Takeaways from Mohnish Pabrai's Q&A Session with Indiana University
Portfolio diversification, identifying compounders and mistakes in investing.
Despite Mohnish Pabrai never meeting me, or even knowing of my existence, he had a great influence on my investment style. His book “The Dhandho Investor”, epitomizes the value investing mindset. Just like his book, his talks always leave me inspired with new ideas. Here are my takeaways of the Q&A Session with Indiana University.
Finding investment opportunities and when to dig deeper
As there are more than 100,000 stocks in the world, one needs a system to eliminate large quantities of companies in less than a few seconds or minutes. Mohnish uses Warren Buffett’s method and asks “Is the business in my circle of competence?”. This would eliminate most of the companies. Adding industries that he doesn’t have an interest in, like US Healthcare or defense contractors, there are suddenly fewer opportunities available. A lot of tech names tend to be high-flyers and lose him on valuation. A company similar to Snowflake would take him just around 15 seconds to move on.
One idea finding generator is Value Investors Club, where investors have made thousands of write-ups to create ideas. Since there are harsh restrictions on who can post they provide a good way to hunt and learn. Many of the write-ups and comments are very insightful. Value Line (Note: Many libraries have an online Value Line subscriptions, and some even allow Non-US residents to acquire an online card) and SumZero (Note:quite expensive) are other idea generating sources. Additionally he receives emails that contain investment ideas. Going through all those, some of the companies stick out and he spends more time with them. The objective is to quickly eliminate them. Saying no in 15 seconds is great, a minute is good. To become a good investor one needs to be good at saying no. The investment idea should be so compelling to convince a very deep skeptic, then one can dig deeper into the company.
Looking through the filings can give great insight into a business. Management over- or under-delivering on their promises made five to ten years ago, gives invaluable understanding of the company. It is a mixture of a treasure hunt and a jigsaw puzzle. You have pieces and ideas on why a company looks interesting looking for evidence that confirms and denies that. He often looks at flimsy reasons to stop doing his research.
There are times where he looks at a company for three days and then finds a reason to move on. As you learn a lot about the industry and the company one shouldn’t be discouraged to discard an idea, even if it took long to research.
Circle of competence and diversification
One should never compromise the circle of competence in the name of diversification. Most entrepreneurs like Sam Walton (founder of Walmart) aren’t diversified for their whole lives and aren’t plagued by sleepless nights. Charlie Munger’s friend John Arillaga only invests in a two mile radius close to the Sanford campus, yet he is a billionaire. His circle of competence is restricted to real estate in a specific geography, but that doesn’t stop him from doing well. If you only understand a single industry, and your competence is solid, a focus on two or three stocks is enough. Don’t compromise to become diversified.
As he handles other people's money he never puts more than 10% into one position and he is historically unwilling to cut positions back. After a big run up, there were times where two stocks made over 70% of the portfolio. Mohnish doesn’t like to cut the flowers and water the weeds (originally coined by Peter Lynch). Instead of cutting positions in the name of “risk management” he carefully looks at the business and what makes most sense in this situation.
In his personal portfolio he is even more concentrated, hardly ever having more than three stocks and sometimes only one. There are not many ideas that you understand and are priced well.
Many would lose sleep being as concentrated as he is. An investor needs to do what gives him comfort,yet maximizes the potential returns.
Knowing where to draw the edges of your circle
To ask the question is to answer it. If you ask yourself if it is in your circle of competence, or chances are high it isn’t, if you have to question your business valuation it is outside of your circle of competence. If you are competent, valuation and the soundness of the business will be very apparent. Staying dead center in your circle of competence is important. As there is no clear boundary between confidence and incompetence, as you get closer to the edges your risk factor increases. Mohnish says he doesn’t understand 99% of all stocks, you just need to understand a few things well.
Expanding the circle of competence
In his book, he had to research the shipping industry in order to make an investment. He was intrigued by the industry as it isn’t very complicated. He was especially interested in large crude carriers and started to read about the industry and companies inside it. To grasp how the industry functions, he used a mental model from an industry he already knew. In commercial real estate building office towers take around 4-6 years to build. When the market is tight and rents are rising, lots of projects are started at a similar time. As the towers get ready at the same time it causes an oversupply, creating a boom and bust circle. The same happens to large crude carriers, but on steroids. There are only a few places that built them and it takes at least three years to deliver them. Understanding the dynamics on how daily rates are determined and how you couldn’t instantly expand the fleet was important. Learning about different industries and businesses is always interesting, if you can get a deep enough understanding to make an investment is another question. One needs to learn enough to understand the dynamics of both the industry and the business.
