Monday, August 13, 2012

Notes from meeting with value investor Mr. Mohnish Pabrai

From Left to Right: Mr. Sanjay Bakshi, Mr. Mohnish Pabrai and Mr. Ashish Kila

Mohnish Pabrai is an Indian-American businessman, investor and philanthropist. In his Pabrai Investment Fund, which is a family of hedge funds inspired by Buffett Partnerships, he successfully manages over $500 million of assets and consistently achieves above average rates of return. Pabrai has high regards for Warren Buffett and admits that his investment style is copied from Mr. Warren Buffett and others. He has written a book on his investing style: "The Dhandho Investor: The Low - Risk Value Method to High Returns".

Mr. Pabrai started with studying Mr. Buffett. Then he added Munger, Templeton, Ruane, Whitman, Cates/Hawkins, Berkowitz etc. According to him it is 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.

Books by the Author
1.       Mosiac: perspective on investing
2.       The Dhandho investor

Mr. Ashish Kila had an opportunity to interact with Mr. Mohnish Pabrai at MDI (lecture organised by Mr. Sanjay Bakshi & Mr. Amitabh Singhi) where Mr. Pabrai presented his astute insights regarding the course of action investors should adopt in ever uncertain markets. Note: - We have humbly tried to make some additions (highlighted in Italics) to the note below for better understanding of the content.

·                     How to go about Cash Allocation
o        When an investor finds a stock that has a potential to turn into a two bagger, 75% of the total portfolio allocation should be made towards such stocks.
o        For the remaining 25% of the portfolio, the investor becomes more conscious and conservative and tries to find an investment that will be either a three bagger or a five bagger.
o        The remaining Allocation should be made in the proportion of 10% for a 3 bagger another 10% for a four bagger and remaining 5% for a potential five bagger.
§  Here the seasoned investors raised a question regarding the time frame one should have patience and let the investment attain its true value.
§  Mr. Pabrai showed the real strength of patience by quoting the example of Daily Journal’s investments under the guidance of Charlie Munger  
§  Charlie Munger had the company’s money invested in treasuries for almost 10 years till he found a potential multi bagger in Wells Fargo and Bank and within 1 quarter he invested 100% of the treasuries amount in the stock.
§  Investment history behind Wells Fargo & Co.: - Although in the banking sector, Munger picked Wells Fargo, a superbly-managed, high-return banking operation. Munger investment conviction in this case was mostly the reliance on the management.
o   The banking business was no favorite of theirs. When assets were twenty times equity - a common ratio in this industry - mistakes that involve only a small portion of assets could destroy a major portion of equity. And mistakes had been the rule rather than the exception at many major banks. Most had resulted from a managerial failing that the Berkshire team described last year when discussing the "institutional imperative:" the tendency of executives to mindlessly imitate the behavior of their peers, no matter how foolish it may be to do so. In their lending, many bankers played follow-the-leader with lemming-like zeal; now they were experiencing a lemming-like fate.
o   Because leverage of 20:1 magnifies the effects of managerial strengths and weaknesses, they had no interest in purchasing shares of a poorly-managed bank at a "cheap" price. Instead, their only interest was in buying into well-managed banks at fair prices.
o   With Wells Fargo, Munger obtained the best managers in the business, Carl Reichardt and Paul Hazen.
§  The managerial qualities that attracted Mr. Munger: First, the pair was stronger than the sum of its parts because each partner understood and admired the other.
§  Second, the managerial team paid able people well, but abhorred having a bigger head count than is needed.
§  Third, they attacked costs as vigorously when profits are at record levels as when they are under pressure.
§  Finally, both stuck with what they understood and let their abilities, not their egos, determine what they attempt.
§  The purchase of Wells Fargo in 1990 was helped by a chaotic market in bank stocks.
§  The disarray was appropriate: As one huge loss after another was unveiled - often on the heels of managerial assurances that all was well - investors understandably concluded that no bank's numbers were to be trusted.
§  Aided by their flight from bank stocks, Mr. Munger purchased 10% interest in Wells Fargo for $290 million, less than five times after-tax earnings, and less than three times pre-tax earnings.
§  Wells Fargo was big - it had $56 billion in assets - and was earning more than 20% on equity and 1.25% on assets.
§  Their purchase of one-tenth of the bank may be thought of as roughly equivalent to their buying 100% of a $5 billion bank with identical financial characteristics. But if they were to make such a purchase, they would have to pay about twice the $290 million, they paid for Wells Fargo.
§  In recent years, Wells Fargo executives have been more avidly recruited than any others in the banking business; no one, however, has been able to hire the dean.
§  Of course, ownership of a bank - or about any other business - was far from riskless.
o   California banks were faced with the specific risk of a major earthquake, which could create enough havoc on borrowers to in turn destroy the banks lending to them.
o   A second risk was systemic - the possibilities of a business contraction or financial panic so severe that it would endanger almost every highly-leveraged institution, no matter how intelligently run.
o   Finally, the market's major fear of the moment was that West Coast real estate values were to tumble because of overbuilding and deliver huge losses to banks that have financed the expansion. Because it was a leading real estate lender, Wells Fargo was thought to be particularly vulnerable.
§  None of these eventualities could be ruled out. The probability of the first two occurring, however, was low and even a meaningful drop in real estate values was unlikely to cause major problems for well-managed institutions. Consider some mathematics: Wells Fargo earned well over $1 billion pre-tax annually after expensing more than $300 million for loan losses. If 10% of all $48 billion of the bank's loans - not just its real estate loans - were hit by problems in 1991, and these produced losses (including foregone interest) averaging 30% of principal, the company would roughly break even.
§  A year like that - which they considered only a low-level possibility, not likelihood - would not have distressed them. In fact, at Berkshire they would love to acquire businesses or invest in capital projects that produced no return for a year, but that could then be expected to earn 20% on growing equity.
§  Nevertheless, fears of a California real estate disaster similar to that experienced in New England caused the price of Wells Fargo stock to fall almost 50% within a few months during 1990. Even though they had bought some shares at the prices prevailing before the fall, they welcomed the decline because it allowed them to pick up many more shares at the new, panic prices.

