Mohnish Pabrai's Advice for Value Investors
By: SumZero Staff | Published: June 27, 2018 | Be the First to Comment
Mohnish Pabrai immigrated to the US from India to attend Clemson University in the 1980s. He studied engineering, and after graduating worked in IT. Following several years in the business, Pabrai founded, ran, and sold a small IT company. One auspicious day after selling his company, he picked up a copy of Roger Lowenstein's Buffett: The Making of An American Capitalist. After finishing the book, Pabrai moved onto Buffett's Berkshire letters. He was hooked.
Pabrai now runs the Pabrai Investment Funds, a group of hedge funds modeled on Buffett's original partnerships. Across these funds, Pabrai manages in excess of $800M. He has also published two award-winning books on value investing, The Dhandho Investor, and Mosaic: Perspectives on Investing.
Pabrai made headlines in 2008 for bidding $650,100 to win a charity lunch with Warren Buffett. Pabrai has since befriended both Buffett and his long-term business Charlie Munger. At a recent DJCO meeting, Munger asked Pabrai to stand for applause for his fund's Buffett inspired fee structure.
Pabrai has been an active SumZero member since 2012, and has judged several SumZero contests. Kevin Harris from SumZero sat down with Pabrai to discuss the state of value investing, the Pabrai Funds, and the unique philanthropic approach of the Dakshana Foundation.
Kevin Harris, SumZero: What or who have been your most important investing influences?
Mohnish Pabrai, The Pabrai Funds: That’s an easy one. My important influences have been Warren Buffet and Charlie Munger. I was introduced to Warren through reading Lowenstein’s biography ‘The Making of an American Capitalist’ and that was about 24 years ago. That led to the Berkshire letters, which radically changed my life for the good - for the better, which was wonderful.
Harris: What is your take on the current state of value investing? Where do you think that the most inefficiencies exist and why?
Pabrai: I think that in terms of value investing - the principles and the approach, there will never be any major change on that front. That said, there two types of adjustments that one has to make. One is that markets go through periods of euphoria and periods of pessimism. In general, when markets are pessimistic there are more fish in the ocean if you will. In pessimistic markets it is easier to find widely mispriced securities than in euphoric markets. The second is that from a geographic point of view, some parts of the world may be euphoric while at the same time other parts may be pessimistic or more mispriced. From that perspective, this is a very interesting time.
I find the USA a very difficult area to find mispriced securities, and I find that if you look at markets like South Korea or India or Japan there is a lot more mispricing to be found. The markets vacillate between fear and greed, and especially in Japa n and South Korea there has been a very long period where markets have flatlined or gone negative. Generally when you have multi-decade periods of that sort of activity then market participants throw in the towel and go on. That’s when you should be stepping in as an investor.
That’s the way I see the world right now. One thing interesting that I've found in the Pabrai Funds portfolio - despite my never approaching things from the top down, we have nothing in the US. Zero percent of our current assets are in the US. Which has never happened in the 19 years of running the fund. We always had a very large portion of assets in the US. I would have never guessed that we would get to the point where we would be at zero - but here I am. It’s the nature of the beast, I just can’t find much in US markets at this time.
Harris: Would you ascribe that to more of a bottoms up not finding companies in the US that meet the Dhando checklist, or a macro level stepping away from the US market?
Pabrai: I don’t look at investing from a macro perspective. In the US in the last few decades, the number of public companies listed on exchanges has gone from something like 8000 to under 3500. And at the same time, the number of eyeballs focused on them, what I would call “high-IQ” eyeballs, of the kind from SumZero’s community, has skyrocketed. So you have a diminishing pool of companies that are being tracked by an increasing pool of high-IQ people with significant amounts of capital. The combination of the two is not great for investors. That’s the backdrop.
But again, I don’t really use that when I’m making investments. My investments are always bottoms-up, one company at a time. I find that when I look at businesses in the US, I don’t see much in the way of mispricing. At the same time, when I look at other places, like India for example, I have found very significant mispricing. The portfolio ended up the way it did purely from an opportunistic perspective.
Harris: In 2007, you and Guy Spier bid $650k for lunch with Warren Buffett. How was the lunch? What are your biggest takeaway from your conversation with Buffett?
