Plan A

Great Q&A with Mohnish Pabrai (from www.gurufocus.com):

“Question: How does your investment philosophy differ from Warren Buffet’s and Charlie Munger’s and why? As a follower of Buffet you insist in buying into companies with a “moat”; nevertheless the kind of companies you tend to invest in do not appear to have wide moats as generally described by Warren Buffett and reflected in his holdings like Coca Cola, Gillette or American Express. Could you please expand on your definition of a moat and contrast it with Warren’s definition? Warren Buffett stated that his ideal holding period is ‘forever,’ and that 20 investments in a lifetime are more than enough for any individual investor. Do you agree with these statements, or should one be more flexible in their investing strategy?

Mohnish Pabrai: There are many different approaches that Buffett has applied over his long career. Even today, Buffett’s investing approach when investing for his own account differs significantly from his approach when allocating capital for Berkshire . Berkshire is a very inefficient vehicle for investing in stocks. Gains are taxed at 35%. In addition, shareholders are taxed when they sell Berkshire stock. Plus Berkshire is drowning in cash. With these realities, the best approach for Berkshire is to buy and hold stocks for a long long time.

If you’re a buy and hold forever investor, then having a very durable moat becomes extremely critical. Berkshire needs to invest in businesses that have very high returns on equity (Coke, Moody’s American Express), the ability to redeploy earnings at high rates of return and it needs to buy into these businesses below intrinsic value so that the annualized return is atleast the returns the businesses generate on their equity. Very very few businesses generate ROE exceeding 15-20% annually and have the ability to redeploy earnings at greater than 15-20% ROE. Thus it is unlikely Berkshire ’s stock portfolio can generate long term returns exceeding 15%. Their float helps then get higher effective returns. Buffett once said that float added about 7% to Berkshire annualized returns.

On the other hand, Buffett the individual investor can buy a cheap stock and sell it at full price and pay mostly 15% long term gains. He gets taxed once. It is very efficient. Thus Buffett bought REITs when they got cheap – and then sold them all. He bought Korean stocks when they got really cheap. He’s either already unloaded or will unload those stocks in a year or two. He generates much higher returns for his own portfolio than Berkshire does. It is much smaller and does not have the incentives Berkshire has to just do buy and hold forever investing.

So, if you bought a business worth a dollar for fifty cents and it was a below-average business with a shallow moat. Let’s assume you held the business for 2 years and during those two years intrinsic value grew by zero, but the market recognized it was worth a dollar and two years later it was trading at a dollar. Now, if you sold it after 2 years, you annualized returns is over 41%. Buy and hold forever cannot generate 40+% annualized. If you have small amounts of capital and are focused and patient, you’ll probably get a chance to take that dollar and invest it in another 50% off business and convert it into two dollars in a year or two.

Plan A is always to buy the Coke and Moody’s of the world at 50% off. If you buy these type of businesses at that discount and it takes 2-3 years to trade at intrinsic value, you’ll do very well. Intrinsic value will be much higher in 2 to 3 years. So 50 cents may be worth $1.30 or $1.40. This is always Plan A. But plan A is virtually impossible to execute across the entire portfolio because they are so very very rare.

When plan A fails, we go to plan B. Plan B is to buy at half off, regardless of business quality (as long as you’re pretty sure intrinsic value is very unlikely to decline). Most of Pabrai Funds investments over the years have been Plan B.”

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~ by eboro on December 24, 2008.

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