Interview With Value Investor Mohnish Pabrai
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It is my privilege to bring you the following interview I recently conducted with value investing superstar Mohnish Pabrai. Mohnish is my favorite investor who doesn't have the initials W.B. His stock selection style is similar to mine, except that he's more successful at it. Much, much more successful.
I'll let the numbers speak for themselves: A $100,000 investment in Pabrai Funds at inception (on July 1, 1999) was worth $722,200 on March 31, 2007. That works out to an annualized return of 29.1%, and that's after all fees and expenses. Assets under management are over $500 million, up from $1 million at inception. Although a person probably can't get into the investing hall of fame with eight years of outperformance (even if they crush the indices), Pabrai is already mentioned in most articles about the search for the next Warren Buffett, and justifiably so.
Equally importantly, he genuinely wants to help others become better investors, and in that spirit has just published his second book, The Dhandho Investor. The book is both illuminating and easy to read, and it deserves to be on every investor's bookshelf next to Benjamin Graham's The Intelligent Investor. This is why I felt extremely fortunate when he recently agreed to answer some questions about his investment strategy in this exclusive interview, conducted by email. I hope you find it useful, and I hope it inspires you to pick up a copy of his book if you haven't already.
InvestorGuide: You have compared Pabrai Funds to the original Buffett parternships, and there are obvious similarities: investing only in companies within your circle of competence that have solid management and a competitive moat; knowing the intrinsic value now and having a confident estimate of it over the next few years, and being confident that both of these numbers are at least double the current price; and placing a very small number of very large bets where there is minimal downside risk. Are there any ways in which your approach differs from that of the early Buffett partnerships (or Benjamin Graham's approach), either because you have found ways to improve upon that strategy or because the investing world has changed since then?
Mohnish Pabrai: The similarity between Pabrai Funds and the Buffett Partnerships that I refer to is related to the structure of the partnerships. I copied Mr. Buffett's structure as much as I could since it made so much sense. The fact that it created a very enduring and deep moat wasn't bad either. These structural similarities are the fees (no management fees and 1/4 of the returns over 6% annually with high water marks), the investor base (initially mostly close friends and virtually no institutional participation), minimal discussion of portfolio holdings, annual redemptions and the promotion of looking at long term results etc. Of course, there is similarity in investment style, but as Charlie Munger says, "All intelligent investing is value investing."
My thoughts on this front are covered in more detail in Chapter 14 of The Dhandho Investor.
Regarding the investment style, Mr. Buffett is forced today to mostly be a buy and hold forever investor today due to size and corporate structure. Buying at 50 cents and selling at a dollar is likely to generate better returns than buy and hold forever. I believe both Mr. Munger and he would follow this modus operandi if they were working with a much smaller pool of capital. In his personal portfolio, even today, Mr. Buffett is not a buy and hold forever investor.
In the early days Mr. Buffett (and Benjamin Graham) focused on buying a fair business at a cheap price. Later, with Mr. Munger's influence, he changed to buying good businesses at a fair price. At Pabrai Funds, the ideal scenario is to buy a good business at a cheap price. That's very hard to always do. If we can't find enough of those, we go to buying fair businesses at cheap prices. So it has more similarity to the Buffett of the 1960s than the Buffett of 1990s. BTW, even the present day Buffett buys fair businesses at cheap prices for his personal portfolio.
Value investing is pretty straight-forward - you try to get $1 worth of assets for much less than $1. There is no way to improve on that basic truth. It's timeless.
InvestorGuide: Another possible difference between your style and Buffett's relates to the importance of moats. Your book does emphasize investing in companies that have strategic advantages which will enable them to achieve long-term profitability in the face of competition. But are moats less important if you're only expecting to hold a position for a couple years? Can you see the future clearly enough that you can identify a company whose moat may be under attack in 5 or 10 years, but be confident that that "Mr. Market" will not perceive that threat within the next few years? And how much do moats matter when you're investing in special situations? Would you pass on a special situation if it met all the other criteria on your checklist but didn't have a moat?
Pabrai: Moats are critically important. They are usually critical to the ability to generate future cash flows. Even if one invests with a time horizon of 2-3 years, the moat is quite important. The value of the business after 2-3 years is a function of the future cash it is expected to generate beyond that point. All I'm trying to do is buy a business for 1/2 (or less) than its intrinsic value 2-3 years out. In some cases intrinsic value grows dramatically over time. That's ideal. But even if intrinsic value does not change much over time, if you buy at 50 cents and sell at 90 cents in 2-3 years, the return on invested capital is very acceptable.
If you're buying and holding forever, you need very durable moats (American Express, Coca Cola, Washington Post etc.). In that case you must have increasing intrinsic values over time. Regardless of your initial intrinsic value discount, eventually your return will mirror the annualized increase/decrease in intrinsic value.
At Pabrai Funds, I've focused on 50+% discounts to intrinsic value. If I can get this in an American Express type business, that is ideal and amazing. But even if I invest in businesses where the moat is not as durable (Tesoro Petroleum, Level 3, Universal Stainless), the results are very acceptable. The key in these cases is large discounts to intrinsic value and not to think of them as buy and hold forever investments.
InvestorGuide: For that part of our readership which isn't able to invest in Pabrai Funds due to the net worth and minimum investment requirements, to what extent could they utilize your investing strategy themselves? Your approach seems feasible for retail investors, which is why I have been recommending your book to friends, colleagues, and random people I pass on the street. For example, your research primarily relies on freely available information, you aren't meeting with the company's management, and you don't have a team of analysts crunching numbers. To what extent do you think that a person with above-average intelligence who is willing to devote the necessary time would be able to use your approach to outperform the market long-term?
Pabrai: Investing is a peculiar business. The larger one gets, the worse one is likely to do. So this is a field where the individual investor has a huge leg up on the professionals and large investors. So, not only can The Dhandho Investor approach be applied by small investors, they are likely to get much better results from its application than I can get or multi-billion dollar funds can get. Temperament and passion are the key.
InvestorGuide: You founded, ran, and sold a very successful business prior to starting Pabrai Funds. Has that experience contributed to your investment success? Since that company was in the tech sector but you rarely buy tech stocks (apparently due to the rarity of moats in that sector), the benefits you may have derived seemingly aren't related to an expansion of your circle of competence. But has learning what it takes to run one specific business helped you become a better investor in all kinds of businesses, and if so, how? And have you learned anything as an investor that would make you a better CEO if you ever decide to start another company?
Pabrai: Buffett has a quote that goes something like: "Can you really explain to a fish what it's like to walk on land? One day on land is worth a thousand years of talking about it, and one day running a business has exactly the same kind of value." And of course he's said many times that he's a better investor because he's a businessman and he's a better businessman because he is an investor. My experience as an entrepreneur has been very fundamental to being any good at investing.
