“Unlike brain surgery, in investing you can be wrong 40%
of the time and still do fine”
Mohnish Pabrai is used to making investment pilgrimages. The ace investor is a regular at Warren Buffett’s annual Berkshire Hathaway meeting as well as at the Value Investing Congress that is held every year in New York. This year, too, Pabrai has made the trip from his Irvine, California, office on the West Coast to check if he is missing out on anything. That is enough opportunity for us to catch up with him at the Marriott Marquis Hotel, on New York’s Times Square. The Marquis raked up much controversy when it was being built, but is now famous for housing New York’s only rooftop revolving restaurant. Pabrai’s investing style, however, has been anything but controversial. His cloning strategy, which almost anyone can implement but not many do, has made Pabrai a multi-millionaire many times over. All those millions are now being put to very good use through his Dakshana Foundation. It seems then he has decided to not only clone Buffett’s investing style but also his intent to give away most of his riches, to causes that matter. Make no mistake, though, while the thought is benevolent, return on investment is still the driving factor.
What prompted you to get into investing? You were a techie and then you had your own business before you became an investor.
I was an entrepreneur and I really enjoyed running my business. What happens is that as an entrepreneur perhaps 3-5% of your time goes in figuring out your strategy and direction and what you want to do; 90-95% of your time goes in the heavy lifting of your execution, getting after people and motivating them, and getting all your structures in place. I definitely enjoyed the 5% more than the 95% — getting things right in terms of direction is much more interesting. When I first encountered investing and Warren Buffett, it was as if in investing, that 5% increased to 80%. That is what I enjoy so much about investing.
Buffett says, “I am a better investor because I am a businessman and I am a better businessman because I am a better investor.” You need the same skills in investing as when you are an entrepreneur. The good news in investing is there are no HR problems. If there are no humans, there are no problems! And, you get massive leverage on your time, on your thoughts. Your brain cells can effectively be leveraged almost infinitely, almost as if I have huge amounts of capital. People want to pay for thoughts and I can give them some thoughts.
Despite starting off as a techie, you haven’t invested in technology at all. Why is that?
I don’t invest in technology stocks because I understand it. Basically, Buffett would say that he doesn’t invest in tech businesses because they are subject to change. Industries with rapid change are the enemy of the investor. Tech businesses, particularly biotech, is a problem from that point of view. All industries work with change but you should ideally be investing in businesses with a low rate of change, not a high rate of change.
What lessons did you learn as an entrepreneur and by spending time with your father?
|When we buy distress bonds, most of my time is spent on why it will not work, not on why it will work|
I think the human brain goes through two periods of very rapid change: the first, in the first five years of life and the other is during teenage. There are scientific studies that have proven that the experiences you have during your teenage have a lasting impact on you. Luckily for me, this was a period of great learning. I was lucky that my father ran a whole bunch of businesses, started, grew and bankrupted them. Many of these businesses were very highly leveraged. My father was always optimistic and he was maximising leverage on the businesses. But they would blow up because there was no stability in them. From the age of 12 or 13, my brother and I were like the board of directors. He and I would sit down, looking at details of cash flows, trying to figure out how to get past the next day, just one day, every single day. On many occasions when my father travelled, my brother and I actually ran the company. Sometimes we dealt with the staff. I didn’t realise it then, but when I started to work and talked to a lot of people, I realised that I had finished many MBAs before the age of 18. So that period with my dad helped me crack business models much faster than others of my age who were much smarter than me. I was lucky in that regard. That experience was also useful in starting my own business and it is extremely useful now in what I do.
What are the investing mistakes that you have made and what did you learn from them?
Mistakes are the best teachers. One does not learn from success. It is desirable to learn vicariously from other people’s failures, but it gets much more firmly seared in when they are your own. I can give you a couple of examples of permanent losses of capital and my critical learning from those mistakes. One is Sears Holdings. I made this investment because the vast real estate and brand assets of this company are worth multiples of the stock price. But I learnt that those are virtually impossible to monetise because one would need to liquidate the business and lay off tens of thousands of workers. That is gut-wrenching and highly unlikely. Another one is Pinnacle Airlines.