Mohnish at the time was looking at Frontline, one of the largest crude carrier operators in the world. As 100% of their fleet was on the spot market the dynamic of widely fluctuating daily shipping rates (sometimes in the order of 50:1), greatly influenced the company. After the Exxon Valdez there were a new set of regulations that all new ships need to be double hulled. Ships that were built before that were single hulled and were rented out for lower rates. As the demand for oil went down, rates collapsed and the delta between single and double hulls disappeared. This resulted in the ship operators scraping the old ships. If inevitably oil demand rises again, rates fluctuate more widely than the price of bitcoin, going from $10,000 to $200,000 in a matter of just three weeks. Looking at the business and the fleet, he knew that the liquidation value in a fire sale was around $8 a share, while the stock was $5. He invested 10% of the fund and in just a few months it went up to $11. Patting himself on the back, he exited the position. As he looked at the company one year latter the price was at $150. He missed the ride, because the market went from fear to euphoria, while his thesis was just not losing money. Being savvy about euphoria and greed is important in investing and often having a small position to capture that pop at the other end can be beneficial.
Emerging and Efficient markets
Efficiency doesn’t depend if the market is developed, emerging or declining. There are, were and will be times where the US market is extremely inefficient. As today’s inefficiencies of the US market are on the side of being overvalued, he looks in different corners on the globe. Today there are very few undervalued names that have the significant discounts he looks for. Mohnish wants to buy something that is worth $10 and selling for $4. Different countries are at different points of the inefficiency circle. Taking advantage of those cycles and markets outside of the US can be a huge advantage for an investor.
On Shorting
While mathematically it looks nice to reduce potential returns in a falling market and create alpha, there are very few who can do it well. As the Forbes 400 is dominated by people who are long only and non-diversified like the Walton family, Bill Gates or Jeff Bezos, Mohnish isn’t interested in shorting.
To be good at shorting, one has to be competent as risk management. If one shorts Tesla at $50 dollars, you need to cut your position by 10% if it rises to $100 and if it goes down, you need to increase your short position - else you risk losing too much. Warren Buffett and Charlie Munger had short candidates and were right on the company, but often horribly wrong about the timing. Since you need to get both timing and the business correct it is much easier to make money on the long side. When you have a short position you always need to know what the market does. As Mohnish has no leverage and no short positions it is irrelevant what happens today, tomorrow or even next month to the share price of the company. The only thing he has to worry about is if the company gets better each year.
How long to hold a stock?
In a book from 1972 “100 to 1 in the Stock Market” by Thomas Phelps there was a sentence that said that every sell decision you make is to acknowledge an investing mistake. In a Utopia you would only hold investments that compound over decades at a good rate. Those companies do exist and while it is easy to find them in hindsight it is very hard to find them at the starting staging of the compound curve.
As 2020 was a year of learning for him, he had a change in his thinking. Whereas before he tried to find dollar bills for 50 cents he now tries to find those compounders. Managing those 50 cent stocks is tax inefficient and requires a treadmill of activity. He now looks at the destination of the business in 10-20 years. Finding compounders that the world hasn’t figured out yet is the holy grail of investing.
Checklist for companies that are great
Mohnish had Dinner with Charlie Munger a week ago and he is doing well. Charlie often talks about cinches (as a non-native speaker I had to look up what the hell a cinch is: basically an easy and certain thing). So a company isn’t a cinch when the odds are high that something destroys the company. When Charlie says something is a cinch he know he has to back up the truck and life will be good. Charlie Munger would probably say that Costco is a cinch. It is hard to imagine forces that destroy Costco, to the contrary it becomes more valuable the more stores they open. Capitalism is brutal, 98% of all companies go bankrupt in less than 10 years and even the fortune 500 don’t last more than a few decades. Just like in nature at the end almost all of them die. While it seems like a fool’s errand to find the exception to those inherent traits it is the path to the promised land.
Ten years ago a friend of his analyzed American Towers and showed up early to an analyst meeting. As he went to the office of the CFO, he saw that the CFO was relaxing and had nothing to do. After questioning if he had nothing to do, he answered that everyone who wants to sell a cell phone tower has our number and we already know what we will pay, we just have to sit and wait to acquire it. So if the CFO has the luxury of having his feet on the desk it is a kick-ass business. Most businesses can’t even think to run that way and would go bankrupt in less than three month.
In the future he only wants to have cinches and “feet on the desk” businesses in his portfolio. According to him, his current portfolio only has two of those companies. As time progresses he wants to replace his 50cent ideas with awesome companies.
