Interviews

Mohnish Pabrai Interview 1 (via vinvesting.com):

Emil Lee: You’ve modeled your partnership after the Buffett Partnership — do you mind providing any detail on how that’s going? Are you on track in terms of performance, assets under management, etc.?

Mohnish Pabrai: It has gone far better than I would have forecasted. Mr. Buffett deserves all the credit. I am just a shameless cloner. A $100,000 investment in Pabrai Funds at inception (on July 1, 1999) was worth $659,700 on Dec. 31, 2006. That’s seven and a half years. The annualized return is 28.6% — after my outrageous fees and all expenses. Assets under management are over $400 million — up from $1 million at inception. On all fronts, Pabrai Funds has done vastly better than my best-case expectations. Going forward, I expect we’ll continue to beat the major indices, but with just a small average annualized outperformance.

Lee: You clearly believe in having a broad latticework of knowledge from different educational disciplines from which to draw upon when judging investment ideas. Can you describe how you spend your day? Do you devote a general percentage of your time to reading “non-investment” material versus 10-Ks, etc.?

Pabrai: My calendar is mostly empty. I try to have no more than one meeting a week. Beyond that, the way the day is spent is quite open. If I’m in the midst of drilling down on a stock, I might spend a few days just focused on reading documents related to that one business. Other times, I’m usually in the midst of some book, and part of the day goes to keeping up with correspondence — mostly email.
I take a nap nearly every afternoon. There is a separate room with a bed in our offices. And I usually stay up late. So some reading, etc., is at night.

Lee: In Trade Like Warren Buffett, you mention that you let investment ideas come to you by reading a lot, and also monitoring familiar names on the NYSE. Can you describe your process of generating investment ideas — is it simply just reading a lot? Do you do anything else to actively seek out ideas?

Pabrai: The No. 1 skill that a successful investor needs is patience. You need to let the game come to you. My steady-state modus operandi is to assume that I’m just a gentleman of leisure, and that I’m not in the investment business. If something looks so compelling that it screams out at me, saying “Buy me!!,” I then do a drill-down. Otherwise, I’m just reading for reading’s sake. So, I scan a few sources and usually can find something scream out at me a few times a year. These sources (in no particular order) are:

1. 52-Week Lows on the NYSE (published daily in The Wall Street Journal and weekly in Barron’s)
2. Value Line (look at their various “bottoms lists” weekly)
3. Outstanding Investor Digest (www.oid.com)
4. Value Investor Insight (www.valueinvestorinsight.com)
5. Portfolio Reports (from the folks who put out OID)
6. The Wall Street Journal
7. Financial Times
8. Barron’s
9. Forbes
10. Fortune
11. BusinessWeek
12. The Sunday New York Times
13. The Value Investors’ Club (www.valueinvestorsclub.com)
14. Magic Formula (www.magicformulainvesting.com)
15. Guru Focus (www.gurufocus.com)

Between all of the above, I have historically found at least three to four good ideas every year. Sometimes I make a mistake, and a good idea turns out to be not so good.

Lee: A big part of investing is knowing what to pay attention to and what not to [focus on]. How do you sift through the thousands of investment ideas? Often, bargains are bargains because they’re unrecognizable — how do you spot the needles in the haystack, and how do you avoid the value traps?
Pabrai: I wait to hear the scream. “Buy me!” It needs to be really loud, as I’m a bit hard of hearing.

Lee: Would it be fair to say you are more balance sheet-oriented, versus income/cash flow statement-oriented? If so, how do you get comfortable with the asset values (i.e., Frontline, death care)?