My dad was a quintessential entrepreneur. Over a 40-year period, he had started, grown, sold and liquidated a number of diverse businesses - everything from making a motion picture, setting up a radio station, manufacturing high end speakers, jewelry manufacturing, interior design, handyman services, real estate brokerage, insurance agency, selling magic kits by mail - the list is endless. The common theme across all his ventures was that they were all started with virtually no capital. Some got up to over 100 employees. His downfall was that he was very aggressive with growth plans and the businesses were severely undercapitalized and over-leveraged.
After my brother and I became teenagers, we served as his de facto board of directors. I remember many a meeting with him where we'd try to figure out how to juggle the very tight cash to keep the business going. And once I was 16, I'd go on sales calls with him or we'd run the business while he was traveling. I feel like I got my Harvard MBA even before I finished high school. I did not realize it then, but the experience of watching these businesses with a front-row seat during my teen years was extremely educational. It gave me the confidence to start my first business. And if I have an ability to get to the essence of a subset of businesses today, it is because of that experience.
TransTech was an IT Services/System Integration business. We provided consulting services, but did not develop any products etc. So it wasn't a tech-heavy business. While having a Computer Engineering degree and experience was useful, it wasn't critical. TransTech taught me a lot about business and that experience is invaluable in running Pabrai Funds. Investing in technology is easy to pass on because it is a Buffett edict not to invest in rapidly changing industries. Change is the enemy of the investor.
Being an investor is vastly easier than being a CEO. I've made the no-brainer decision to take the easy road! I do run a business even today. There are operating business elements of running a fund that resemble running a small business. But if I were to go back to running a business with dozens of employees, I think I'd be better at it than I was before the investing experience. Both investing and running a business are two sides of the same coin. They are joined at the hip and having experience doing both is fundamental to being a good investor. There are many successful investors who have never run a business before. My hat's off to them. - For me, without the business experiences as a teenager and the experience running TransTech, I think I'd have been a below average investor. I don't fully understand how they do it.
InvestorGuide: Is your investment strategy the best one for you, or the best one for many/most/all investors? Who should or shouldn't consider using your approach, and what does that decision depend on (time commitment, natural talent, analytical ability, business savvy, personality, etc)?
Pabrai: As I mentioned earlier, Charlie Munger says all intelligent investing is value investing. The term value investing is redundant. There is just one way to invest - buy assets for less than they are worth and sell them at full price. It is not "my approach." I lifted it from Graham, Munger and Buffett. Beyond that, one should stick to one's circle competence, read a lot and be very patient.
InvestorGuide: Some investment strategies stop working as soon as they become sufficiently popular. Do you think this would happen if everyone who reads The Dhandho Investor starts following your strategy? As I've monitored successful value investors I have noticed the same stocks appearing in their various portfolios surprisingly often. (As just one example, you beat Buffett to the convertible bonds of Level 3 Communications back in 2002, which I don't think was merely a coincidence.) If thousands of people start following your approach (using the same types of screens to identify promising candidates and then using the same types of filters to whittle down the list), might they end up with just slightly different subsets of the same couple dozen stocks? If so, that could quickly drive up the prices of those companies (especially on small caps, which seem to be your sweet spot) and eliminate the opportunities almost as soon as they arise. Looked at another way, your portfolio typically has about ten companies, which presumably you consider the ten best investments; if you weren't able to invest in those companies, are there another 10 (or 20, or 50) that you like almost as much?
Pabrai: As long as humans vacillate between fear and greed, there will be mispriced assets. Some will be priced too low and some will be priced too high. Mr. Buffett has been talking up the virtues of value investing for 50+ years and it has made very few folks adopt that approach. So if the #2 guy on the Forbes 400 has openly shared his secret sauce of how he got there for all these decades and his approach is still the exception in the industry, I don't believe I'll have any effect whatsoever.
Take the example of Petrochina. The stock went up some 8% after Buffett's stake was disclosed. One could have easily bought boat loads of Petrochina stock at that 8% premium to Buffett's last known buys. Well, since then Petrochina is up some eight-fold - excluding some very significant dividends. The entire planet could have done that trade. Yet very very few did. I read a study a few years back where some university professor had documented returns one would have made owning what Buffett did - buying and selling right after his trades were public knowledge. One would have trounced the S&P 500 just doing that. I don't know of any investors who religiously follow that compelling approach.
So, I'm not too concerned about value investing suddenly becoming hard to practice because there is one more book on a subject where scores of excellent books have already been written.
InvestorGuide: You have said that investors in Pabrai Funds shouldn't expect that your future performance will approach your past performance, and that it's more likely that you'll outperform the indices by a much smaller margin. Do you say this out of humility and a desire to underpromise and overdeliver, or is it based on market conditions (e.g. thinking that stocks in general are expensive now or that the market is more efficient now and there are fewer screaming bargains)? To argue the other side, I can think of at least two factors that might give your investors reason for optimism rather than pessimism: first, your growing circle of competence, which presumably is making you a better investor with each passing year; and second, your growing network of CEOs and entrepreneurs who can quickly give you firsthand information about the real state of a specific industry.
Pabrai: Future performance of Pabrai Funds is a function of future investments. I have no idea what these future investment ideas would be and thus one has to be cognizant of this reality. It would be foolhardy to set expectations based on the past. We do need to set some benchmarks and goals to be measured against. If a fund beats the Dow, S&P and Nasdaq by a small percentage over the long-haul they are likely to be in the very top echelons of money managers. So, while they may appear modest relative to the past, they are not easy goals for active managers to achieve.
The goals are independent of market conditions today versus the past. While circle of competence and knowledge does (hopefully) grow over time, it is hard to quantify that benefit in the context of our performance goals.
InvestorGuide: Finally, what advice do you have for anyone just getting started in investing, who dreams of replicating your performance? What should be on their "to do" list?
Pabrai: I started with studying Buffett. Then I added Munger, Templeton, Ruane, Whitman, Cates/Hawkins, Berkowitz etc. Best to study the philosophy of the various master value investors and their various specific investments. Then apply that approach with your own money and investment ideas and go from there.
Buffett Succeeds at Nothing
By Mohnish Pabrai
Editor's Note: Occasionally, we like to feature articles from readers in this space. Mohnish Pabrai, the managing partner of Pabrai Investment Funds and mpabrai on the Fool discussion boards, offers his view on the difficulty investors have -- professional and individual alike -- in just sitting still.
Seventeenth century French scientist Blaise Pascal is perhaps best remembered for his contributions to the field of pure geometry. In the 39 years that he lived, he found time to invent such modern day fundamentals as the syringe, the hydraulic press, and the first digital calculator. And, if that weren't enough, he was also a profound philosopher. One of my favorite Pascal quotes is: "All man's miseries derive from not being able to sit quietly in a room alone."
I've often thought that Pascal's words, slightly adapted, might apply well to a relatively new subset of humanity: "All portfolio managers' miseries derive from not being able to sit quietly in a room alone."
