Oxstones Investment Club™By Phil DeMuth, Forbes,
Mohnish Pabrai’s long-only equity fund has returned a cumulative 517% net to investors vs. 43% for the S&P 500 Index since inception in 2000. That’s outperformance of 474 percentage points or 1103 percent. [Disclosure: I and/or some of my clients are long Pabrai’s fund or specific holdings within his fund.]
To anticipate your next question: Yes, his fund is closed to new investors. But there is still hope. Read on — sadist that I am, I put the answer at the end.
Pabrai is a classic value investor in the tradition of Warren Buffett, Charlie Munger, Seth Klarman and Joel Greenblat. I recently had an opportunity to hear him talk and thought I’d pass along some of my bright yellow highlighting.
How to start investing
For Pabrai, this yellow brick road begins with Warren Buffett’s annual letters to shareholders (totaling 730 pages, now conveniently available for your Amazon Kindle for $2.99 cheap). From there he recommends the Buffett biographies (mentioning the ones by Lowenstein and Schroeder). I might add, though he didn’t, that you could do worse than to read Pabrai’s own book, The Dhando Investor.
Like Buffett, Pabrai looks at a stock not as a piece of paper but as the ownership of a business. He has no interest in a company that looks ten percent undervalued. He is angling to make five times his money in a few years. If he doesn’t think the opportunity is blindingly obvious, he passes. This requires him to apply his X-Ray vision to the fundamentals, and weigh the downside risk (the margin of safety) vs. the upside potential (the moat) at a given price. His mantra: Heads I win, tails I don’t lose much.
Next, Pabrai practices patience. He takes Charlie Munger’s admonition to heart that money is made not in the buying or selling but in the waiting. As far as I am aware, he has not made a single new investment in 2013. He says that if he can find a couple of investment ideas a year, that’s plenty. His current preference is to keep a cash store of between 10%-20%. This seems like a tremendous drag for a fund posting numbers like his, but he is really biding his time for a distressed situation to come along when he can deploy this trove at the valuation he wants. During the next crisis, when everyone is jamming the exits, he will go all in.
Once you start purchasing stocks, Pabrai says the next step is to closely examine every trade that doesn’t work, and figure out what went wrong. Let me pause right here, because this is key to his whole method.
There is nothing more tempting that to sweep mistakes under the rug. Denial is one of our top defense mechanisms. If you are lucky, these trades come to haunt your sleep like Marley’s ghost. If you are unlucky, you repress them forever.
Due to his background in engineering, Pabrai does not gloss over mistakes. Investing is a field where you can have a high error rate (buying something you shouldn’t have, selling something you shouldn’t have, not buying something you should have, not selling something you should have) and still be successful. He takes as a given that mistakes are inevitable. The point is to learn from them so they are not repeated. A major portion of his annual meeting is devoted to publicly analyzing investments where he lost money for his partners. Lately these errors are becoming harder to find, so he has been reduced to talking about investments that didn’t fare as well as expected.
The checklist
Pabrai was impressed by Atul Gawande’s Checklist Manifesto, which recounts how a technology seemingly as trivial as a checklist led to life-saving results in the airline cockpit and the operating room. He wondered whether it could work the same magic for investors.
He began by looking at the public record of the investors he admired and deconstructing the mistakes they made — cases where there were klaxons sounding even the great ones missed. He cites the example of Berkshire Hathaway’s purchase of Dexter Shoes — a New England factory with a great product used by everyone with feet. It immediately got hacked to pieces by cheap foreign labor. Hence, one checklist item: is this a business that can be negatively impacted by low-cost competition from abroad?
After this analysis, he came up with one hundred or so check boxes. He keeps it proprietary, but claims that if we were to see it, we would think it was jejune and throw it away. I wonder. In any event, the items are grouped into categories. A lot of them have to do with leverage, for obvious reasons. A second group relates to the durability of the business’s “moat” — how difficult it is for new entrants or competitors to duplicate their product or service. A third set of questions examine the quality of the company’s management. Is the company being intelligently run for the benefit of shareholders? There is also a fourth set of miscellaneous items, such as unions and labor relations, or is the company operating with a tailwind that may be only temporary?
Yale economist Robert Shiller has noted that many of the biggest advances in financial risk control seem ridiculously modest today: the widespread availability in the 19th century of cheap paper made from wood pulp instead of cloth, the typewriter, carbon paper, the standardized form, the filing cabinet — all these made substantial improvements in the reliability of business operations.
Pabrai can can tick most of the boxes in twenty minutes, but then it gets interesting, because he realizes there are some areas — often not top-of-mind — that need more research and clarification. This is the biggest payback, because it forces a 360 degree look at risk. The human animal gets into tunnel thinking once it likes an investment idea, and this usefully stops that momentum. Since 2008, Pabrai also has started talking over his investment ideas with a peer prior to jumping in.
The checklist is doubly important for a concentrated fund like his, which might only contain ten tickers. Since he is angling for big total returns, these are usually companies in some distress to begin with — either from their own misdeeds or due to macro factors. So far, it has radically trimmed the downside tails, although it has yet to be tested in a crash landing.
Cloning
For Pabrai, investing is not an originality contest. He shamelessly appropriates the ideas of others. For example, he lifted the structure of his fund directly from the Buffett partnerships of the 1950s. His primary source of investment ideas? The 13F SEC filings from other value managers he admires: Berkshire, Longleaf, Baupost, Greenlight, Pershing Square, Third Avenue, etc. He cites the University of Nevada study by Martin and Puthenpackal showing how merely investing alongside Warren Buffett (after information about Berkshire’s buys and sells became public) managed to beat the market by 11% a year over a 31-year period.
It looks like Pabrai holds the world in a paper cup. To make matters worse, he’s also charitable, and his Dakshana Foundation is one of the best charities on the planet (see the sidebar). While he makes it sound easy, remember that he has nerves of steel and when he does invest, he goes in with unshakable conviction. He’s willing to reach out and grab a stock falling like a dagger and then to keep buying while it plummets into the abyss. I remember seeing him in September 2008 when his fund was down 60% and the global financial system was coming off the rails. These facts bounced off him like a pea-shooter. His only concern was finding cash to buy stocks while they were still cheap.
While his fund is closed for the present, you can invest alongside him by checking out his own SEC filings here.
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