Pabrai: John Burr Williams was the first to define intrinsic value in his The Theory of Investment Value, published in 1938. Per Williams, the intrinsic value of any business is determined by the cash inflows and outflows — discounted at an appropriate interest rate — that can be expected to occur during the remaining life of the business. The definition is painfully simple. So, cash can be gotten out of a business in a liquidation or by cash the business generates year after year. It is all a question of what is the likelihood of each. If future cash flows are easy to figure out and are high-probability events, then liquidation value can be set aside. On the other hand, sometimes the only thing that is a high probability of value is liquidation value. Both work. Depends on the situation. But you first need to hear a scream …

Mohnish Pabrai Interview 2 (via gurufocus.com):

Mohnish Pabrai, the Managing Partner of the Pabrai Investment Funds, has outperformed market indices over the last nine years by consistently believing in concentrated value investing. Pabrai likes to hold fewer stocks positioned in industries that he understands well, paying attention to two key variables: the intrinsic value of a business and its current price.

Q:  What is your investment philosophy?

A : Our investment philosophy is derived from the value investment philosophy first developed by Benjamin Graham and later successfully applied by Warren Buffett, Charlie Munger and others. Simply said, I believe in concentrated value investing, which basically translates into buying assets for less than what they are worth and selling them at or close to what they are worth.

Following this philosophy, one does not buy hundreds of stocks, but only a few of them, maybe 10 to 15 to construct the entire portfolio. You feel comfortable holding these positions for multi-year periods, which is what the timeframe might be for the market to recognize the value gap.

Q:  Is the philosophy that measures market value at discount or premium to the intrinsic value really a matter of subjective opinion?

A : It gets into issues about a circle of competence. First, you want to buy businesses that you understand well. If you are successful in doing so, then it is a somewhat predictable business, and, as a result, you do not only have a high degree of certainty but you are also able to forecast what the business might be worth a few years from now based on cash flow or hard assets or liquidation values. It always depends on the specific situation. At that stage you have a basis to place a bet if there is a wide gap between the intrinsic value and market value.

Q:  What is your research process?

A : There are thousands of publicly traded companies in the U.S. and around the world to choose from. If I look at a given public company, in the first three or four minutes of preliminary analysis, I would put it in one of three buckets. Either I would say that, “Yes, this is worth drilling down because it is a business that I either understand very well, or it is something that I can get my hands around fairly quickly.” Alternatively, it is ‘no’, because it is something that is just outside the circle of competence. Or, in some cases, it is too difficult. I would say that probably 99% or more of businesses I look at go into the “No” or “Too Difficult” pile and very few businesses make it through, so to speak, the first three-minute filter into saying that, “Yes, there are attractive fundamentals here. Let us drill further down.” So the first cut is basically one where you just ask yourself a few honest questions about how well you understand the business, or whether there is a basis to get to a valuation in the future, and ultimately if it is a predictable business.

Q:  Generally, what kind of businesses are not predictable or do not make it through your first cut?

A : Industries of rapid change are an almost automatic pass. Technology companies and biotech companies would be an automatic pass. A company like Google would be a very quick pass. Generally, I would not be spending time on anything that is in an industry subject to quick change, or a business that is subject to quick change.

For example, we used to have an investment a few years ago in Stewart Enterprises, a company in the funeral services business. The way humans deal with the deceased is extremely slow to change. In fact, that process has changed little over several centuries and it is unlikely to change much in the next few centuries. That is a business that one can firmly predict. You would not know who is going to pass away, but you can process data and calculate how many will.

Therefore, this is a business that you can forecast because it is based on death rates, which set the parameters in the revenue model. Moreover, you can also forecast what the earnings are because the margins are stable. That is something that, on a number of fronts, makes Stewart Enterprises the actual opposite of some biotech company. Actually, in 2002, 2001, when I made the investment, Stewart was a business that was trading at less than three times cash flow and, even if you assumed that the business was not going to grow, a business that has that much stability is worth a lot more than three times cash flow. It was a no-brainer investment to buy a stake in Stewart. We doubled our money in a few months’ time and moved on.

Q:  Where is it trading now after 7 or 8 years?