Why should portfolio managers sit and do nothing? And why would that be good for them? Well, let's start with the story of D.E. Shaw & Co. Founded in 1988, Shaw was staffed by some of the brightest mathematicians, computer scientists, and bond trading experts on the planet. Jeff Bezos worked at Shaw before embarking on his Amazon.com(Nasdaq: AMZN) journey. These folks found that there was a lot of money to be made with risk-free arbitrage in the bond markets with some highly sophisticated bond arbitrage trading algorithms.
Shaw was able to capitalize on minuscule short-term inefficiencies in the bond markets with highly leveraged capital. The annualized returns were nothing short of spectacular -- and all of it risk-free! The bright folks at Shaw put their trading on autopilot, with minimal human tweaking required. They came to work and mostly played pool or video games or just goofed off. Shaw's profit per employee was astronomical, and everyone was happy with this Utopian arrangement.
Eventually, the nerds got fidgety -- they wanted to do something. They felt that they had only scratched the surface and, if they only dug deeper, there would be more gold to be mined. And so they fiddled with the system to try to juice returns.
What followed was a similar path taken by Long-Term Capital Management (LTCM), a fund once considered so big and so smart on Wall Street that it simply could not fail. And yet, when economic events that did not conform to its historical model took place in rapid succession, it nearly did just that. There was a gradual movement from pure risk-free arbitrage to playing the risky arbitrage game in the equity markets. A lot more capital could be deployed, and the returns looked appealing. With no guaranteed short-term convergence and highly leveraged positions, the eventual result was a blow-up that nearly wiped out the firm.
Compared to nearly any other discipline, I find that fund management is, in many respects, a bizarre field --where hard work and intellect don't necessarily lead to satisfactory results. As Warren Buffett succinctly put it during the 1998 Berkshire Hathaway(NYSE: BRK.A) annual meeting: "We don't get paid for activity, just for being right. As to how long we'll wait, we'll wait indefinitely!"
Buffett and his business partner Charlie Munger are easily among the smartest folks I've come across. But, as we've seen with Shaw and LTCM, a high I.Q. may not lead to stellar investing results. After all, LTCM's founders had among them Nobel Prize-winning economists. In the long-run, it didn't do them much good. In fact, they outsmarted themselves. In a 1999 interview with BusinessWeek, Buffett stated:
Success in investing doesn't correlate with IQ -- once you're above the level of 25. Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing.
Events at Shaw and LTCM show that high-IQ folks have a hard time sitting around contemplating their navels. The problem is that once you engage in these intellectually stimulating problems, you're almost guaranteed to find what you think are the correct answers and act upon them -- usually leading to bad results for investors.
Having observed Buffett and Munger closely over the years, and gotten into their psyche through their speeches and writings, it is clear to me that, like the folks at Shaw and LTCM, both men need enormous doses of intellectual stimulation as part of their daily diet. How do they satisfy this intellectual hunger without the accompanying actions that get investors into trouble?
Consider the following:
While Buffett plays bridge (typically 10-20 hours per week), Munger spends his time mostly on expanding his worldly wisdom and constantly improving his latticework of mental models. He is a voracious reader of intellectually engaging books on a variety of subjects, ranging from the various Ice Ages to The Wealth and Poverty of Nations. He spends considerable time in applying perspectives gained from one field of study into other disciplines -- especially capital allocation.
At the Wesco(AMEX: WSC) annual meeting this year, Munger acknowledged that the first few hundred million dollars at Berkshire came from "running a Geiger counter over everything," but the subsequent tens of billions have come from simply "waiting for the no-brainers" or, as Buffett puts it, "waiting for the phone to ring."
Buffett still has a tendency to run his Geiger counter over lots of stuff. It's just too enticing intellectually not to. How does he avoid getting into trouble? I believe there are three reasons:
1. Running the Geiger counter can work very well if one knows when to run it. Reflect on the following two quotes:
In 1970, showing his dismay at elevated stock prices, Buffett said: "I feel like a sex-starved man on a deserted island."
In 1974, expressing his glee at the low levels to which the market had fallen, he said: "I feel like a sex-starved man in a harem filled with beautiful women!"
By 1970, he had terminated his partnership and made virtually no public market investments until 1974. The P/E ratio for the S&P 500 dropped from 20 to 7 in those four years. By 1974, he had acknowledged selling "stocks he'd bought recently at 3 times earnings to buy stocks selling at 2 times earnings."
Then, from 1984-1987, Buffett did not buy a single new equity position for the Berkshire portfolio. Berkshire Hathaway was sitting on a mountain of cash, and still he did nothing. In the latter half of 1987, Berkshire used that cash pile to buy over a billion dollars' worth of Coca-Cola(NYSE: KO), over 5% of the company. He invested 25% of Berkshire Hathaway's book value in a single company that they did not control!
What were Buffett and Munger doing from 1970-1973 and 1984-1987? Both men realize that successful investing requires the patience and discipline to make big bets during the relatively infrequent intervals when the markets are undervalued, and to do "something else" during the long periods when markets are fully priced or overpriced. I'm willing to bet that Buffett was playing far more bridge in 1972 than he was in 1974.
2. The Geiger counter approach works better in smaller, under-followed companies and a host of special situations. Given their typical smaller size, investing in these companies would do nothing for Berkshire Hathaway today. So Buffett usually makes these investments for his personal portfolio. A good example is his recent investment in mortgage REIT Laser Mortgage Management (LMM), where there was a decent spread between the liquidation value and quoted stock price. These LMM-type investments are significant for Buffett's personal portfolio and, more importantly, soak up intellectual horsepower that might lead to not-so-good results at Berkshire Hathaway.
Being versatile, he moves his Geiger counter away from the equity markets to other bastions of inefficiency whenever the public markets get overheated. These include high-yield bonds (Berkshire bought over $1 billion worth of Finova bonds at deep discounts in 2001), REITs (bought First Industrial Realty in 2000 for his own portfolio at a time when REIT yields were spectacular), or his recent investing adventures in silver.
3. The Munger/Buffett relationship is an unusual one. Both men are fiercely independent thinkers, and both prefer working alone. When Buffett has an investment idea, after it makes it through his filter, he usually runs it past Munger. Munger then applies his broad latticework of mental models to find faults with Buffett's ideas, and shoots most of them down. It is the rare idea that makes it past Buffett, and it has to be a total no-brainer to make it past both of them.
The Buffett/Munger approach of multi-year periods of inactivity contrasts starkly with the frenzied activity that takes place daily at the major exchanges. Which brings me back to the fundamental question: Why have we set up portfolio managers as full-time professionals with the expectation that they "do something smart" every day? The fund management industry needs to reflect on Pascal's potent words and how Warren Buffett and Charlie Munger have figured out how to sit quietly alone in a room, indefinitely.
Guest writer Mohnish Pabrai is the managing partner of Pabrai Investment Funds, an Illinois-based value-centric group of investment funds. He owns shares of Berkshire Hathaway. You can email him at email@example.com, or find him on the Rule Maker discussion boards. To read his other writings, visitwww.pabraifunds.com. The Motley Fool is investors writing for investors.