Pabrai: I actually didn’t have any expectations from the lunch. My driver was that I had learnt so much from Warren that I felt an obligation to at least thank him. And to do that in person, to express my gratitude. Given the fact that he was willing to take a bribe to sit down for a meal, I said okay, let’s try to pay the bribe. The good news about the bribe was that it was going to a good charity, which was wonderful. Anything beyond my getting five minutes with Warren to just tell him straight up how much I had appreciated what he had done, was a bonus from my perspective.
The lunch went for over three hours. I went with my wife and my two daughters. They were at a great age at that time - 10 and 12 years old. A great age for them to absorb his lessons. They were sitting on either side of him, and had a lot of banter going on between them. Guy Spier joined us with his wife.
One of the first things that I realized, was that Warren wanted to make sure that whoever wins these annual lunch auctions feels like they got a bargain. He tries very hard to make sure that he’s delivering as much value as possible. Clearly on my end, I would say that we got a terrific bargain. It was exceptional on many fronts. The first thing, for example, that he told us, was that he had absolutely nothing going on all afternoon - and that when we were sick and tired of him we could ask him to leave. But otherwise he was happy to be with us for as long as we wanted him to be with us. He converted many questions which may have been innocuous - lemon questions, into lemonade of great learning opportunity.
There were a lot of great lessons and learning opportunities that came out. One of the things about Warren and Charlie is that there is so much about them in the public domain, especially Warren, that there is only so much you can glean in terms of insight that you couldn’t get if you studied the vast amount of materials on them in the public domain. What the lunch helped me do was to calibrate and understand better what were things that were important to him, and what were things that were less important to him.
To give you an example, one of the things that Warren talked about was the concept of an ‘Inner Scorecard’. At this time, Alice Schroeder’s 'Snowball' had not yet come out, and he mentioned that there was coverage of it in the book. He said look - you can live your life in two ways. You can grade yourself based on what you think the world thinks of you - an outer scorecard, or you can grade yourself internally - an inner scorecard. He said “Would you rather be the greatest lover in the world, and have the world think that you were the worst, or the worst lover in the world, and have the world think that you were the greatest?”. He said, that if you know how to answer that question, then life becomes pretty easy. I think that you can read about the Inner Scorecard in Schroeder’s book - but some of the concepts like that which he picked out to go into, exhibited what the important principles to Warren were - what he focused on. Versus what was lower down on his list.
Harris: Do you still use Berkshire shares in place of cash in your fund’s portfolio? Why or why not?
Pabrai: No. I used to do that a while back. In hindsight, I realized that was not a good idea. The idea was: to use [Berkshire] as a placeholder while you don’t have anything interesting to invest in. One of the pitfalls of doing that was that in the case of major market corrections, everything goes down, including Berkshire. It may not go down as much, but it will go down. So I think that my take is that it’s probably best to leave cash as cash so that you have the complete freedom and optionality to put it to work when opportunities show up. If I put it into something like Berkshire, I may be looking at a loss right at the time I need those funds for more opportunities. I haven’t done that for a while, and I think that it was a mistake to do it.
Harris: How has the ‘Dhando’ framework evolved over time? What differentiates your fund from those of other value investing disciples?
Pabrai: I think that the core of the Dhando framework is heads I win, tails I don’t lose much. You’re trying to place bets where the upside overwhelms the downside. I think that it’s a great framework from that perspective, where you’re trying to buy assets at a very significant margin of safety, and that margin of safety in effect gives you the upside. The only evolution, not so much in the Dhando framework but more in my own framework of looking at businesses, is that I pay more attention to the qualitative factors around a business than the quantitative. In the past I used to be much more focused on the quantitative. For example, the quality of management, the durability of the moat, and those sorts of things. I’ve learnt that if you get exceptional managers, and even if they don’t have such exceptional businesses that they’re running, they will produce some incredible results. Sometimes jockey bets - paying out for the right jockey, is a great way to go.
Harris: What are the most important parts of your investment checklist? How much do you rely on your checklist and how have you iterated on it over time?