The third question concerns the destination of the business. Costco just entered China and they had to put up restrictions as the store got mobbed. In 20 years there is the probability that there are many stores in China and since there are more than 170 countries where Costco has no presence, there is enough room to grow. If the DNA of the company remains intact it looks like a cinch in 2021.
His investment checklist is a living and breathing document and he just recently added those three to the moat section. He has a lot of other factors but he won’t all list them.
Is it a cinch?
Is it a “feet on the desk” business?
Where is the destination?
However it is not difficult to come up with a good checklist. He looked at how great investors lost money and if there were things to know before the investment was made, that could have prevented you from doing so. Warren Buffett’s investment in Dexter Shoes turned sour as they got decimated by cheap overseas labor. So he added it to his checklist:
Is this a business that can be negatively impacted by cheap overseas labor?
Valuing a business
Mohnish wants to have the cake and eat it too. Great businesses rarely are cheap, but he still aims to buy Costco at 3 times earnings. At the moment it is at 36 P/E, which is not bad for a kick-ass business, but as it goes into the lower double digit range he passes most investments.
In order to value a business one has to take many scenarios into account. Costco has a range of future stores, membership and profitability per store. Getting these numbers and backtracking from there get you to a reasonable price to pay for the company. Depending on the business and the circumstances regarding the nature of the business one has to take different scenarios into account. Mohnish isn’t a fan of DCF. If you need Excel to value a business it is probably too difficult. In an older talk he outlines 10 commandments of investing and one of those was “Thou shall not use Excel”. If Costco would sell at 9 times earnings, one doesn’t need Excel to know it’s a great deal.
I collected the ten commandments:
Thou shall not have an investment team (hard to have a good working relationship with an analyst)
Thou shall accept I shall be wrong one-third of the time
Thou shall look for hidden 1x price-earnings stocks (based on future or hidden earnings and not shown by any screen)
Thou shall never use Excel
Thou shall always have a rope to climb out of the deepest well (setbacks are part of the course, learn to deal with them
Thou shall be singularly focused (Focus on the company, not the macro
Thou shall never short (Unlimited downside, only 100% upside)
Thou shall not be leveraged.
Thou shall be a shameless cloner (look for ideas from great investors, VIC…)
Thou shall not skim off the top (Investment Managers should only make money when they create returns - similar to old Buffer/Munger Partnerships)
Setbacks in investing
If wealth is lost - nothing is lost, if health is lost - something is lost and if character is lost - everything is lost. It is in the nature of investing that at least four out of ten ideas don’t work out as you expected. Predicting the future is hard. Nobody predicted the pandemic and even less how stock prices would look like after a year. The way the future unfolds is often different than one’s logic dictates.
Mohnish had several zeroes. A mortgage company in 2007, a zinc recycler and countless picks that went flat or declined somewhat. One must have the discipline and the process to still continue and learn from those setbacks.
Most important trait for investors
While there are many things that are important, extreme patience is required to do well. Business changes happen not in minutes or days, they take years. If you love to see paint dry one is suited to be an investor. Doing nothing and being in bliss is a great trait to have as an investor.
Starting a fund and career advice
When he was a student he had no idea what he wanted to do. The key is to work for someone you like, admire and trust. We all have a tendency to go for the name brands, but ask yourself what you would really like to do. Focus not what would look good on a resume but what you would like to do and what allows you to maximize your potential.
Mohnish started his fund in 1999. In the previous five years he turned 1 million to 10-14 million. As he always gave his friends stock tips they one day approached him and asked if he could manage their money. As his priority was keeping his friends, he guaranteed their principle and 6% a year, above that he took a 25% cut similar to the Buffett/Munger partnership in the 1960s. As his fund grew he knew he had to run it like a real business. He set up another fund, with similar conditions except the guarantee of principle. While his friends protested as he closed the first fund, they all transferred their money to the new one. They will swim to you in shark infested waters to invest with you, if you can create above market returns.
There are three requirements to start a fund:
Be independently wealthy
Have a good track record
Friends and family should be willing to let you manage their assets.
Biggest mistake in his career
While there were many left and right turns, the journey was good. His biggest mistake was probably in 2014, where he had the idea of a holding company that acquires insurance companies and invests with the float. After raising 150 million in capital buying an insurance company, and intensive learning, he realized that his plan won’t work out. He unwinded and sold the insurance company for a slightly higher price than what he bought it for, returning the money. While returns for investors weren't great there wasn’t a loss of capital. In the process he learned a lot and got a great understanding of the insurance business.
I hope you enjoyed the talk as much as I did. Feel free to contact me on Twitter @InvestRoiss