A : It trades at approximately, 9 or 10 times earnings. It makes sense because, in general, I think that the population in the U.S. is growing at 1% every year mainly owing to immigration. This is not a growth business. There are also extensions such as life expectancy, which is increasing. I would say the growth in the U.S. death rate is increasing at an annual rate somewhere between 0% and 1%, so you can assume that the growth rate of the business is zero. Therefore, as a zero growth business, if it generates 70 cents a year in cash flow that can be pushed out to shareholders, in my book, the business is worth around $7.00 a share if it does not have excess capital. That is about where Stewart trades right now.

Q:  How do you look for new ideas and how many of them do you tend to look for every year?

A : Between all of these sources, I need to find one pick on average every three months. I can usually find over the course of a year or two four to eight ideas. It is quite a straightforward process. I look at the 52-week lows on the New York Stock Exchange, if not on a daily basis, at least on a weekly basis. I just scan that list to see some names that are quite familiar and then, if something looks interesting, I will only spend a couple of minutes looking at earnings multiples and other financial fundamentals. If it something that looks substantially out of the norm, I might drill down further into it.

I also subscribe to Value Line’s information service that provides lists of stocks with the lowest earnings multiples. For instance, Stewart Enterprises is a company I found on Value Line’s list of stocks with the lowest P/E. At that time, it was trading at 2.5 times earnings and you have to go through many years of Value Line to find a business trading at 2.5 times earnings. Simply scouring Value Line on a weekly basis gives you plenty of different lists, stocks with the lowest P/E ratio, widest discounts to book value, stocks that have lost most of their value in 13 weeks, high earnings yields, high dividend yields, and so on. I look at those lists of the top companies and see if any of those may seem interesting.

Then, there are a couple of other publications. A newsletter called Outstanding Investor Digest is published once every couple of months. They do some in-depth drill-downs, targetting businesses bought by prominent value managers. Value Investor Insight is another newsletter that I follow. By doing so, I look at the SEC filings of value investors that I respect, such as Warren Buffett, Bruce Berkowitz, Marty Whitman, Longleaf Partners, and others.

I also look at a Web site called Value Investors’ Club, which has an annual flow of about 500 ideas posted along with very detailed analysis.

We have never had more than 15 names with equal allocation in the fund. My target is to have 10 positions each at 10% but we usually fall slightly off that mark. Still, we have always had 80% of assets in 10 or fewer names.

Q:  What is your research process?

A : I never speak to management or visit the companies. In the case of a company such as McDonald’s, I may visit a McDonald’s restaurant, but not necessarily the company’s headquarters.

I am interested in looking at long histories of the business and collecting historical annual reports as far back as I can find. If it is the same senior management team, then I will start reading from the last few years onwards in order to see how the business has evolved over time, how it works, and how it feels. I try to form a picture in my mind of what the next few years are likely to be and what the earnings, cash flow, asset values, and market value of the business are like. I am only interested in making an investment if I can get at least a 50% discount to what the business is likely to be worth a couple of years from now. If the numbers indicate that, then I conduct a thorough analysis of the business to make sure I understand the key drivers. With most businesses, two or three variables control 80% to 90% of the outcome. I want to make sure that I understand the right variables with a good sense of how they are likely to play out.

Pabrai Funds has 400-odd families all over the world invested in the fund with the majority of these families being entrepreneurial. The companies that they run or have built and sold are in a diverse range of industries. When I look at a particular company, I look at my list of investors and try to come up with a list of those who are likely to have knowledge about the industry I am looking at. Some of them may even have deep knowledge about the business I am looking at. It is what I call “the unpaid analysts pool” at Pabrai Funds.

Q:  Can you give us one example of a company that you were helped by to invest from this ‘unpaid analysts pool?’

