With Mohnish Pabrai, Founder and Managing Partner of Pabrai Investments Funds
Pabrai On What Being A Value Investor Means
Continuing our conversation with Mohnish Pabrai, Steve asks Mohnish to talk about what it means to be a value investor. His reply is a bit tongue-in-cheek, yet truthful: it’s the art of “laying out money today with the idea that you hopefully get more back in the future.” Moreover, he continues, since the future is not too distant, when the amount returned is the same as the amount you put in, that’s “wonderful.” He explains that value comes “in many flavors”: sometimes a stock is cheap and a great value buy, other times a stock is cheap and not a good value even at that price. This holds true for expensive stocks as well. The price is not always an accurate reflection of the value, in other words, despite market efficiency theories. You have to be able to “peel the onion” and peer deeply into the company’s finances and understand its cash flow prospects for the next several years to make a determination on the relative accuracy of its stock price. Many times this is impossible, Mohnish declares, and this is fine; you just have to move on to another company that does offer the necessary level of financial detail. It may turn out that only a tiny sliver of businesses is both in your core competency and sufficiently transparent regarding finances. If he discovers a big enough distortion between a stock’s worth and its price, Mohnish wants to own that stock. The rest of the time, he does nothing. Far from being a throwaway phrase, this last statement is a statement of profound purpose. Steve picks up on this “doing nothing” philosophy, arguing that while it might look like passivity (especially as teenagers practice it), it is, in fact, a very active behavior for investors—and a critical one at that.
Pabrai Funds Cares About Individual Companies, Not Broader Markets
Steve asks Mohnish about his comments to the effect that he doesn’t care about the whole market, only individual companies. Mohnish confirms that this does sum up his approach well. He talks about how when he had just started up Pabrai Funds in 1999, the dot-com boom was in full swing and traditional brick and mortar companies’ stocks were suffering a thorough beating. He notes that the NASDAQ peaked on the same day in March 2000 that Berkshire Hathaway hit a multi-year low. It looked like money was being siphoned away from Berkshire Hathaway and directly into tech stocks. Instead of worrying about the NASDAQ or other indexes, his fund stayed focused on individual companies. He identified a section of the market that he thought was really cheap and aimed his fund’s research, and later money, towards the best of those companies. He believes that there are always mispriced or underpriced stocks, sometimes only a few, other times many. He adds that this has been his M.O. as a fund manager consistently throughout the years and into the present.
Value Investing Opportunities In 2017: Overseas Or Domestic Stocks?
Mohnish asserts that the investing environment today is similar to the one in his fund’s early years and might even be worse as far as US stocks are concerned. He points out that he’s not necessarily describing the whole market as overbought (as mentioned in the previous segment, he believes that the direction of interest rates over the next 5 to 10 years holds the key to that question) but he claims that it’s very difficult to find stocks of US companies that he likes right now. He invested in some US airline stocks last year—Southwest Airlines and airline leasing company AirCap—and has instead turned his attention to South Korea, India, China, and Europe among other places for attractive equity value. While for most of its history, Pabrai Funds has held about 20% of its portfolio in international stocks, today that percentage is close to 70%, and he believes it could climb higher. He further notes that many of his US stocks have a large exposure to foreign business and investment, like General Motors.
The Value Of Patience And Decisiveness
Steve states that many market participants like to get in and out of stocks quickly, an approach that is frequently talked up in the financial media and in shows like Jim Cramer’s Mad Money. Berkshire’s Charlie Munger, on the other hand, says that the big money is not made in buying and selling, it’s in waiting. Steve asks Mohnish to explain what Munger means and what he’s waiting for. Mohnish responds with a story about how Munger was a regular reader of Barron’s magazine for 50-something years, just decades poring over all this financial data, and then finally he decides to make one investment in an auto parts company called Tenaco. He invests $10 million in Tenaco stock and another pile in some of their distressed bonds, and then a couple of years later he sells it for $80 million. He turns around and gives the $80 million to a talented manager named Li Lu who was focused on Asian markets. That fund is now worth about $500 million. In a span of about 17 years—or 50+ years if you want to go back to all those decades of patiently waiting on the sidelines—Munger made two decisions that led him to a return of 50 times his original investment. That’s the kind of waiting that Munger is talking about, Mohnish claims.