Mohnish Pabrai’s portfolio is not perfect because of what is inside, but rather because of how the fund is assembled. Pabrai is the managing partner of the Pabrai Investment Funds, a partnership with $500 million under management. Besides the 29% returned annually to partners, Pabrai has designed brilliant portfolio concepts.
Incalculable amounts of time are spent studying which investments to buy, but very little time is spent thinking about how much. The decision is usually left up to the investor’s confidence in the investment, something that has been shown to be unstable. The truth is, deciding how much to buy can have a large impact on a portfolio, occasionally just as much as what is bought. There are copious amounts of information on what to buy, but very little on how much.
To combat his untrustworthy feelings of self-confidence, Pabrai developed a new “portfolio theory.” I will call it the ten by ten portfolio. Ten investments that each make up ten percent of the portfolio. Pabrai holds between seven and fifteen different investments, but appears to stay close to the ten by ten benchmark. The fund is difficult to proportion perfectly, because a stock can run up before a full lot has been purchased or because a previous position has already advanced.
The proportioned ten by ten portfolio has other, less obvious effects. The benchmark percentage ensures the investor is confident enough to place 10% of their holdings in the investment. If they aren’t, then they should not invest at all. Simply put, the portfolio attempts to ensure only the best ideas get in.
As Buffett says repeatedly:
“ When making investments, pretend in life you have a punch-card with only 20 boxes, and every time you make an investment you punch a slot. It will discipline you to only make investments you have extreme confidence in.”
Additionally, a portfolio with ten stocks is focused enough to be able to beat the market, but not so focused that one wrong pick means the death of the whole fund. Pabrai admits he knows he is not as good a judge as Warren Buffett, who put nearly his entire wealth into GEICO stock at a young age. Therefore, if Pabrai is wrong, his fund can still do quite well. He has been wrong in the past ten years, while still returning nearly thirty percent per year after expenses.
Pabrai gave the following portfolio as an example at his 2005 annual meeting. He provided the following information to demonstrate how the ten by ten portfolio will do well even with some bad investment decisions.
He went on to explain that if the above returns took three years to achieve; the fund would have an annual return of 14.5%. If the returns took two years to achieve, the fund would have returned 22.5% per year and if only one year passed, the return would be 50%.
Another Pabrai concept is the “placeholder.” He contends that money sitting in the bank is actually risky because of the potentially declining dollar. Economically speaking, this is true. To combat the risk, Pabrai believes one should invest the cash in something safe, yielding enough return value. Currently, he is using Berkshire Hathaway as a placeholder until he finds other cheaper investments. Putting the money in the hands of the world’s greatest investor seems like a better idea than leaving dollars in the bank.
A past placeholder returned an annualized rate of about 116%. In mid October of 2004, Pabrai began buying Canadian Oil Sands, a company that owns 35% of Syncrude, when oil was forty dollars a barrel. The stock price was still undervalued by over 25% in comparison to the price of oil at the time, and appeared to value the company as if oil was never going to rise. In essence, Pabrai decided to take his cash and buy crude oil reserves at thirty dollars instead. He believed this to be a “productive commodity hedge against a declining dollar.”
He began buying the stock at forty-eight dollars and eighty one cents. Over an average of fourteen months, Pabrai had realized a gain of 145%.
His rational was stunningly simple. If oil prices did not rise, Pabrai did well from the dividend he was collecting. If prices rose to forty or fifty dollars a barrel, then he won big. Oil as it turned out climbed around sixty dollars and Pabrai began selling. He had invested in a stock that appeared to have little risk, was already selling at a decent discount, and had a catalyst to rise a great deal in the future.
Pabrai knows the dollar over time will likely decrease in value, and he has developed a concept to protect his portfolio from the risk. He has chosen to buy commodities or other safe companies that will be a better steward of his cash.
The last part to Pabrai’s portfolio is actually the first concept he addresses when researching an investment and is unique to the Pabrai Investment Funds.
In an article published on February ninth, 2004, Pabrai explains what he calls the “Yellowstone Factor”. He explained that Yellowstone national park is actually one large volcano that statistically speaking erupts every six hundred thousand years, with enough force to kill everyone within 700 miles. An eruption has not occurred in six hundred and thirty thousand years.
Therefore Pabrai explains, no matter how small the probability an event might occur, the risk must be taken into consideration. He goes on to point out that no business on earth is totally risk free. There is always a Yellowstone.
Before Pabrai makes any investment, he will “first fixate on what factors can cause the investment to result in a significant permanent loss of capital”. He believes simple estimations or “back of the envelope accounting” is all that is required. Similar probabilities can be assigned to other kinds of risk such as accounting fraud.
While the analogy of Yellowstone erupting is interesting, the message is paramount. Consider all possible risks of loss and ascribe a probability of the event occurring.
To reduce risk as much as possible, Pabrai ensures his holdings have little overlap. For instance, he will usually only hold one investment in the oil industry. He can minimize industry specific risk effectively by isolating his holdings.
Pabrai has simplified portfolio design with straightforward concepts. He has whittled Buffett’s ideas into easily followed rules. By limiting holdings, hedging against the declining dollar, and estimating risk, Pabrai has developed a portfolio that will certainly improve any investor’s performance.
Mohnish Pabrai, is Managing Partner of Pabrai Investment Funds, a group of focused value funds. Since inception in 1999 with $1 million, Pabrai Funds has grown to over $500 million in assets under management. Pabrai is the author of two books on value investing,Mosaic andThe Dhandho Investor.
Mohnish Pabrai’s talk centers on checklists for investing. Mohnish “highly, highly recommends reading Dr. Atul’s book,The Checklist Manifesto: How to Get Things Right.”
In 1935 when the US was looking for next bomber, Boeing invented the B-17 bomber widely exceeded everything the army had previously put out, however they had a test run and two pilots died.
Boeing went back to look at what happened. And they realized that this was too complex. So Boeing engineers came up with a checklist. Afterwards the plan had a flawless bomber.
Today the aviation check list has become very organized, and the pilots are trained to live and die by that checklist.
The list is highly practical and easy to understand. The checklist is extensively researched and is stimulated by flight simulators to see if anything should be added or subtracted.
In America there are five million lines inserted into America in ICUs. About 80% of these line insertions led to infection, of which 20-25% of which were fatal.
A doctor in John Hopkins had nurses stand by the doctors before line insertions.
He listed five points in his check list which are all pretty basic thinks like washing hands with soaps before line insertions.
Nurses noticed that a lot of these rules were missed, so he had the nurses make sure the doctor kept to the five rules. After this happened the amount of infections went down to zero. He took this approach to other hospitals. And nowadays this procedure has become standard in US hospitals.
The FAA is actually one of the most successful agencies.
The FAA has very little to do with actual flights, they only go into action when an accident occurs. The FAA gets down of what happened. Bird hits happen to be a major problem for airplanes. When the Hudson crash occurred due to the Canadian geese, the FAA made sure to keep better track of Canadian Geese.