A : We used to have an investment in a Brazilian aircraft manufacturer, Embraer. We actually bought Embraer just a few days after the 9/11 attack at a moment when people thought no one would ever want to get on an airplane. Embraer’s stock actually had gone from $40 to $10 just in a couple of weeks. Their stock price approximately equaled the cash the company had on the balance sheet, so we were actually getting the business for free. I did a drill down on Embraer, partially through a friend of mine who is a CEO of a publicly traded airline in Latin America. I had looked at Embraer from a very different perspective in the sense that that business is really a duopoly business. Only two companies split that market, Embraer and Bombardier. Between the two companies, Embraer has what I would call an unfair cost advantage because labor rates in Brazil are much lower than those in Canada. Thus, they are actually able to produce airplanes at a much cheaper price than Canadians can.

I spoke to the CEO trying to understand the dynamics of what I was looking at and whether there was anything I had missed. He was able to give me some good data points on the future growth prospects in the 70 to 110-seater airplanes and to explain how the next generation of these new planes was more fuel-efficient, making them very attractive to the airline company.

Q:  But were you not worried about the technology risk?

A : The last time when jet engine technology changed significantly was more than sixty years ago. It is not an industry that changes rapidly. The Boeing 747 went into service more than 30 years ago and it is still regarded as a state-of-the-art airplane. These two manufacturers, like Boeing and Airbus, are toll bridges that the airlines have to pass through to serve their customers. The width of the toll bridge will change, the length of the toll bridge will change, but it is very unlikely that a third toll bridge will be built. If you look at the history of aviation, there have been so many attempts by a large number of countries to break the duopoly. Unlike car companies, the intrinsic nature of larger airplanes makes it unlikely to allow for 15 companies in the market.

Another segment of the aviation market is the small, private, regional jets. Small jets are coming in for personal use. There is an incredible amount of competition now with the 4 to 8-seaters. Honda, Eclipse, Citation, and other players are all scrambling in that $2 million to $5 million price range. That becomes a much more competitive market than the ones that Boeing, Airbus, Embraer, or Bombardier are facing.

Q:  How and when do you decide to sell?

A : The anchor for buying and selling is intrinsic value. After I make a decision to buy a business, I write about a one-paragraph thesis. I explain why I am buying the business, what it is worth, and how that value is arrived at. If it takes more than a few sentences to explain it, it is a red flag. I go back and make some notes to that usually once every quarter to update if there is any change in intrinsic value. I like to buy assets at 50 cents or less and to sell them at 90 cents or more. If a stock gets passed 90 cents on the dollar, it is a candidate to be sold as long as the only consideration is taxes. We generally want to be tax efficient, so if that gain takes place in less than a year, unless it goes up dramatically, we are likely to hold on for at least a year.

Q:  You like to sell stocks when the market value reaches the intrinsic value of the company. Isn’t this view different compared to other well-known value investors such as Warren Buffett who do not like to sell stocks?

A : Mr. Buffett applies the same approach that I am applying when he operated with smaller amounts of capital. If you look at Warren Buffett, the individual investor, he has a portfolio of a few hundred million dollars in his personal account. That goes through some very significant buys and sells. I am not aware of any holdings he has in that account that are permanent holdings.

Berkshire-Hathaway, run by Warren Buffett, has a different situation because they do not get the benefit of lower long-term gains taxes. Everything is taxed at the corporate rate, which is rather high. For a company that is sitting on a mountain of cash, to sell something like Coca- Cola, pay 35% or 40% tax, and then put it into cash would hardly make any sense. Berkshire’s peculiar corporate structure almost forces it to take a “buy and hold” approach. Mr. Buffett, in his personal account, has traded a basket of Korean stocks in a short period of time. In 2001 and 2002, he bought a basket of REIT stocks he went in and out of in a few years. He bought several bonds in 2002 and sold them within 18 months or so. He is an active trader in his personal portfolio. The approach is actually the same; it is just the vehicles that are different.

Q:  How do you perceive risks and what do you do to manage it?