As important as patience and inaction are to investing success, Mohnish explains, so are decisiveness and a willingness to commit significant resources. Ideally, you ought to be, or to hire, someone with the temperament of one who, to mix metaphors, doesn’t mind watching the paint dry but, when the do stars align, is ready to step up and swing for the fences. Steve says that the hard part is recognizing when the stars are aligned, but Mohnish counters that the math of the situation ought to be recognized as a no-brainer before taking any action. Returning to the subject of patience, Steve wonders whether inaction ought to be cultivated by more fund managers. Perhaps it’s an antiquated ideal dating back to Victorian times when gentlemen would drop their leisurely pursuits when markets were in great fear, roll up their sleeves and find and seize the best opportunities. While it seems easy on the face of it, in practice, it’s actually quite hard to do. Mohnish agrees wholeheartedly, saying that most managers should reduce their activity “dramatically.” He thinks that perhaps some people are more wired than others to be happy with this kind of approach to life and investing: mostly unfocused on equity markets but ready to act when bargains manifest themselves.
Entrepreneurs And The Pursuit Of Low Risk, High Uncertainty, High Return Business Models
A common stereotype about entrepreneurs is that they take on high risks in the pursuit of high returns. Mohnish argues against this view, stating instead that most successful entrepreneurs are actually engaged in seeking high returns with low risks. Entrepreneurs use a variety of tactics to minimize their risks. He says that this model for entrepreneurial success translates well into investing success. Warren Buffett has said that being a businessman has made him a better investor and being an investor has made him a better businessman. There’s more potential for cross-pollination between these categories than many people recognize. For entrepreneurs who have grown a successful business, many of the things they’ve learned along the way can be applied as elements of a successful approach to investing. Mohnish talks about Bill Gates’ humble beginnings and how little outside money was invested in Microsoft on its way to becoming a dominant force in its industry. Because its founder never invested much of his or anyone else’s money in the company and almost all of their growth has been generated internally, it’s inaccurate to describe the launch or evolution of Microsoft as “high risk.” In Mohnish’s opinion, a more accurate description of the company’s early years would be “high uncertainty.” This quality, uncertainty plus low risk, is one that Mohnish thinks investors should look for and seriously consider taking a position in. Markets hate uncertainty and will punish companies with high uncertainty by underpricing them and—voila!—another opportunity for a canny value investor is created. Businesses with a high degree of certainty and consistent growth are practically never underpriced, he says, but businesses with high uncertainty are sometimes deeply discounted, and that is when value investors should act.
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Steve Pomeranz: I’m back with Mohnish Pabrai as part of our Great Investor Series. Mohnish began his investing career in 1999 and has been using the ideas and philosophies of Warren Buffett and Charlie Munger ever since. Mohnish, so you are a person who invests using value techniques, what does it mean to be a value investor?
Mohnish Pabrai: Well, to be a value investor is investing the art of laying out money today with the idea that you hopefully get more back in the future, and, of course, if the future is not too distant and the amount returned is the amount of what you put in, then that’s wonderful.
So, value comes in many flavors. Sometimes, a stock that’s really cheap, can be a value buy and sometimes a stock that’s really cheap cannot be a value buy. The reverse holds true as well, where things that appear expensive may be a bargain. So one has to really, kind of, peel the onion to truly understand the business and then truly understand the cash flow that businesses are likely to produce over the next several years, and for most businesses, we are unable to do that, which is perfectly fine. We don’t need to figure it out for every business. But for a small sliver of businesses that may be within our circle of competence, we may be able to figure that out. And when there’s a big distortion between price and what something is worth, that’s when the likes of me will step in, and the rest of the time we’ll just do nothing.
Steve Pomeranz: Yeah, I want to talk about that because that’s my favorite part of your philosophy is this “doing nothing”. I often say unless you’re a teenager doing nothing is actually an active activity. So, you don’t really care so much about the whole market, you’re just looking at individual companies?
Mohnish Pabrai: Yeah, I have never particularly cared about the market. I mean, actually, when I was starting Pabrai fund in ’99, the NASDAQ, about 9 months after it started, hit an all-time high and then went on to lose 80% of its value; and I actually understood in ’99 when I was looking at the evaluations of many companies that broader markets were elevated. But we did really well because I’ve never been concerned about the broader market. We pick stocks that make sense. And, actually, what was happening in the ’99, 2000, 2001, 2002 timeframe was that boring, kind of, brick and mortar companies got really cheap while sexy sizzle companies, technology companies, dot-coms, got really expensive. And so, if you look at the day the NASDAQ peaked in March 2000 was the same day that Berkshire hit a multi-year low. I think the stock dropped about 40,000. And both events happened on the same day. And it was almost like money was being sucked out of Berkshire Hathaway and being dumped into all these frothy NASDAQ stocks.