Flying is very cheap and safe. However, the nuclear industry took a different approach which was not pragmatic and could not tolerate a single human life. And we are praying the price 20 years later.
Mohnish found that the FAA approach could be used in investing. He compares a crash to a loss of capital.
Mohnish started building an investment checklist. He looked at mistakes Warren Buffett and Charlie Munger made and mistakes by other great value investors.
Mohnish compiled a list of 70 items two years ago. Since then Mohnish has achieved a zero error rate. However, Mohnish warns there are bound to be errors in the future.
Mohnish looked at many the great fund’s 13Fs from 2004 to see approximately what their buy price and look at their sell price. He analyzed twelve investors and came up with a list of 320 companies that these investors lost money in totaling $20 billion. He looked at why they might have bought and sold these securities.
He picked 26 of the 320 companies and looked in depth at them. He only looked at three financial companies to diversify across industries. Now Mohnish is up to 97 points in his checklist.
Mohnish quotes Jack Welsh as stating that GE will only be in an industry where they are number one or two.
HP and Lexmark had a duopoly in printers. Oakmark and Davis Funds lost a lot of money in Lexmark.
However, if you looked at checklist you likely would have avoided this investment. Lexmark was more similar to Schick than to Gillette.
One are with the largest area of mistakes has to do with moats. The question that must be asked is if the moat is sinking. LongLeaf lost $550 million in Sun Micro systems.
There was a huge decrease in computer prices over the past few years, plus a shift from desktops to laptops this affected Dell a lot. LongLeaf, and Fairfax had some pain in that company.
LongLeaf bought GM thinking that GM owned the truck business. When gas went to $4, GM was decimated. One of the checklist items is to look at what other factors can affect a moat in this case being commodity prices.
There are give categories in the check list:
Personal biases are a small part.
Leverage, Management, Moat and valuation are the main four items of the checklists.
The checklist highlights the possible main failure points. But there will never be an investment that will fit all 97 items.
Mohnish is currently building a cheap Japanese basket of cheap stocks. Mohnish believes there is a great opportunity in that market. Despite the fact that it is hard to invest in the low cap and micro cap Japanese stocks.
Mohnish does not currently have a checklist for selling.
Intelligent Investing Transcript
Transcript: Mohnish Pabrai
Steve Forbes, 04.12.10, 6:00 AM ET
Lessons From Buffett
Steve Forbes: Mohnish, thank you very much for joining us today.
Mohnish Pabrai: You're most welcome.
Forbes: You are one of the noted value investors, one of those who is an admirer of Warren Buffett. What did you take from Warren Buffett? And what do you do differently from Warren Buffett? You're not a clone.
Pabrai: Well, you know, we will never have another Warren. I think Warren is a very unique person. And also, I think that his investing prowess is so strong that many of his other attributes and, I would say, his other qualities get ignored. I believe the best things about Warren have nothing to do with investing. But they have everything to do with leading a great life. So many of the things, I think, most of the great things I've taken from Warren have more to do with life than investing.
Forbes: Such as?
Pabrai: Well, such as, you know, how to raise a family, interaction with friends, the importance of keeping your ego in check. You know, humility. Just a whole bunch of different attributes. The importance of candor, the importance of integrity. Just all these, the soft skills that are very important in life.
Forbes: They do interconnect. Now, in terms of how you approach an investment, you, I think, probably pay more attention to intangibles than perhaps Warren Buffett or Ben Graham might have done.
Pabrai: Well, Warren pays attention to intangibles, but Ben Graham was very much a tangible guy. And yeah, so we're looking at the qualitative as well as the quantitative. And yeah, so I would say that one way to look at that is to consider what Charlie Munger would call his latticework of mental models. So when you look at a business, look at it in a broader context of how it fits into the world. And sometimes, if you can see it in a light that the world is not seeing it in, that can give you an edge.
Forbes: Munger also said, "You have three choices: yes, no, or too difficult." You subscribe to that too.
Pabrai: That's right. And 98% is too difficult.
Find Deep Moats
Forbes: So that gets to knowing your areas of competency. You share Warren Buffett's antipathy to technology. Not that you dislike it, but you just don't feel you're going to bring value added there.
Pabrai: Yeah, you know, my degrees are in computer engineering. I spent a lot of time in the tech industry. And I like to say that I don't invest in tech because I spent time in it. And I saw firsthand that the durability of technology moats is many times an oxymoron.
Forbes: Now quickly define moats, in terms of a business that keeps the competition away.
Pabrai: Well, you know, if you talk to Michael Porter, he would give you five books on what is meant by, you know, strategy and competitive advantage and durable competitive advantage. And if you talk to Warren and Charlie, they would just say it's a moat. And they'd break it down to one word. But basically it's the ability of a business to have some type of an enduring competitive advantage that allows it to earn a better-than-average rate of return over an extended period of time. And so some businesses have narrow moats. Some have broad moats. Some have moats that are deep but get filled up pretty quickly. So what you want is a business that has a deep moat with lots of piranha in it and that's getting deeper by the day. That's a great business.
Forbes: So summing up in terms of what do you think do you bring to value investing that others perhaps don't, that give you a unique edge?
Pabrai: I think the biggest edge would be attitude. So you know, Charlie Munger likes to say that you don't make money when you buy stocks. And you don't make money when you sell stocks. You make money by waiting. And so the biggest, the single biggest advantage a value investor has is not IQ; it's patience and waiting. Waiting for the right pitch and waiting for many years for the right pitch.
Forbes: So what's that saying of Pascal that you like about just sitting in a room?
Pabrai: Yeah. "All man's miseries stem from his inability to sit in a room alone and do nothing." And all I'd like to do to adapt Pascal is, "All investment managers' miseries stem from the inability to sit alone in a room and do nothing."
Forbes: So you don't feel the need to pick 10 stocks a quarter or one stock a quarter, just what turns up?
Pabrai: You know, actually, I think that the way the investment business is set up, it's actually set up the wrong way. The correct way to set it up is to have gentlemen of leisure, who go about their leisurely tasks, and when the world is severely fearful is when they put their leisurely task aside and go to work. That would be the ideal way to set up the investment business.
Forbes: Does this tie into your ideas and other value investors' ideas of low risk, high uncertainty?
Pabrai: That's right. I mean, I think the low risk, high uncertainty is really something I borrowed from entrepreneurs, and you know, the Patels in India or the Richard Bransons of the world. Basically if you study entrepreneurs, there is a misnomer: People think that entrepreneurs take risk, and they get rewarded because they take risk. In reality entrepreneurs do everything they can to minimize risk. They are not interested in taking risk. They want free lunches and they go after free lunches. And so if you study any number of entrepreneurs, from Ray Kroc to, you know, Herb Schultz at Starbucks and to even Buffett and Munger and so on, what you'll find is that they have repeatedly made bets which are low-risk bets, which have high-return possibilities. So they're not going high risk, high return. They're going low risk, high return.