Pabrai: The checklist is a wonderful tool and I think that every investor should use it. The main reason is that it carries significant weight, in terms of how much it helps you, versus the time it takes to go through it. The current checklist that I have has about 150 questions on it. In the first year that I had it, it had close to 90 questions on it. Over the last 8-9 years there has been some increase, but there’s a much slower pace of questions being added at this point. The interesting this is that the questions generally fall into some nice buckets - and I've organized the checklist into categories.
The biggest area of why business or investments don’t do well is leverage. Leverage is generally the one that I’ve had the most difficulty with in the past. There are a host of questions related to leverage, debt and that genre. The second area is a toss up between management and ownership or comparative advantage and the durability of the moat. Those three areas, leverage, management / ownership, and comparative advantage / moats, make up 70-80% of my checklist. Beyond that, it goes into other areas, including environmental factors, labor / unions and some other things.
But those three are the big buckets, where most of the failures are. These checklist items were developed from analyzing specific failures that great investors had made with investments that didn’t work out. The checklist took some time to put together. When I have a new business or new idea, running through the checklist is usually one of the last things I do before pulling the trigger. The process itself normally doesn't take very much time. The first time I run it, it usually brings up a few questions which I cannot answer. I then go back and do work on those, which demonstrates the real value of the checklist. Then, I run through it a second time, which goes a lot faster, taking less than thirty minutes or so.
As to iterating, the checklist is a living, breathing document. There will be more questions added to it over time, but the rate at which questions are being added has gone down a lot because of its breadth of coverage. To give you an example, I’m currently making a lot of investments in India. In India, many of the public companies are audited by non big-four auditing firms. Among these, there are some auditing firms that are well known as having low ethics and that have in the past audited companies that subsequently went onto being exposed as frauds.
So, for example one of the checklist items I’m adding today as we speak, is that I know a few of these firms and so I’m putting that into the checklist. Is the firm audited by one of these bad auditing firms, with the second question being can we drill into the non big-four auditor to see what other companies they are auditing to get a better sense of not being taken into a fraud.
Harris: How concentrated is your portfolio, and how often do you trade in and out of positions?
Pabrai: I think that very few people run as concentrated as I do. By the time you get to my 6th position, that accounts for 75% of the portfolio. We do have between 15 and 20 names in the Pabrai funds portfolio, but numbers 6 through 18 altogether are less than a quarter of the pie. By the time you get to the 9th or 10th position, it’s well past 90%. The top two positions, top two or three, might approach 50% of the portfolio.
Harris: At a recent DJCO meeting, Charlie Munger applauded your high-water mark reliant fee structure. Value investors scrutinize management incentives - why has this same scrutiny not been applied industry-wide to investment management fees? Do you expect this to change?
Pabrai: That’s a great question. I hope and pray that fees change industry-wide over time. To date, the only thing that we’ve seen change in terms of fees or the reaction to fees is a change towards indexing. As people move towards indexing in general, the frictional costs and the fees go down. Fees haven’t gone down overtly- although we’ve seen some movement where 2% is becoming close to 1.5 or 1%.
I like to say that there are ten commandments of investing. And near the top of the list of those top ten commandments, one of the first is “thou shalt not skim off the top” while managing money for others. Almost everyone violates that commandment.
At Pabrai Funds, we have a 0% management fee, and a 6% hurdle, with a highwater mark, and then I get one third of above 6%. And from 1999 when I started to about 2007 I was paid very well because the funds did very well. But from 2007 to about 2017, 10 years, in one of the funds we collected no fees. That was correct because I was below our 6% annualized watermark going up from 2007, and when we finally got past that in 2017, and I got paid quite nicely.
I think that it’s a fair arrangement, and I think that it’s the way that money ought to be managed. Both Charlie and Warren managed money without skimming off the top. I think that money managers in general, if they are any good at what they do, they’ll have been successful in the past, so in general are wealthy. Once you have a base level of wealth, why do you need to have a low ethics fee approach designed to make money where you make money when your investors don’t? That’s just not right.
And though it was a surprise to hear Charlie Munger appreciate that, it was as close to me as I could get to being patted by the back by God, and I appreciated it.
Harris: At a recent talk at Google, you spoke about commitment bias with regard to stock research. What are the biggest biases or heuristics you’ve identified that negatively impacted your investment performance? How did and do you avoid these?