A : We are not concerned with the level of the market. We are not concerned with it going up or down in a week or a month, or even in a year. It only boils down to two variables. First, what is the intrinsic value of the business and what it is likely to do over the next few years? Second, what is the price it is available at to be bought today? These are probability bets in the sense that even a mutual fund management company or a rating agency like Moody’s has a probability of going bankrupt. We want that probability to be extremely low. Even Embraer has a probability of going bankrupt if many of their airplanes go down. Should that happen, they will face very significant liabilities. Therefore, there are downside risks. The important factor is to have a situation where the odds of those downsides playing out are very low.

Q:  How do you regard volatility in the market?

A : That is an element, and it can be our friend. It gives us a chance to buy stocks at exceptional prices or sell them at great prices.

Q:  Do you look at macro trends?

A : I think you need to have what Munger would call “a latticework of mental models” and you also need to have wisdom in understanding the way the world works. It is a fairly simple but very critical fact. When I was looking at Stewart Enterprises, I looked at the thousand-year history of humans dealing with the deceased. With Embraer, I looked at the long history of the country.

I think of investing as being one of the broadest disciplines. Rather than visiting the business, it is probably better to spend more time understanding a variety of different subjects, though many of them may not seem to be connected with investing. Yet, the interplay is there. They work within that same macro environment or framework.
When Buffett looked at Coke, he looked at a hundred-year history of volume growth. When he looked at American Express, he looked at decades of the growth in a number of cards and charging per card and at the number of merchants. You have to have a clear view on the direction for a period of 10-20 years from now.

One of the key things to understand is that if you look at a company like Moody’s versus a company like Coke, they both generate high returns on invested capital. However, Moody’s generate extremely high returns because it is a knowledge intensive business, not a capital intensive business. In terms of capital expenditure, all you need is a person with a desk and a pencil to do what they do.

The thing is that you always see advertisements for Coke, and Coca-Cola Company spends an incredible amount of money on brand building. At the same time, you never see an advertisement for Moody’s because what happens is that The Financial Times will attribute quite a few ratings upgrades and downgrades to Moody’s. Moody’s gets its brand on the front page of The Financial Times probably once every two or three weeks and pays nothing for it.

Mohnish Pabrai Interview 3 (via gurufocus.com):

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? 

PabraiInvesting 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.

Warren Buffet Sham Gad Interview (via shamghad.blogspot.com):

I asked Buffett about the state of the securities markets in the U.S. going forward and how they will compare to the period in which he operated and how he could make 50% or more per year…

Buffett: “It’s a structural issue…yes, with a small sum like a million dollars, I could make 50% or more a year. The key is rationality. There are always going to be times when humans act irrational and this is time to make your money. I’ve made a career of cashing in when people act irrational.”

If you consider some of Buffett’s most successful investments–American Express, the Washington Post Company, and Gieco–they were all made during the absolute worst times for these companies. Times when nobody wanted anything to do with them.

Buffett then picked up a copy of the 2004 Citigroup Investment Guide to Korean stocks and began flipping through the pages,

Buffett: “A couple of years ago I got this investment guide on Korean stocks. I began looking through. It felt like it was 1974 all over again. Look here at this company…Dehan, I don’t know how you pronounce it, Flour Company. It earned 12,879 won previously. It currently had a book value of 200,000 won and was earning 18,000 won. It had traded as high as 43,000 and as low as 35,000 won. At the time, the current price was 40,000 or 2 times earnings. In 4 hours I had found 2o companies like this.”

What Buffett said next is critical,

Referring to having found 2o or so companies like Dehan Flour Buffett remarks,

“When you invest like this, you will make money. Sure 1 or 2 companies may turn out to be poor choices, but the others will more than make up for any losses.”

It’s critical to understand the mental model Buffett has going into these investments in Korea. A portfolio of carefully selected stocks in understandable businesses trading at very attractive valuations generate abnormal returns. While I don’t have Buffett’s personal investment record, I am certain he was making 40-50% returns in Korea simply by choosing a portfolio of stocks with strong earnings records trading at very low multiples to earnings. Ironically, this model is not new…it was actually revealed by efficient market advocates Fama and French in there three-factor model. Over time, low P/E, low book, small companies tend to outperform. Apply a little more intensity, as Buffett is famous for doing, and you can make lots of money.