And even with Bill Gates, for example. The total amount of capital that ever went into Microsoft was less than $50,000, between the time it started and today. That's the total amount of capital that went into the company. So Microsoft you cannot say was a high-risk venture because there was no capital deployed. But it had high uncertainty. Bill Gates could have gone bankrupt. Or Bill Gates could have ended up the wealthiest person on the Forbes 400. And he ended up at the extreme end of the bell curve, and that's fine. But he did not take risk to get there. He was comfortable with uncertainty. So entrepreneurs are great at dealing with uncertainty and also very good at minimizing risk. That's the classic great entrepreneur.
Low Risk, Low Capital
Forbes: This is your almost third career. And this idea you have on uncertainty and risk. You started a company. It worked. You sold it. You started another company. It did not work. What did you learn from that that gave you insights on investing that, those that had not been in the trenches, don't bring?
Pabrai: Well the first company took no capital and generated an enormous amount of capital for me. Then I got fat, dumb and happy and my second company, I put in a lot of capital.
Forbes: You thought you knew what you were doing.
Pabrai: And I violated the low risk, high uncertainty principle. I got my head handed to me. And I got that seared heavily in my psyche. And now the third business, if you call Pabrai Funds a business--I call it a "gentleman of leisure" activity--but Pabrai Funds is, again, low risk, high uncertainty in the sense that there is no downside. It never took capital. So it's a great business.
Forbes: So as a gentleman of leisure, is that why you take a nap each day at 4 p.m.?
Pabrai: There's nothing better. Do you have a nap room?
Forbes: I wish.
Pabrai: You know, when I went to Warren's Berkshire headquarters last year, my friend Guy asked Warren, he said, "Warren, Mohnish has a nap room in his office. Do you have a nap room?" And Warren's answer was, "Yes." OK, so I was surprised. So I said, "Warren, you're telling me in Kiewit Plaza, there's a nap room for you." He says, "Yes." He says, "Not every day, but every once in a while, I need to go to sleep in the afternoon."
Forbes: Well there's something to that. My father called it having a conference.
Pabrai: That's right. No, it does wonders. I have a hard time getting past the day without the nap, so the nap is a must.
Forbes: So having those two experiences--no capital, then as you say, fat and happy and then you got your head handed to you--when you look at an equity, when you look at a possibility, what are those experiences, give what insight do you get from those experiences.
Pabrai: Well, the insight is the same, in the sense that I think that, you know, Warren says that I'm a better investor because I'm a businessman, and I'm a better businessman because I'm an investor. So the thing is that my experiences as a businessman have very direct, long-term positive impacts on me as an investor, because when I'm looking at an investment, I now look at it like the way I looked at my first business, which is, the first thing I'm looking at is, how can I lose money on this? And can I absolutely minimize my downside?
The upsides will take care of themselves. It's the downsides that one needs to worry about, which is why even the checklist becomes important. But so the important thing that value investors focus on is downside protection. And that's exactly what entrepreneurs focus on--what is my downside? So that is the, I would say, the crossover between entrepreneurship in investing, and value investing especially, is protecting your downside.
Forbes: Now you're a hedge fund manager, but you're unusual. First, your fee structure. Explain that.
Pabrai: Well you know, my fee structure, one of my attributes about a great investor is be a copycat. Do not be an innovator.
Forbes: What's it, pioneers take the arrows?
Pabrai: Yeah. When I started Pabrai Funds, I actually didn't know anything about the investing business. And the only, if you can call it a hedge fund, that I was familiar with was the Buffett partnerships. And when I looked at the Buffett partnerships, I found that Warren Buffett charged no management fees. He took 25% of the profits, after a 6% hurdle. And all of that made all the sense in the world to me, because I felt it aligned my interests completely with my investors. So I said, "Why mess with perfection? Let's just mirror it." And that's what I did. And what I didn't realize at the time--it took me a few years to realize it--is that that mirroring created an enormous moat for Pabrai Funds. Because the investors who joined me will never leave, because it's the first question they ask any other money manager they go to work for or they want to put money with is, "What is your fee structure?"
When they hear the fee structure, they say, "I'm just going to stay where I am." And so first of all, it creates a moat where the existing investors do not want to leave. And the new ones who join the church are happy to join.
Forbes: You're also unusual in another way. You don't seem to go out of your way to woo institutional investors.
Pabrai: Yeah, I mean, I think I'm looking for people who want to invest their family assets for a long period of time. I really don't want investors who are looking at putting things into style buckets or going to look at allocations every quarter or might need to redeem in a year and those sorts of things. So their frameworks are very different. So in general--
Forbes: So someone who comes with you is a minimum of, what, two years, three years, what, before you allow them an exit?
Pabrai: Our exits are annual. So people can get out once a year. But what we suggest to them is to not invest if they don't have at least a five-year horizon. But we don't impose any, because people can have hardships. They can have all kinds of things happen.
Forbes: Now, low cost, one of the things that apparently institutional investors are flummoxed by is, it's you.
Pabrai: Our total expenses for running the funds, which the investors get charged for, is between 10 and 15 basis points a year. That's what they pay for, for all the accounting, audit, tax, administration and everything. They don't pay for my salary or my staff's salary. We take that out of the performance fees. And they only pay the performance fees after 6%. So what a deal.
Forbes: Now, you're not big on schmoozing investors.
Pabrai: You know, I think the thing is that every business ought to figure out who their ideal customer is.
And at Pabrai Funds, what I've found is that investors who do their own homework find me and do the research on me on their own, without any middlemen involved, and then invest in Pabrai Funds like Amazon--which is wire the money and send the forms--tend to be the best investors. In fact the investor base we have is mostly entrepreneurs who created their wealth themselves. And they're very smart. And they're in a wide range of industries. In fact, my analyst pool is my investor base. So I have investors in all kinds of industries. And when I'm looking at investment ideas in particular industries, I can call them. And I get the best analysts at the best price with no conflict of interest. So it works out great.
Forbes: Free. That sounds really good. They pay you.
Pabrai: Yeah, exactly. It's great.
Forbes: You're not even registered with the SEC?
Pabrai: I think the hedge funds so far have not had to. I don't know if the rules will change. If the rules change, of course, we'll follow the rules. But you know, we have audits by Pricewaterhouse. We have to report 13fs to the SEC. So I think there's plenty of disclosure and transparency.
Forbes: You also don't engage in things like short-selling.
Pabrai: You know, why would you want to take a bet, Steve, where your maximum upside is a double and your maximum downside is bankruptcy? It never made any sense to me, so why go there?
Forbes: You focus on a handful of individual investors, maybe institutional investors, but people who know you, are with you.
Forbes: You're not part of a formula, not spit out of a computer.
Pabrai: That's right.
Use Index Funds
Forbes: What's an individual investor to do? You have some unique advice for individual investors.