It’s surprising you invested in an airline, considering that Buffett has labeled it as a bad business.
I have a 1-800 helpline to call any time I have an urge to buy an airline stock! I made sure to dial that helpline before deciding to put money into Kingfisher! As you can see Mr Vijay “Branson” is having his share of trouble with airlines and the UB group is being auctioned off piece by piece. Jokes apart, it is a lesson learnt properly.
The reason I bought Pinnacle was that it wasn’t an airline in the traditional sense like Kingfisher or British Airways. Traditional airlines are a losing proposition because of various structural issues — your pricing is set by your dumbest competitor, your costs are subject to a duopoly of airplane manufacturers, a duopoly of engine manufacturers, and a duopoly of maintenance guys and all of them can get whatever they want from you. On top of it, your entire workforce is unionised on every front. You don’t have any leeway to control cost.
|If wealth is lost, nothing is lost. If health is lost, something is lost and if character is lost, everything is lost|
What attracted me to Pinnacle is that it did not deal with the public, but had these contracts to fly planes for other airlines. They have 200 planes that they fly for Delta Air and according to the contract, Delta pays all their cost plus 10%. It is a cost-plus model, so Delta can be losing money on the flights but they still are obliged to pay Pinnacle. What was seductive to me was that those cash flows and profits were very stable.
Why did it fail? One is high degree of customer concentration. The top two or three customers made up 80% of their revenue and profits. And add to that the fact that you get business while your dominant customer loses money. So the first learning is that you should not look at business models in isolation — it has to be a win-win for the full ecosystem. And the second learning is heavy customer concentration is a big risk.
Was this the costliest mistake in your investment career?
The costliest mistake was a financial services company, Delta Financial. The company made money by writing, bundling and securitising mortgages. Actually they ran a perfectly sane business. They wouldn’t do strange mortgages or give loans to people who wouldn’t get loans. When the securitisation market shut down during the financial crisis, they simply were caught with nowhere to go. They were sitting on a bunch of mortgages and their credit lines got pulled. So they filed for bankruptcy. We lost $60 million. We went to zero on that. It was a 10% bet and it went to zero.
When you stare at losses like that, how do deal with it at an emotional level?
Actually, my funds were down from peak to bottom 65% or so. But my wife mentioned to me that she didn’t realise the funds were down that much because throughout that period, she saw no change in my behaviour pattern or my sleep pattern or anything like that. You have to keep things in context. There is a famous quote: if wealth is lost, nothing is lost. If health is lost, something is lost and if character is lost, everything is lost.
We don’t believe in inheritance and we intend to pretty much give away everything we have. But I would be deeply concerned if I lost money for people who entrusted it to me. That was one of my biggest concerns while setting up the funds. But now my family is the second-largest investor in the funds and if the funds go down, we suffer more than anyone else. I am pretty much eating my own cooking.
The other important thing is I am not bouncing up and down with stock prices. I don’t even know what the markets or my stock did today. All of that is just irrelevant.
Your 13F filing shows you are really overweight on financials. Do you think the risk in financials is now over?
They are extremely low risk at this point. In general, financials tend to be risky because they are very highly levered. They have more liabilities than their capital and so, tend to be difficult investments from that point of view. Buffett’s partner Charlie Munger says that you can only buy a financial services company if you understand the ethos and competence of management. Here is what happens. If the management is incompetent then what they define as book value for their own capital can be off. They have to have competence to come up with a judgement of what is reserves and what is capital. If they are incompetent, you have a problem. If they are unethical because they get to choose what they are reporting, you again have a problem. So, before you invest in a financial company it is important that you know two things: are these guys honest and are they competent? The answers are in the affirmative for the stocks in my portfolio. They are fine in both ethos and competence. When you get past those two and you get to valuations, these companies are trading well below book value. And going by our judgement about the management running the banks, the book value itself is conservatively portrayed.
Do you believe there is too much unjustified pessimism in financials today because of the 2008 crisis?