Pabrai: One of the big issues investors face is preconceived perspectives. When we look at a stock, what goes on in our brains when we encounter a company for the first time? For the first 30, 60 seconds, or first couple minutes? That has a huge impact on our financial well being and how our portfolio does. In the first few minutes, you’re making a decision on whether you’re going to take a pass at a company, or spend another 15 minutes. And at the end of that 15 minutes, you’re going to make another decision as to whether you’re going to take a pass or spend an hour or two, and so on. No investor has enough time in the day, week or year, to look at anything more than a small handful of businesses in some depth.
Even if I look at the United States with its 3500 some odd publicly traded businesses, an investment manager can really not drill down on more than a few dozen of them every year. So they have to make a decision relatively quickly on which ones they are or are not going to focus on. Commitment bias that comes in once we start spending time on something, our brains play games with us. One of the games our brain plays is that we feel entitled. “Hey, if I spent some time on it, I ought to make money on it”.
And that’s really not how investing works. I think it’s very important to be aware of commitment bias, and to be very aware that the first two or three minutes that when you’re looking at a company are when you have to make the call. It’s okay to let a winner go, but more important not to let a loser stay.
Harris: Why do you not have any analysts? How has this contributed to the success of the Pabrai Funds?
Pabrai: We’ve already talked about commandment number one, “Thou shalt not skim off the top”. Commandment number two is “Thou shalt not have a team”, and the inversion of that commandment number two is “Thou shalt not be part of a team”. Where this commandment comes from is Warren and Charlie.
They both, in the Partnership years operated solo. Even today, Warren with $400+ billion in capital does all his investment research himself. He had, until recently, 70+ managers reporting to him. If he can manage hundred of billions of dollars without having another human in the picture, then for most money managers who are managing well under a billion, or a few hundred million, there isn’t really any reason why they need a team.
The second issue, you get to, when you get to talking about teams, is that this isn’t really a team sport. Investing is about having convictions and acting on them. In general, when you have multiple people involved, one of the issues you get to is circle of competence. Every person has a different circle of competence.
So you tend to get to conflict or frustration amongst teammembers, where A might be convinced that something is really good based on their past experience of how the world works, and B may not see it that way. So I think you get to the nuance where it’s better if A and B run their own portfolios and make their own calls and went from there. The other issue is that when you have a team, there is an impetus to action. In general, being active in your portfolio is more likely to do more harm than good. I think that the best portfolios are the ones that have the least amount of turnover. As you add more team members, you’re going to have people come up with more ideas, and in general you’re going to have more decisionmaking to go around. And so for a number of reasons it makes more sense to operate in a team. At Pabrai Funds, I run north of $800M and I don’t really have any bandwidth issues. I don’t think I’d have bandwidth issues at $5 billion.
Harris: How have you applied your investment philosophy to philanthropy through the Dakshana Foundation?
Pabrai: I think that investors naturally have an edge with philanthropy, because we’re used to looking at return on capital. I looked at Dakshana through that lens. One of the issues I take with most of the nonprofit world is that there is too much heart, and too little head. For philanthropy to work well, you definitely need a great heart, but you also need a great head. You need both working in tandem. The head is mostly missing in many philanthropic organizations. Most of the people who run these organizations have never allocated capital, or thought about return on capital.
We don’t look at return on capital as such at Dakshana, but we do look at the social return on capital. Which is quantifying impact to maximize the impact of our investments. Warren regularly reads the Dakshana reports, and he has told me that they’re among the best annual reports that he’s ever seen from a nonprofit. I think that the reason he says that is for a couple of reasons: one is that we focus on our mistakes up front.
The reports normally start with where we screwed up. And the second is that we go through a lot of trouble to measure our impact. If you were to pick up any other nonprofit or charitable foundation’s annual report, two things come up. One is, they’ve never admitted to a mistake. You never see anything negative. The second is there’s no discussion about anything related to return on capital, which is terrible.
Harris: Has the growth of online research tools at all changed your research process? More generally, how has technology impacted your investment career?
Pabrai: As you know, I am a SumZero member. And as part of my research when I look at a company, I will usually go on and do a search to see if someone’s written up a report on it. SumZero is a great platform because it encourages the community sharing of investment research. Beyond that, I don’t use a lot of online tools. I mostly rely on public disclosures that have been made by companies, and I take it from there, and run from there.