Pabrai: Well the best thing for an individual investor to do is to invest in index funds. But even before we go there, you know, Charlie Munger was asked at one of the Berkshire annual meetings by a young man, "How can I get rich?" And Munger's response was very simple. He said, "If you consistently spend less than you earn and invest it in index funds, dollar-cost average," because you're putting in money every paycheck, he said, "that in, what, 20, 30, or 40 years, you can't help but be rich. It's just bound to happen."
And so any individual investor, if they just put away 5%, 10%, 15% of their income every month, and they just bought into the low-cost index funds, and just two or three of them, to split it amongst them--you're done. There's nothing else to be done. Now if you go to active managers, the stats are pretty clear: 80% to 90% of active managers underperform the indexes. But even the 10% or 20% who do, only one in 200 managers outperforms the index consistently by more than 3% a year. So the chances that an individual investor will find someone who beat the index by more than 3% a year is less than 1%. It's half a percent. So it's not worth playing that game.
Forbes: And in terms of index funds, S&P 500 or--
Pabrai: I'd say Vanguard is a great way to go. I think you could do S&P 500 index. You could do the Russell 2000. And if you wanted to, you could do an emerging-market index. But you know, I think if you just blend those three, one-third each, you're done. And if you're in your 20s and you start doing this, you don't need to even go into bonds and other things. You can just do this for a long time and you'll be fine.
Don't Go in the Roach Motel
Forbes: On TV when these folks make recommendations--you compare it to if you buy something that you heard somebody recommend on TV as going into the roach motel. Can you please explain?
Pabrai: Well you know, you remember those ads that ran where the roaches check in.
Pabrai: But they never check out. So the thing is, you watch some talking head on TV. And he tells you, "Go buy whatever company, Citigroup."
When its price gets cut in half, he's nowhere to be found. And now you're like that roach in the roach motel and you don't know what to do. You don't know whether you should hang on or sell or stay. So the only reason--
Forbes: Or if it goes up, do I get out? Do I wait?
Pabrai: Yeah, yeah. If it goes up 10% or 50% or 100%, what are you supposed to do? Do you want to go for long-term gain, short-term gains? Basically you have no road map. So the only way one should buy stocks is if you understand the underlying business. You stay within the circle of competence. You buy businesses you understand.
And if you understand the business, you understand what they're worth. And that's the only reason you are to buy a stock.
The Chinese Books
Forbes: And looking around the world, you made mention I think in the past, if you want an index fund with the emerging markets, OK. But you have us take a skeptical eye to investing in other countries around the world. You don't preclude it, but you see some risks.
Pabrai: Well, you know, Steve, there's plenty of great opportunities in many countries. But I would say it's probably a no-brainer to avoid Russia, Zimbabwe. And even if you look at a place like China, which I think will create incredible amount of wealth for humanity in this century, the average Chinese company has three sets of books.
You know, one for the government, and one for the owner's wife and one for the owner's mistress. And so the problem you have is you don't know which set of books you're looking at. And so I think in Chinese companies, or even in Indian companies, there you have to add another layer, which is you have to handicap the ethos of management. And that can get very hard, especially when someone like me is sitting in Irvine with naps in the afternoon, trying to figure that out.
Forbes: You also say you don't think you get much talking to CEOs, because they're in the business of sales.
Pabrai: Yeah, you know, the average CEO, first of all, the average public CEO is a person you'd be happy to have your daughter marry, any five of them. But they got to those positions because they have charisma and they are great salespeople. Now you cannot lead, you cannot be a leader, without being an optimist. So CEOs are not deceitful. I think they are high-integrity people. But if you sit down with a high-charisma CEO of an oil company, and he knows everything about oil and you know nothing about oil, by the time you finish that meeting, you just want to run out and buy all the stock of his company that you can. And it's just not the right way to go about it. So you're better off not taking the meeting, but looking at what he's done over the last 10 or 15 or 20 years. So not being mesmerized by charisma will probably help you.
Forbes: And what areas are you looking at right now? You remember back in 1968, '69, we did a story on Buffett when he was fairly unknown. And he was getting out of the market, height of the bull market of the '60s. Five years later after the crash of '73, '74, we went out to see him again, to see what he was saying after the market had gone down 50%, 60%. And he politically incorrectly said that he felt like a sex maniac in a harem because of all the bargains around.
Forbes: You've probably had the same feeling a year ago. What do you see? How does the harem look now?
Pabrai: That's right. In 1969 Warren told you "I feel like a sex-starved man on a deserted island." And in '74, that deserted island had become a harem. Well nowadays, we're twiddling our thumbs. It's good that I enjoy playing racquetball and bridge and so on. So there's a lot of bridge. There's a lot of racquetball. And you know, I have an eye out on the markets, but there's just not a whole lot of value presently. But value can show up tomorrow, for example. So we're not in a hurry. Happy to have a leisurely lifestyle and wait for the game to come to us.
Forbes: So in the first quarter of 2010, did you add any positions?
Pabrai: Yeah, actually, we did. We did find. In fact, there's one I'm buying right now. But I found two businesses, but they're anomalies. They were just, you know, businesses that had distress in them because of specific factors. And I think we'll do very well on both of them. They'll go nameless here. But no, I think, for example, in the fourth quarter of 2008 or the first quarter of 2009, you could have just thrown darts and done well. And that is definitely not the case today.
Forbes: And finally, telling you about mistakes, one of the things I guess an investor has to realize, they cannot control the universe. Delta Financial: You had done the homework, you fell and then events took it away from you.
Pabrai: Well Delta Financial was a full loss for the firm, for the fund. We lost 100% of our investment. It was a company that went bankrupt. And we've learned a lot of lessons from Delta. And one of the lessons was that Delta was, in many ways, a very highly levered company and they were very dependent on a functioning securitization market. And when that market shut down, they were pretty much out of business. And they were caught flat-footed. And so there's a number of lessons I've obviously learned from Delta.
It's easier to learn the lessons when you don't take the hits in your own portfolio. But when you take the hits in your own portfolio, those lessons stay with you for a long time.
Forbes: So that gets to, you're a great fan of The Checklist Manifesto. And you now have checklists. You said one of the key things is mistakes, in terms of a checklist, so you don't let your emotions get in the way of analyzing. What are some of the mistakes on your checklist now that you go through systematically, even if your gut says, "This is great. I want to do it."
Pabrai: Yeah, so the checklist I have currently has about 80 items on it. And even though 80 sounds like a lot, it doesn't take a long time.
It takes about 30 minutes to go through the checklist. What I do is when I'm starting a business, I go through my normal process of analyzing the business. When I'm fully done and I'm ready to pull the trigger, that's when I take the business to the checklist. And I run it against the 80 items. And what happens the first time when I run it, there might be seven or eight questions that I don't know the answer to, which is great, which what that means is, "Listen dummy, go find out the answer to these eight questions first." Which means I have more work to do. So I go off again to find those answers. When I have those answers, I come back and run the checklist again. And any business that I look at is going to have some items on which the checklist raises red flags. But the good news is that you're looking in front of you with all your facilities at the range of things that could possibly cause a problem.