Investors always overshoot and undershoot. Today financials are out of favour. If you look at the 12-month trading range of Bank of America, it has traded at $5 a share on the lower end and $13 on the higher end. So at the lowest point it was valued at $50 billion and the highest at $130 billion. Which is correct? The business has not changed much in the last 12 months. So both cannot be right. I think both ends are wrong.
What is your worst fear with respect to financial stocks?
|Industries with rapid change, like technology, are the enemy of the investor|
I don’t believe we will have a loser among any of our financial stocks. I think the margin of safety is very deep. If you look at somebody like Bank of America, the tangible book value is $13-14 a share. It has about 10 billion shares, so its book value is about $140 billion. It trades at $90 billion. Plus, they have $40 billion of reserves, which is not even part of the book value. That is to pay future claims. Plus, every quarter they produce cash. So when the book value is accurate, the adverse development would need to be so high that it is off the chart — say, someone sues them for something huge. But even then, you have to look at the time value of money, because you have cases going on in courts for 20 years, and how much would the company’s earnings be by the time the case is resolved. So I think that the downside is muted.
You have rarely invested in India…
I invested twice in India. One was an investment that returned 100x! And the other was the ADR of Dr Reddys. Ironically, the 100x investment was Satyam when Satyam was good. I invested in 1995 and I exited in 2000. But I don’t invest in India because there are too many regulatory hurdles.
But why would you have picked Satyam? Because the management always had a dubious image...
Actually, that is not my perspective on Satyam. I think Satyam is a situation where he [Raju] went off the rails because of the human vices of greed and envy. He got envious of Infosys and he wanted to match those numbers. The other was this greed. I used to run an IT services company and that’s when I interacted with the company — not the senior management people, just the people in the US when they were trying to build their business here. I just looked into their business and I was surprised that they were trading below liquidation value. Business at that time was growing probably more than 50% a year and you could have liquidated the company with cash and the properties they held in Hyderabad and that was above the stock price. I sold it in March 2000. I could not justify the valuation, no matter how you approached it. I took a massive exchange rate hit but I bought the stock at about Rs 40 and sold at Rs 7,000, within about 7% of the high. After that Satyam dropped to about Rs 1,000 in a couple of years when it got closer to what it was probably worth. So I benefited unfairly from a bubble valuation. But I think that the book doctoring and all that started later. During the time I was invested, the books were solid.
How do you avoid a value trap? Satyam started to look like a value trap towards the end. And then, in 2008, some of the US financials looked like value buys but turned out to be traps...
There is no such thing as a value trap. There are investing mistakes. If you bought financials in 2008 and lost money, you lost money for a very good reason. Basically, the books had liabilities that unfolded, which were not in the projections; they were not in your analysis. John Templeton used to say that there is no investment manager who is going to be right more than two times out of three. Even if you look at Buffett, Berkshire Hathaway owns 80 companies. If you look at each of the 80 buy decisions, which are independent decisions, at least 40% of them have not met his expectations. They are perhaps an outright loss of capital or they are producing such poor returns that it was a mistake. If you look at it from the point of view of dollar weighted, probably 90% of them have been good decisions. But if you look at each of the 80 decisions as each being equal weighted, the error rate exceeds the one-third that Templeton talks about. There are other mistakes like mistakes of omission where we should have bought something and we didn’t. We sell something, it goes up in price. What we buy doesn’t go up in price as much. These are all mistakes.
The good news is that, unlike brain surgery, we can be wrong 40% of the time and still do fine. I think from that point of view investing is a great business. The second thing is that investing mistakes are part of the landscape.
You invest in distressed bonds. How do you decide which ones to buy?
The bonds we buy aren’t your grandmother’s bonds! Typically we have bought level-3 bonds. We bought into a telecom company and did not pay more than 40 cents for a dollar. Generally, when we buy bonds they tend to have equity-like characteristics. Sometimes it is better to be on the debt side because you get more protection and still have an upside. Most of my time is spent on why will this idea not work, not on why it will work. I will look very hard at what will kill this company. That is what I get paid for.