·                     Wife v/s Mistress- Dilemma
o       In the time of uncertain markets an investor does feel that the other stocks (those not owned by him) are looking attractive, but its human psychology that a person finds thing which he not owns more attractive and lucrative.
o       During the uncertain periods a fall in the fundamentally strong stock (here the wife) from 1 to 0.7 may lure an investors to switch over to other attractive stock which has fallen from 1 to 0.2 and started looking cheap (the mistress), during this time frame. An investor must hold on to the fundamentally strong stock which has a higher upside potential when the Economy is on the upswing.

·                     Buy for a time frame of at least two year
o        The real knowledge comes after two years of owning the stock.
o        The investor needs to give the time for his investment thesis to work around and what new aspects arise for the stock.

·                     Expert’s Helping Hand- The Checklist
o        Atul Gawande in his book The Check List Manifesto makes a distinction between errors of ignorance and errors of ineptitude. Failure in the modern world is really about the second of these errors which means mistakes we make because we don’t make proper use of what we know.
o        A team is only as strong as its checklist i.e., a way of organizing that empowers people at all levels to put their best knowledge to use, communicate at crucial points, and get things done.

·                     The Rule of Reciprocity
o        Robert B. Cialdini In his book ‘Influence the psychology of persuasion’ mentions that a person tries to repay what another person has provided.  
§     Quantum of Favor: To be rid of the uncomfortable feeling of indebtedness, an individual will often agree to a request for a substantially larger favor, than the one he or she first received.
§     Mr. Pabrai demonstrated this with his own example. Whenever an investor shows interest in Mr. Pabrai’s fund he gifts them Cross-pens along with the brochures, humbled by the small gesture by Mr. Pabrai the investors usually ends up pumping a fortune in their funds. J 
o        This sense of future obligation according to the rule makes possible the development of various kinds of continuing relationships, transactions, and exchanges that are beneficial to society.
o        A possible and profitable tactic to gain probable compliance would be to give something to someone before asking for a favor in return.

·                     The Power of Cloning
o        Mr. Pabrai suggests no one in this world is going to copy you, even if you beg and plead others to do so. Humans are not able to take in new ideas. It is essential to know one in crores become Steve Jobs, we should try to become Bill Gates, try cloning (i.e. inversion mental model).
o        The Burger King and Sam Walton Examples –Power of cloning can be best judged by studying the cases of burger king and Sam Walton as pointed out by Mr. Mohnish Pabrai.

