss of capital is under 1 percent. It is a textbook example of a situation with ultra high uncertainty and ultra low risk. If presented with such a scenario, Wall Street will irrationally collapse the quoted value of the business. Always take advantage of a situation where Wall Street gets confused between risk and uncertainty. The results will usually be quite acceptable.
I hadn’t heard of the Kelly Formula back then, but I didn’t need anything beyond third grade math to know that this is a very favorable bet to make. (As an aside, per the Kelly Formula, about 97 percent of your available bankroll ought to be put on this very favorable bet.) Pabrai Funds invested 10 percent of its assets into Stewart Enterprises at under $2 per share in the third and fourth quarters of 2000 with the intent of exiting at anything over $4 per share within two years.
A few months later, on a conference call on March 15, 2001, the company announced that it had begun to explore the sale of international funeral homes and cemeteries in Europe, Mexico, and such. International assets comprised about 20 percent of revenues and assets, but weren’t generating much cash flow. Stewart had about $460 million in assets outside the United States. With some of the uncertainty beginning to lift, the stock rallied from $2 to $3.
Stewart was expected to generate $300 to $500 million in cash from these sales. The amazing thing was that management had come up with a better option than I had envisioned. They were going to be able to eliminate the debt without any reduction in their cash flow. The lesson here is that we always have a free upside option on most equity investments when competent management comes up with actions that make the bet all the more favorable.
By March 2001, Stewart had paid down $50 + million of debt and cash flow remained strong. A few weeks thereafter, Stewart’s stock price went over $4 per share and I exited.
Subsequently, when Stewart got the sales consummated, the stock rallied to $8 per share and traded for quite a while between $6 to $8 per share. Wall Street could not distinguish between risk and uncertainty, and it got confused between the two. Savvy investors like Buffett and Graham have been taking advantage of Mr. Market’s handicap for decades with spectacular results. Take advantage of Wall Street’s handicap by seeking out low-risk, high-uncertainty bets.
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