One of Buffett’s most successful international investments was PetroChina, China’s largest oil producer.

Buffett: “The whole company was selling for $35 billion. It was selling for one-fourth of the price of Exxon, but was making profits equal to 80% of Exxon. I was reading the annual report one day and in it I saw a message from the Chairman saying that the company would pay out 45% of its profits as dividends. This was much more than any company like this, and I liked the reserves.”

The Chinese government owns 90% of PetroChina, so only 10% was available to outside investors. Even with this lopsided ownership, Buffett liked the company enough to buy 13% (actually 1.3% of 10%, but Buffett likes to joke that the company is owned by him and the Chinese gov’t)

“I was considering buying this company, but I was also looking at Yukos in Russia. This was cheap, too. I decided I’d rather be in China than Russia. I liked the investment climate better in China. In July, the owner of Yukos, Mikhail Khodorkovsky (at that time, the richest man in Russia) had breakfast with me and was asking for my consultation if they should expand into New York and if this was too onerous considering the SEC regs. Four months later, Khodorkovsky was in prison. Putin put him in. He took on Putin and lost. His decision on geopolitical thinking was wrong and now the company is finished. Petro China was the superior investment choice. 45% was a crazy amount of dividends to offer but China kept its word. I am never quite as happy as I am in the US, because the laws are more uncertain elsewhere, but the point is to buy things cheap.”

Once again, “the point is to buy things cheap.” Because the company is not in the U.S., Buffett applies more filters before committing capital.

So we own 1.3% of this company and it cost us around $400 million. Now it’s worth $3 billion.”

Look closer and you can see the real value in this investment…the dividend payout. When Buffett made his investment, PetroChina was paying a dividend of close to 9-10% (I know because I bought some shares the minute I heard of Buffett’s stake and about 5 minutes of my own research.) At the time the stock price was about $30 per ADR, but Buffett purchased H shares directly in China at a lower price. The stock currently trades at about $125 per ADR and yields 5%…you do the math…about $6 per share on a $30 cost basis or even lower…margin of safety?

Buffett also had a copy of the 1951 Moody’s Banking and Insurance Manual.

“There were four Moody’s manuals at the time. I went through them all, page by page, over 10,000 pages. On page 1433, I found Western Insurance Securities. Its earnings per share were as follows: 1949 – $21.66, 1950 – $29.09. In 1951, the low-high share price was $3 – $13. Ten pages later, on page 1443, I found National American Fire Insurance (“This book really got hot towards the end!”) NAFI was controlled by an Omaha guy, one of the richest men in the country, who owned many of the best run insurance companies in the country. He stashed the crown jewels of his insurance holdings in NAFI. In 1950, it earned $29.02. The share price was $27. Book value was $135. This company was located right here in Omaha, right around the corner from I was working as a broker. None of the brokers knew about it. This book made me rich.”

Seth Klarman Interview (via vinvesting.com):

“We’re not the stereotypical hedge fund in terms of an idea a minute. We come in with a view that a security is trading for less than it’s worth, and we buy it.”

How did you decide value investing was for you?

I was fortunate enough when I was a junior in college — and then when I graduated from college — to work for Max Heine and Michael Price at Mutual Shares [a mutual fund founded in 1949]. Their value philosophy is very similar to the value philosophy we follow at Baupost. So I learned the business from two of the best, which was better than anything you could ever get from a textbook or a classroom. Warren Buffett once wrote that the concept of value investing is like an inoculation- — it either takes or it doesn’t — and when you explain to somebody what it is and how it works and why it works and show them the returns, either they get it or they don’t. Ultimately, it needs to fit your character. If you have a need for action, if you want to be involved in the new and exciting technological breakthroughs of our time, that’s great, but you’re not a value investor and you shouldn’t be one. If you are predisposed to be patient and disciplined, and you psychologically like the idea of buying bargains, then you’re likely to be good at it.