§     Mc Donald’s with its entire Logistics’ arm works extensively to find new avenues for its outlets while burger king with a few people to track Mc Donald’s new avenues opens an outlet near every Mc Donald’s outlet, results in Cost Savings and Expansion simultaneously.   
§     The power of cloning in its true meaning of passionately studying competitors magnified when it came to knowledge that it was actually Sam Walton, the owner of Wal-Mart, who was found lying in a K-Mart store to measure the aisle distance and not a random person suffering a heart attack as reported in the news.  
·                     Re-engineering the time allocation and using it your advantage
o        Mr. Pabrai’s way to get started on your own
§     Mr. Pabrai believes that business can be made along with job. After the work hours still a lot of time is available to work on things of your interests.
§     In a week there are 168 hours, take out 56 hours of hours to sleep and 45 hours of work (9 hours a day and 5  days a week ) then also there are 67 hours left to do pursue work of your interest.

·                     The Comparative Approach of fair value
o        Humans don’t know the price of anything, often the fair value of anything is known by comparison.
§     An excellent work on this is found in the book titled “Priceless” by William Poundstone. Poundstone argues that much of what we think of as "fair" pricing is nothing more than a collection of cognitive fallacies and biases.
§     The most important of these fallacies are the contrast effect (pricing taking on significance from neighboring prices) and the anchoring effect (we take reference from the benchmark available to us).

·                     Management Psychology
o        It is better to not meet the management because they are too optimistic regarding their future prospects.

·                     Graham V/S Munger
o        A very significant distinction between investment techniques of Benjamin Graham and Charlie Munger is while Graham focused on buying cheap distressed business, Munger followed a practice to find great assets and be patient for sale. Mr. Mohnish Pabrai demonstrated this with the help of a grocery store example.
§     Suppose Graham and Munger are to visit a grocery store. Here Graham will prefer to buy all the cheap stuff available collectively as a basket (with an aim to have a net benefit) while Mr. Munger would identify the best articles and prefer to purchase them at attractive prices like in case of a sale.

·                     Learn from mistakes
o        A person should learn from yesterday. It is better to make the mistakes public and improve on the aspects.

·                     The macro stuff
o        The macro context of the economy and industrial outlook should be viewed in context of the business i.e., the probable effects of the macro outlook will have on the business of the company.

·                     Circle of competence
o        The circle of competence means which pond (industry) and fish (company) should investors choose. The important thing to note is that the best way to ask a question is to answer it. A way to increase the circle of competence is to read all kind of stuff, this broadens the horizon.

·                     The art of reverse Engineering
o        This can be termed as the essence of investing which in real terms means applying the knowledge and expertise gained by the notable investors (the likes of warren Buffet, Charlie Munger) in our investing methodologies.
o        Even if an investor purchases a particular stock (even at the highest price of the month) for which a notable investor has announced a regulatory filing, and simultaneously sells the stock (even at the lowest price of the month) when the notable investor squares off his position, the investor can still beat the market handsomely.
o        A best way to practice it is to keep an eye on what the big investors are buying.
o        A watch on the successors of the Veteran Investor’s-An interesting aspect
§     It’s very interesting to keep a track of the buying pattern of the successors of the veteran investor’s.
§     It will be interesting to take the example of the next generation leaders of Warren Buffet’s Berkshire Hathaway.
§     Mr. Buffet has appointed two hedge fund managers Mr. Ted Weschler and Mr. Ted Combs, with excellent track record even in the gloomy markets, to replace him as the Next CIO and CEO when he retires.
§     Mr. Combs is assembling a group of stock picks of his own after being hired by Berkshire last year to take smaller stakes than Buffett, and has stakes in Direct TV,  CVS Caremark Corp., Intel Corp. (INTC) and Visa Inc. (V).
§     The crux here is that when assigned with the responsibility to build a portfolio under the guidance of the notable Mr. Buffet himself, the acquisition of the stakes in the above mentioned companies indirectly represents the decision framework of Mr. Buffet and the Magic of reverse engineering can be  replicated by an investor in the same manner as the stocks picks were done by Mr. Buffet himself.    

·         The Potential business
o   A potential investible company must have simple business, low Capex and a strong ‘moat’. Here it will be very useful to understand the case of Direct TV.
§     As coined by Mr. Pabrai It will be interesting to study the Journey of Mr. Michael White former Vice Chairman of PepsiCo.
§     Mr. White is the Chairman, President and CEO of Direct TV and has served as a Director since November 18, 2009.
§     Mr. White has always lead from the front and has been a key catalyst in success of the organization’s such as Frito-Lay’s, PepsiCo, whirlpool and PepsiCo Foods International.    