And when you look at that list, you can also compare it to how those factors correlate with the rest of your portfolio. And at that point, kind of, you have a go, no-go point, where you can say, "I'm comfortable with these risk factors here. I'm comfortable with probabilities. And I'll go ahead with it." Or you can say, "I'm just going to take a pass."
And one of the things that came out of running the checklist was I used to run a 10x10 portfolio, which is when I'd make a bet, it was typically 10% of assets. And after I incorporated the checklist and I started to see all the red flags, I changed my allocation. So the typical allocation now at Pabrai Funds is 5%. And we'll go as low as 2%, if we are doing a basket bet.
And once in a blue moon, we'll go up to 10%. In fact I haven't done a 10% investment in a long time. And so the portfolio has become more names than it used to have. But since we started running the checklists, which is about 18 months ago, so far it's a zero error rate. And in the last 18 months, it's probably been the most prolific period of making investments for Pabrai Funds. We made a huge number of investments, more than any other period, any other 18-month period in our history. So with more activity so far, and it's a very short period, we have a much lower error rate.
I know in the future we will make errors. But I know those errors, the rate of errors will be much lower. And this is key. The thing is that Warren says, "Rule No. 1: Don't lose money. Rule No. 2: Don't forget rule No. 1." OK, so the key to investing is downside protection. The upsides will take care of themselves. But you have to make sure that your losers are few and far between. And the checklist is very central to that.
Forbes: Can you give a couple of the things that are on your 80 [item] checklist?
Pabrai: Oh yeah, sure. The checklist was created, looking at my mistakes and other investors' mistakes. So for example, there's questions like, you know, "Can this business be decimated by low-cost competition from China or other low-cost countries?" That's a checklist question. Another question is, "Is this a win-win business for the entire ecosystem?" So for example, if there's some company doing, you know, high-interest credit cards and they make a lot of money, that's not exactly, you know, helping society. So you might pass on that. Also, a liquor company or tobacco company, those can be great businesses, but in my book, I would just pass on those. Or a gambling business, and so on.
So the checklist will kind of focus you more toward playing center court rather than going to the edge of the court. And there's a whole set of questions on leverage. For example, you know, how much leverage? What are the covenants? Is it recourse or non-recourse? There's a whole bunch of questions on management, on management comp, on the interests of management. You know, just a whole--on their historical track records and so on. So there's questions on unions, on collective bargaining.
So you know, and all of these questions are not questions I created out of the blue. What I did is I looked at businesses where people had lost money. I looked at Dexter Shoes, where Warren Buffett lost money. And he lost it to low-cost Chinese competition. So that led to the question. And I looked at CORT Furniture, which was a Charlie Munger investment. And that was an investment made at the peak of the dot-com boom, where they were doing a lot of office furniture rentals. And the question was, "Are you looking at normalized earnings or are you looking at boom earnings?" And so that question came from there. So the checklist questions, I think, are very robust, because they're based on real-world arrows people have taken in the back.
Forbes: Terrific. Mohnish, thank you.
Pabrai: Well thank you, Steve.
Los Angeles hedge fund manager Mohnish Pabrai, 39, seems to have some talent as a stock picker. Since he started Pabrai Investment Funds in 1999, he has delivered a 35.3% compound annual return (after fees), to the 14.2% a year you would have made owning Berkshire shares.
There are two reasons the $116 million portfolio has done better than the competition in Omaha. One, says Pabrai, is that he doesn't try to emulate Berkshire's holdings in wholly owned subsidiaries. That has kept him out of property/casualty insurance, which accounts for a big part of Berkshire's revenue and had suffered some setbacks (such as claims from Sept. 11). The other is that he hews a little more closely to the kind of value investing espoused by Buffett's mentor, Benjamin Graham. Graham liked to buy companies for less than net current assets, meaning cash, inventory and receivables minus all obligations. Buffett has pushed the definition of intrinsic value in new directions. He is willing to pay for intangibles, like a consumer brand name or a newspaper monopoly, provided those assets throw off "owner's profits"--cash that can be extracted from a business after necessary capital outlays are paid for.
Like Buffett, Pabrai keeps his distance from Wall Street. He buys no research and has no hired help. If he can't understand a company, he doesn't buy the stock. Further, Pabrai won't meet with a company's executives; if he socializes with one, he'll never invest in the stock. "Chief executives are salesmen, as Graham says," Pabrai intones. "That's how they get their jobs."
Pabrai last year bought the Norwegian oil tanker firm Frontline when shipping rates fell to $5,000 a day. To remain profitable, the company needs rates of at least $18,000 a day on its 70 double-hulled oil tankers. Investors fled the stock, and it fell to $3. Frontline wasn't a classic Graham value play since it didn't have much in the way of net current assets. But it did have hard assets--those tankers.
After noticing the stock on a new lows list, Pabrai looked into the oil shipping business and discovered that small Greek shippers with near-obsolete single-hulled tankers were being hurt more than Frontline and were selling their ships for scrap. So he knew that when oil demand next surged, Frontline would be better able to command premium rates. Near the end of 2003 Frontline was charging $50,000 a day per tanker. Pabrai is long gone, but the stock, at $29 a share, trades at a cheap five times trailing earnings.
In 2002 he beat Buffett to the convertible bonds of Level 3 Communications. Like his hero, Pabrai saw value in telecom's distress.
C. Douglas Davenport, manager of the $52 million Wisdom Fund in Atlanta, is Buffett's shadow. If Buffett does something, Davenport will, too--going so far as to buy proxy stocks for companies that Berkshire acquires. Davenport keeps the identical proportion of cash that Berkshire does, a sizable 22% of his portfolio.
Davenport's fund, with backing from Sir John Templeton's family, started in early 1999 as the Berkshire Fund but changed its name after the real Berkshire complained. Davenport, 53, follows Berkshire's public filings and news reports to see what Buffett has been up to. "Buffett is quite well followed. It's amazing how much you can find out about the man on the Internet," he says. Thus Davenport has 8% of his assets in Coca-Cola, and 4% in American Express, just like Berkshire.
When Berkshire acquired carpetmaker Shaw Industries in 2001, Davenport went after competitor Mohawk Industries, waiting two weeks for its share price to settle down. Last year Berkshire bought Clayton Homes, a builder of prefab homes, and Davenport bought into similar Champion Enterprises. To roughly match Berkshire's huge stakes in auto insurance and reinsurance, Davenport has American International Group.
Since inception just over five years ago Wisdom is up an annual 5.2%, after its 1.5% expense ratio, matching Berkshire's showing.
Stocks are simple. All you do is buy shares in a great business for less than the business is intrinsically worth, with management of the highest integrity and ability. Then you own those shares forever. I will tell you how to become rich. Close the doors. Be fearful when others are greedy. Be greedy when others are fearful.
November 27, 2010
Interview With Value Investor Mohnish Pabrai
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