So, for a value investor like me even in that frothy environment, there was a section of the market that was really cheap and that’s where I went looking. And that’s what I’ve always done. I don’t think Jim Cramer has too many great quotes, but one of his quotes I like is “There’s always a bull market somewhere.” There are always companies that are mispriced and underpriced at all times. It can be a small number of companies or it can be a large number of companies, but there are always businesses that are trading well below what they should be trading.
Steve Pomeranz: So what about these days? Are you seeing a small…
Mohnish Pabrai: It’s the exact same thing. I mean, I think what I find in 2017, I find very little to buy in the United States. If I look in the last twelve months, the only thing I’ve bought in the United States is airline stocks. We bought Southwest Airlines last summer. I think about a little over a year ago, I bought an airline leasing company, AirCap. But I haven’t found much in the US, but I have found a good number of things to buy in South Korea, and I found a good number of things to buy in India. Again, like Charlie Munger says, “You go fishing where the fish are.” If I look at the Pabrai Fund’s portfolio today, one of the things that really surprises me is more than 70% of the portfolio today, of the 560 million something we have, is invested in businesses domiciled outside the US.
Steve Pomeranz: Wow.
Mohnish Pabrai: It’s in China, South Korea, India, Europe, et cetera. It’s the largest percentage it’s ever been since I started. And I think for the bulk of the period that the Pabrai Fund has been around, our international investments were usually well under 25%, 20%. So, there’s been a significant change, and I can see it going even beyond 70%. And even when I look at the US stocks, the 30% that are domiciled in the US, I have companies like General Motors, which have very strong amounts of cash flow coming out of places like China. Even though that’s a US company, a lot of its cash flow is coming from outside the US.
Steve Pomeranz: You know, I heard a quote from you that said that you didn’t really care—and this may have been a while ago—but you were saying that you didn’t care to invest in China because in China there are three sets of books. The first set is for the government, the second set is for the wife, and the third set is for the mistress. Which set of books are you looking at in China?
Mohnish Pabrai: Well, that is absolutely true. I think for most of the listeners of your show, I would say they’re probably best to leave China alone. Or if you’re investing, then try to find a high-quality mutual fund or index to go through. I think in China I just have one investment, and we did a lot of due diligence, so I think in this case there is indeed one set of books. I’ll leave the company unmentioned. The government is a large shareholder in that business.
Steve Pomeranz: You know a lot of market participants like to get in and out of stocks. If you watch investment shows, you mentioned Jim Cramer, there’s always an idea for the day, and it’s this idea of getting in and getting out. But Charlie Munger says that the big money is not made in the buying and selling of stocks, it’s in the waiting. What do you mean? What is he waiting for?
Mohnish Pabrai: So, I think one of the best examples, and this happened very recently with Charlie Munger, is he was recently mentioning how he read Barron’s for 50 years, from something like the 1950s to the early 2000s. After 50 years of reading Barron’s, he made one investment. He made an investment in 2002 in a company called Tenaco in auto parts. He put 10 million dollars in 2002 into Tenaco and a couple of years later, he bought the distressed bonds as well, but a couple of years later when he sold that investment, it was 80 million that he collected. It was an 8X in two years. Then he took that 80 million and gave it to a very promising manager who was focusing on investing in Asia, a person named Li Lu. That 80 million, I think my best guess is, it’s sitting at around 500 million today. From 2002 to 2017, and actually, if you go back, it’s really going back to the 1950s, but in this 17-year period, Charlie Munger took two decisions. Those two decisions delivered a 50X return in the US and in international markets. That’s really what he’s talking about.
He did the same thing with the Daily Journal, which is one of the public companies that he controlled. The Daily Journal was sitting on a bunch of cash and then in March of 2009, during the depths of the financial crisis, they bought Wells Fargo and US Bank. They pretty much bought Wells at the absolute bottom tick, when it was I think around ten dollars a share. That is today north of $50 a share. So, inaction and patience are very important traits, but they need to be coupled with decisiveness and willingness to act in size. So, it’s an unusual trait to have someone who’s happy watching the paint dry, but then when all the ducks line up, you swing hard.
Steve Pomeranz: I think the answer is in being able to recognize when the ducks are all lined up. That’s the hard part.
Mohnish Pabrai: Yeah, actually that’s also not hard if you just say “I’m only going to invest in complete no-brainers.”