Is there any fundamental difference between your strategy and Buffett’s, barring the fact you don’t do buy and hold forever?
Yes. Berkshire Hathaway is a different vehicle — it is a permanent capital vehicle. It also has a lot of capital. But I wouldn’t say size is a big difference. What they would look at and what I would look at would be different and they have massive amounts of capital that would keep getting generated and they need to put it to work. So they generally don’t need to sell something to buy something else; they also don’t get the advantage of long term capital gains. So the corporate structure of Berkshire Hathaway requires them to take ordinary income tax on any gains. In my fund, if I hold things for more than a year, my investors pay a long-term gain, which is lower. Buffett has a huge aversion to paying taxes, so he would like to optimise taxes.
|There is no such thing as a value trap. There are investing mistakes|
There are also competence differences. I may not understand some things they invest in because they just don’t fit within my parameters. For example, if you look at their 13F filing, recently they bought a company called Davita. They own $1 billion worth of Davita stock. Davita basically runs dialysis centres. They are the second largest kidney dialysis provider in the world. It is a very specialized business — I don’t understand a lot of dynamics about that. They clearly have a moat but it is unlikely we will invest in them. The commonality would be that I would be looking to buy things well below what they are worth. I don’t understand it but probably Davita is trading well below what it is worth.
Do you also look for the same quality of moat that Buffett professes?
Both of us would prefer something that can grow for a long time. You are always better off buying a business that has a lot of future growth in it because you can hold it for a long time. There are no taxes. He will always be willing to do opportunistic trades when he gets the chance. For example, Goldman Sachs came to him during the financial crisis. And he gave them money at 10% interest and any time they wanted to pay off the loan, they had to pay off another 10%. That was a short term trade for him in the sense that he knew that the moment Goldman got back to health they would want to pay that money back, and they did. It was the same with GE when he gave them money. So there are many investments Buffett makes that by their very nature might not last more than a year or two or three. There are plenty of other investments he makes that may last for 10 years or more.
You said you don’t make short-term opportunistic moves like that — why?
We will do whatever it takes to make money but, in general, there is a huge value to holding cash. For example, I ran into an investment guaranteed to return 7% a month, where you will hold it for a month only. I am not sure I would take that because it would tie up things for the month. That cash would not be available. If at all, we might choose to put in a small portion of the cash we hold if we were convinced there was no downside to it. Now, if you stretch that period from one month to three months and you increase the 7% to 14%, my interest level goes down even further because it is going to lock up my cash for even longer. Of course, I would be willing to deploy a lot more if we were sitting on 100% cash. But essentially, we like to hold cash so we do not miss out on any long-term opportunities.
In today’s context can Buffett’s strategies be replicated to produce the same kind of results? Also, because he says technology is a no go and that is becoming a larger portion of the market.
I think the structure he has is different in the sense that one-third of his investment results come from insurance float. Berkshire has produced around 19-20% return for a long time. If there was no insurance operation he himself has said he would take about 7% off. So you would be down to about a 13-14% return if it was unlevered by insurance. It would not be easy to do that — that is why he is the greatest investor. As for his aversion to technology, what it constitutes of the whole market is really not relevant. He will tell you even when there was no technology he would understand a small sliver of the market only. I don’t think the fact that technology has come into the markets has changed anything. We have so many areas and things to invest in, not only in the US but worldwide. Even in technology he bought IBM. In fact, Buffett says if he could forecast Google’s revenues and cash flows at a particular price, he will consider buying it. His problem is that he can’t forecast the revenues and cash flows.
You have exited Berkshire completely — why?
Berkshire is a great company, somewhat undervalued, but it is not sitting at one-fifth the value. When it is at one-fifth the value, wake me up.
How successful will a cloning investment strategy be, going forward? Which investors apart from Buffett would you like to clone or follow closely?
Cloning to me is the best and the most amazing strategy. The investors that I closely follow include Baupost, Longleaf Partners, Greenlight Capital, Pershing Square, Third Avenue and Fairfax Holdings.