Biggest mistakes?

There are too many examples that we could say, “Ah, that was right in our sweet spot, and we should have had it.” All investors need to learn how to be at peace with their decisions. We as a firm are always going to buy too soon and sell too soon. And I’m very at peace with that. If we wait for the absolute bottom, we won’t buy very much. And when everybody’s selling, there tends to be tremendous dislocation in the markets.

What’s the secret to success?

Every manager should be able to answer the question, “What’s your edge?” This isn’t the 1950s, when all you had to do was buy a corner lot and build a small drugstore and it gradually became incredibly valuable land or you owned a skyscraper or you built a small shopping center and it became the big regional mall. The market’s very competitive; there are a lot of smart, talented people, a lot of money chasing opportunity. If you don’t have an edge and can’t articulate it, you probably aren’t going to outperform.

Seth Karlman Interview (via HBS.com)

While other money managers scrambled to survive the financial market meltdown, value investor extraordinaire Seth Klarman (MBA ’82), president of The Baupost Group in Boston, cautiously pursued buying opportunities. After sitting patiently on the sidelines with a mountain of cash — 40 to 50 percent of Baupost’s $14 billion–plus in assets — for several years, the firm’s recent investments have cut its cash stash in half. Distress selling, it seems, breeds the kind of bargains Klarman lives for.

Fresh out of HBS, Klarman didn’t hesitate when Adjunct Professor Bill Poorvu recruited him to help manage a $27 million pool of capital in the newly formed Baupost. While the starting salary was an underwhelming $35K, it turned out to be the opportunity of a lifetime. In 26 years, Baupost has racked up an enviable 20 percent annual compound rate of return, earning Klarman entry into the Alpha magazine Hedge Fund Hall of Fame. The firm has grown from 3 to 100 employees.

A consummate team player, Klarman rarely uses his private office, choosing instead to sit at the trading desk where he works closely with analysts on investment decisions. But work isn’t all-consuming. He makes time for family and outside pursuits. As his three children grew, he coached his daughters’ soccer teams and attended his son’s recitals. And he is deeply committed to a number of philanthropic causes. Klarman recently took time to discuss investing, the credit crisis, and his approach to philanthropy.

When you started with Baupost at age 25, did you already consider yourself a value investor?

Yes. After my junior year in college and right after graduating, I worked for Mutual Shares Corporation, which was run by a wonderful gentleman named Max Heine. I learned a huge amount about value investing. It turns out that value investing is something that is in your blood. There are people who just don’t have the patience and discipline to do it, and there are people who do. So it leads me to think it’s genetic.

Did you ever waver in your investment style?

Never once.

What gave you the resolve to say no to all the other investment approaches?

There are several answers. First, value investing is intellectually elegant. You’re basically buying bargains. It also appeals because all the studies demonstrate that it works. People who chase growth, who chase highfliers, inevitably lose because they paid a premium price. They lose to the people who have more patience and more discipline. Third, it’s easy to talk in the abstract, but in real life you see situations that are just plain mispriced, where an ignored, neglected, or abhorred company may be just as attractive as others in the same industry. In time, the discount will be corrected, and you will have the wind at your back as a holder of the stock.

Do you set an annual return target?

We think it’s madness to target a return. Return lies in some relationship to risk, albeit there are moments when it’s out of whack, when you can make a high return with very limited risk. My view is that you can target risk versus return. So you can say, I’ll take the very safe 6 percent, I’ll take the somewhat risky 12, or I’ll take the enormously risky 20, knowing that 20 might actually be minus 20 by the time the actual results are known. We just don’t think targeting a return is smart.

You are lead editor of the new edition of Security Analysis, the bible of value investing by Benjamin Graham and David Dodd, first published in 1934. Is their advice still relevant 75 years later?