Harris: What is the most contrarian current position you hold? Why is the market wrong?
Pabrai: If you look at our largest position, which is Fiat Chrysler Automobiles, it’s approximately 30% of the portfolio. It’s a large position. We’ve held the stock for 6 years now. And in the last 6 years, it has delivered about a 7-8x return to us, which is quite satisfactory.
The interesting and unusual thing about Fiat Chrysler is that they tell you what their future long term earnings and cash flows will be. For example in 2014, the company gave very precise guidance on what their 2018 earnings would be. And if you looked at the 2014 stock price (around 5 dollars a share), what you could infer was that in 2018, they would produce north of 5$ a share in earnings. What the company was saying, was that in 5 years they would in effect, trade at a P/E of 1.
Generally speaking if you invest in a company with a P/E of 1, you’re going to do well. And one would expect in an efficient market, if a company is saying in 2014 that it will do X in 2018, then you get a multiple of X. What they actually did, and we’re now about halfway through 2018, is distributing a very large asset to investors in the spin off of Ferrari.
So there's a lot of earnings of Ferrari in that 5 dollars per share, but even after they took that out, Fiat still made it. In effect, they gave away significant assets. In the 2012-14 timeframe Fiat had a $5 Billion dollar market cap. They pushed out an asset which has a market value north of $20B or so, and have another $20 or $25B of market value or so in the mothership.
The interesting thing is that in 2018, just a few weeks ago, Fiat again precisely told us what they would deliver in 2022. And if you look at the forecasted 2022 numbers, in effect Fiat Chrysler is trading at two times earnings. From my perspective, that is really good for something that is 30% of our portfolio. I don’t think that in 2022 it will trade at two times earnings. I think it will trade at a significant multiple of that. The best investments are the ones that are the biggest no brainers. Fiat has been a no brainer for 6 years and you’ll probably see it in our portfolio for another 3-4 years if not more. It’s been the gift that keeps on giving.
Harris: In our last interview, you gave advice as to the hedge fund interview and application process. What new advice would you have for students or sell side analysts looking to pivot to the buyside?
Pabrai: I would repeat what we already spoke about - the commandment that ‘thou shalt not be part of a team’. If someone thinks that they are a good investor, the first thing that should already have happened is the establishing of a track record of positive performance with their own money. Even if it’s a small amount. If you’re a good investor, even with small amounts, it will not be very long before you’re reasonably wealthy. Which takes away the need to skim off the top, which was the point Charlie made.
My advice to would be fund managers is prove it to yourself that you are good, and then go talk to friends, family and fools, especially the fools, to give you money to manage. And do it in a format like the Buffett Partnerships with no skimming off the top. That’s what I would recommend.
Harris: In Peter Thiel’s Zero to One, he mentions that his favorite interview question is ‘What important truth do very few people agree with you on?’ What important investing truth do you very few value investors agree with you on? What is the most contrarian part of your investment philosophy?
Pabrai: Nobody agrees with me on at least two things. They don’t agree with me on team size, and they don’t agree with me on skimming off the top. Because if you were to look at virtually all investors, including those on SumZero, and see how many of them are not skimming off the top in their managing money for others, you would get a rounding error in terms of the folks you’d be able to find. And so those are the two biggest areas where I think that I violate the canon if you will and hopefully at some point both get fixed.
Harris: What names other than Fiat Chrysler are you currently looking at? Anything particularly interesting?
I’ve been very focused on India, and have been finding a lot of very interesting opportunities in India. It’s not as developed of a market as the US, there are a lot more inefficiencies. I think that when you have high growth there is a higher probability of mispricing. Because different people’s perspectives on growth can express itself as different outcomes in terms of price. So I find that India has a lot of tailwinds. It’s embryonic in a number of different industries, and is a bit like venture investing, where you’re looking at industries that are very very early in their development. That’s currently the area I’m most focused on and in fact the largest position we have in India is a company called Rain Industries, where again like Fiat Chrysler, we bought it in 2015, at what would be a P/E of 1 on 2019 earnings. Again, a similar type of situation, where it was radically mispriced. The stock ran up about 5-6 times since we bought it - which is what happens when you buy a P/E of 1. It still has some runway.
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