Steve Pomeranz: Yeah, that’s true.
Mohnish Pabrai: That’s the key. If you’re not convinced you’re looking at a no-brainer, take a pass.
Steve Pomeranz: Yeah. You know there’s this quote from Pascal, “All man’s misery comes from his inability to sit in a room and do nothing.” Would you say the same for money managers as well?
Mohnish Pabrai: Yeah. I’d tweak that quote a little bit and say that all investment misery stems from the inability to sit quietly in a room and do nothing. One of the best things that most investors and money managers can do is dramatically take down the activity.
Steve Pomeranz: But the exercise sounds very Victorian, very 19th century, because you said that the investment industry is set up the wrong way. It should be gentlemen or gentlewomen of leisure going about their daily tasks and when the world is severely fearful, that is when they put their leisurely task aside and go to work. It sounds like an ideal way to live, but it must be harder than it sounds.
Mohnish Pabrai: I mean it is. I think temperament and patience are almost inherited traits and are very fundamental to being a great investor. So to some extent, I think you have to be wired a certain way to be happy with that sort of approach to life. Someone like Charlie Munger is very happy spending his time designing dorm buildings for the University of California-Santa Barbara or reading esoteric books on science or global warming or whatever else. And he’s perfectly fine with that taking up his days, and then when these aberrations show up in the stock market, he can very quickly act on those as well.
Steve Pomeranz: My guest is Mohnish Pabrai. He is an accomplished investor and, as you can see, is someone who thinks a lot about what he’s doing. You know, Mohnish, a lot of people think that when entrepreneurs start businesses they take high risks and that high risk is something that’s very necessary in order to get a high return. But you say that’s not really the fact. What is the fact?
Mohnish Pabrai: Actually, it’s a misnomer. If you look at non-venture backed businesses, entrepreneurs really are kind of like arbitrage players. Someone who’s opening a Chinese restaurant is going to try to see if there are any other restaurants that might compete with him in the area. And if there are four of them, he’d probably just look for another location. So, entrepreneurs look for offering gaps and places where they can arbitrage. And arbitrage by its very nature is risk-free or nearly risk-free. So, entrepreneurs do everything in their power to minimize risk. What they’re trying to do is low risk, high return, not high risk, high return. That model for entrepreneurs is a really good model for investors. This is the reason why Warren Buffet says, “I’m a better investor because I’m a businessman, and I’m a better businessman because I’m an investor” because there’s a huge cross-pollination in those two fields. So, it is a huge advantage if you’ve been an entrepreneur and started and grown a business because the approach you’ve taken to achieve success there, a lot of those elements apply very directly for value investing.
Steve Pomeranz: You mention in one of your talks that Bill Gates when he started Microsoft had very, very little capital actually invested. He really didn’t put a lot at risk.
Mohnish Pabrai: Yeah, well, the thing is, if you’re going to say someone is taking a lot of risk, that has to mean that they have the possibility of losing a lot of money. Well, someone like Bill Gates was a college dropout, so his value in the job market was just maybe barely above minimum wage, and then the total amount of money Microsoft took, from the time it started pretty much to its IPO, was probably less than $50,000. Even the proceeds and the IPO, the company didn’t need that. So, between the time it started and today, they’ve never taken in money. Everything’s been generated internally. So, Microsoft, you cannot say was a high-risk venture. It was a venture with high uncertainty. That’s what investors should look for. The key trait of an investment that is likely to do well is one that exhibits low risk coupled with high uncertainty because when you have high uncertainty, markets hate that, and they will typically underprice companies with a lot of uncertainty.
If you look at a, let’s say, if you look at a company like, let’s say, ADP, which processes payrolls, if you just pull up the stock chart or you look up the dividend history or the earnings history of ADP, what you’ll find is, it’s like clockwork. It just continues to go up almost nonstop for 50, 60 years. That type of a business is a very low uncertainty business. And a low uncertainty business like that is not going to be underpriced. What you want to look for is a business with very high uncertainty, and there you can occasionally get extreme mispricing, and that’s the time to step in like Charlie did with Tenaco. The stock dropped to a dollar, I think he sold it for $15, but then it went to $55 after that. That’s really what you want to do.
Steve Pomeranz: Again, a reason why I have Mohnish Pabrai with us. He is in our Great Investors Series. Mohnish, thank you for taking your valuable time to join us today.
Mohnish Pabrai: Always a pleasure, Steve. Thank you.