§     Mr. White has served on the Board of Directors and as Vice Chairman of PepsiCo from March 2006 to Nov 30, 2009 and as Chairman and CEO of PepsiCo International from February 2003 to Nov 30, 2009.

o        When Indra Nooyi learned she had been selected as CEO, she flew to Cape Cod to talk to her chief competitor for the job, Mike White, who was PepsiCo's foremost operations person, to persuade him to stay on. "Tell me whatever I need to do to keep you, and I will do it," were the words spoken by Indra Nooyi. She enlisted three former CEOs to help convince him and asked the board to increase his compensation to a level close to hers.
o        This kind of efforts to refrain a person from leaving the company requires attention as to how important this person would have been to the PepsiCo.
§  When Mr. White decided to switch over to Direct TV, it should be noted that a person of his caliber must have noticed something great in this business. The low Capex and great potential business might have attracted Mr. White.
§  Low Capex
§     The business requires an expenditure of around $ 30 million dollars to provide satellite television connections in entire Latin America while if same was to done with cable lines it would cost billions of dollars for the same purpose. The company has low capital requirement together with tremendous growth opportunities. These are events that demand the attention of an intelligent investor, who in this case should have immediately studied the case of Direct TV.

Summary of the book “The Dhandho Investor”

We also Read the bible of value investing “The Dhandho Investor” by Mohnish Pabrai. Some useful insights that we found from the book are as follows: -
·         The book focuses on taking few ultra low risk bets which have a high pay-off. The key being ultra low risk.
·         Heads I win, tails I don’t lose much
·         Few bets, big bets, infrequent bets
·         Focus on buying existing businesses
·         Long operating history
·         Simple businesses with ultra slow rate of change
o   We look for mundane products that everyone needs (WB)
o   Five ascending levels of intellect: Smart, Intelligent, Brilliant, Genius, Simple.(Einstein)
·          Buy distresses businesses in distressed industries
o   Getting the purchase price right is more important
o   Entrance strategy is more important than the exit strategy
o    Be fearful when others are greedy, Be greedy when others are fearful (WB)
·         Look for moats – sustainable competitive advantage
·         Bet heavily when odds are in your favor
·         Focus on Arbitrage
·         Buy businesses at big discounts to their underlying intrinsic value – Margin of safety
·         Look for low risk, high uncertainty business
o   Leads to severely depressed prices for buying businesses
·         Better to be copycat than an innovator.

We also viewed some of the interviews of Mr. Mohnish Pabrai. 

Some useful insights from the interviews according to us are as follows: -

·         Short Selling-A perfect recipe for a potential downfall
o   Why engage in something where you know that maximum upside is double and downside could probably kill you. 
·         The checklist magic
o   Prepare a checklist before investing. It helps us to cover all the key areas that we desire to look for in an investment, minimizing the error of ineptitude.
o    The following key points are useful to add in one’s checklist: -
§  Is the business model a win-win situation for the entire ecosystem?
§  Management integrity
§  Competition
§  Historical Track Record
§  Are we looking at Normalized earnings or Peak Earnings?

The author (Mr. Ashish Kila) would especially like to thank his team member Mr. Pratik Arya, for his extensive help in preparation of the above note.

  • Nothing in this article is, or should be construed as, investment advice.
  • This is not an offer (or solicitation of an offer) to buy/sell the securities/instruments mentioned.
  • All the posts on this blog, including this one, are for educational and discussion purposes only.
  • Please do not take buy/sell or any investment decision based on articles you read on the blog. These are only meant to provide information and initiate discussion. Final decision is and always should be, yours and only yours.
  • I may or may not have a position in the stocks discussed on this blog. 


Abhishek Basumallick said...


Sahil Jain said...

Well Written !!!

Anil Kumar Tulsiram said...

Hi Ashish
Great post, thanks. The general review I got for THE DHANDHO INVESTOR was that it’s a highly overated book and I too was thinking when I am studying the master (Bugget, Munger, Martin Whitman) why to study a person who has copied from these people. Now my opinion is completely changed and this book will be on my priority list. Just want to point out one thing regarding cash allocation. Mohnish seems to have changed his view on concentrated bets. This is what he said in presentation given to Columbia Business School “The lesson of 2008-09 crisis seems to be No need to hold 100 names, but unwise to hold 4, 20-30 names seems just right.

Price India Review said...

Wow Very Nice Article