At no time since 1934 has it been so relevant given the financial turmoil and distress in the world and the possibility that we could be reliving some sort of serious economic downturn. What’s wonderful about Graham and Dodd is that their advice is timeless. And it is not just about investing; it’s also about thinking about investing. It basically teaches you the questions that you should ask, and it makes endless references to the foibles of human nature in the markets.

Given the recent credit market meltdown, have we made much progress in figuring out how to avoid the pitfalls pointed out by Graham and Dodd?

No. What happens is that people always want to believe that this time is different, that there’s something new under the sun, and that through their own ingenuity they can wish away risk. The idea that risk premiums would go to zero, that we’re somehow overcoming human nature, is absurd. The whole reason that our capitalist system works the way it does is because there are cycles, and the cycles self-correct. With too much excess, eventually you get a downturn.

So the explosion in securitized assets was a ticking time bomb?

It’s not amazing that securitized products were created. There are huge financial incentives for the people involved. What’s amazing is that anybody actually bought them. That’s because they’re created with a one-dimensional idea of what the economy and the world are going to do. If you have nothing but good times, then securitization makes tremendous sense. But securitization, for all of the commingling and diversification it gives you, also gives you a lack of transparency. So if you have an environment like the one we have now, the assets that have been securitized actually make you worse off than if they were just held as whole loans.

The unanswered question is how did the smartest people in the world who run the major Wall Street firms not understand that these products were toxic and end up getting caught with them on their books?

As Fed chairman, did Alan Greenspan have a hand in creating the current credit market crisis?

Until recently, Greenspan seemed unaware of his role in influencing markets. As Fed chairman, when he advised people not very many years ago to take out variable rate mortgages, he aided and abetted the housing market excesses. When he said there was irrational exuberance in the market [in 1996], he was basically right. But then he didn’t act even though he had plenty of levers he could have pulled that didn’t have to do with changing interest rates. He could have raised margin requirements, for example. But instead, he came up with the ridiculously lame idea that bubbles need to be allowed to run and that the Fed can clean up the mess afterward, which only had the effect of inflating subsequent bubbles, most notably the housing bubble that came as a result of the easy money. So he’s just been unaware of the impact of his encouragement, and his inaction got us into the terrible mess we’re in today. It’s not all his fault, but I hold him largely responsible for it.

How have Ben Bernanke and Henry Paulson (MBA ’70) done in managing the financial crisis?

They have been dealt an unimaginably bad hand. If any of us were in their shoes, we would be doing similar things, although it is reasonable to assume that part of the problem we are facing today is a result of previous government actions, and today’s government actions will give rise to future problems as well.

The lesson should be that we need to get to a point where we don’t need to intervene in the future, because we realize that intervention also delivers incredibly dangerous messages and creates a giant moral hazard. Bernanke and Paulson have to realize that if we’re going to intervene when things are bad, we’re also going to intervene when things are good and take away the punch bowl before the party gets too far along. One-sided intervention is even more dangerous. It will create an ever bigger bunch of excesses that will require an even bigger bailout next time.

Was the $700 billion federal rescue package, sold as a plan to buy toxic mortgage-backed securities from banks, the right way to go?

Defining the problem you are trying to solve is critical in knowing whether this plan will solve it. The bailout does almost nothing to solve the specific problem of declining housing prices. If the government really wants to tackle that problem, making capital available so that banks can make safe loans is crucial. Injecting $250 billion into the nation’s banks is a big step in that direction.

How do you approach philanthropy?

I’m a big believer in giving back. We all have an obligation to leave things better than where we found them.

I have more than I’ll ever need, and more than my family will ever need. I’m only working now for philanthropy. So everything I do is about giving back. In fact, one of the things we did at Baupost when we recently took on some additional clients was to accept only educational endowments and foundations. We figured we would further benefit the world by helping these organizations rather than individuals. That decision was very important for me and for all the firm’s partners.

Also, given the extremely difficult financial environment we are in, I expect charities will be greatly affected. That’s why it’s incumbent on those who can to step up and help fill the void.


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