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July 11, 2007
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.
Happy Investing,
Tom Murcko
CEO, InvestorGuide.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?
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.
About Mohnish Pabrai
Mr. Pabrai has been a
managing partner at Pabrai Investment Funds since
its inception in 1999. Prior to the fund, Mohnish worked
for Tellabs, a telecom company, and later founded TransTech,
Inc., an IT consulting company.
Related Links:
Books by Pabrai:
The Dhandho Investor
Mosaic: Perspectives on Investing
Article by Pabrai:
Buffett Succeeds at Nothing
Articles about Pabrai:
Guru
Focus
Forbes
Interviews with Pabrai:
Motley Fool
Bloomberg Part 1 / Part 2
CNBC
Philanthropy:
The Dakshana
Foundation
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