Monday, October 31, 2005


'We will never see another Warren Buffett'

Mohnish Pabrai currently manages Pabrai Investment Funds, which he founded in 1999. The fund has around half a billion dollars in assets under management. Pabrai went to the US in 1982 to do his undergrad in computer engineering. After that, he worked with Tellabs in Chicago. In 1990, he started his own company TransTech, an IT services/system integration business and ran that for around ten years, before starting Pabrai Investment Funds. He has written a book on investing, The Dhandho Investor: The Low-Risk Value Method to High Returns. Excerpts from an interview:

How did you get into investing business from information technology?
Around 1994 I heard about Warren Buffett for the first time accidentally. The first couple of biographies about him had just been published a year or two before that. I read those books and I was quite blown away by some data points that were coming out about him and the industry and so on. I didn't have any experience or even education in the investment business. But I was very intrigued by it.

I started to invest in the public equity markets using Buffett's model in 1994 and basically did extremely well, north of 70% a year, till about 1999. I was getting more and more interested in investment research and securities analysis and made a decision to leave my company. I brought in an outside CEO and decided that I would spend more time on investing and at the same time some friends of mine wanted me to manage their money for them. It started as a hobby in 1999 with about a million dollars from eight people. About a year later the business (TransTech) actually got sold, I wasn't running it anyway, but I was completely cashed out. And then I thought that let's make my hobby a real business, try to scale it up and get investors. We now manage about $500 million -- ten years later.

How did you narrow down on Warren Bufett and value investing?Basically in 1994, when I read about Buffett, there were two things that stood out. One was that he had compounded money at a very high rate. If you are compounding at a high rate, even if you have a small amount of money -- let's say a million dollars -- in thirty years you could have a billion dollars. So the idea of compounding at a rate above the market rate is an extremely fine notion because it can lead to enormous wealth creation. That was the first thing.
The second thing was that the way Buffett was compounding money at a rate higher than the market was based on a core wisdom which he stood for. If you are physicist, whether you believe in gravity or not, it will always impact you. Just like there are laws of physics, laws of gravity, there are laws of investing.
I noticed in 1994 that the mutual fund business had two things: one, they did not follow the laws of investing, and two, their results were affected by the fact that they did not follow the laws of investing.
For example, a basic law of investing is that you make very few bets, you don't buy a hundred companies because you are not going to have an understanding of business. But if you look at mutual funds, that is not the way they operate.
So essentially, what you are saying is that investors should make fewer bets?
So you make few bets, you make big bets, infrequent bets and you only make bets when the odds are heavily in your favour. What I found very funny was that here is a guy (Buffett) who is telling you very much the approach to investing he follows, and this is like Newton telling you the laws of physics. The second thing is that the investment industry does not care about these laws, and their results reflect it.

The third conclusion I came to is, I said, OK, if what I am saying is right, what it means is that a person like myself, who has no experience in this industry, could come in and apply Buffett's rules and do better than all these managers running all these funds. So I said, well, that hypothesis means nothing until you test it out. I had an asset sale take place of a part of my business in 1994, and I had about million dollars in cash, sitting with me for which I did not have any need for.
I decided I am going to take this million and put this on a twenty or thirty-year compounding engine. I was about 30 years old, I wanted to see if by the age of sixty I had my billion dollars. I started playing this thirty-year game in 1994, and basically I found that first of all, it was very enjoyable and second, that it's been fifteen years now and the original hypothesis I had is absolutely correct -- which is that the industry doesn't get it, they still haven't changed their ways, and there results reflect that.
What are the factors you look at before deciding to invest in a company? Can you give us an example?The first thing you got to look at is, "I am not buying a stock, but I am buying a business." And you only buy the business if you were willing to buy the entire business if you had money for it. So, for example, if Reliance Industries has a market cap of $100 billion and you had a $300 billion, the question you would ask yourself is, would I buy the entire business for a $100 billion?
The first thing is that you are not buying pieces of paper, but you are buying an entire business. The second is that you ask yourself, do I understand the business? Do I truly understand how it will work, how it makes money, how will it do in the future?
Then the third thing is, if Reliance produces$3 billion a year cash flow and it trades for $100 billion, I have no intention of buying it at 33 times cash flow. It is like I have no interest in putting money in an account that pays 3% interest.

So I love Reliance, maybe, if the fair value of business is 15 times cash flow, which is $45 billion. And since I am cheapskate, I don't want to buy it for more than half its fair value, so I just say to myself, that if it goes below $20 billion in value -- or one-fifth the current price -- then I will look at it again. In fact, that is the way to look at the Indian Sensex. You take all the Reliances, the Wipros and Infosyses of the world, chop their price by four, and that's your entry price.

What has been your most successful stockpick till date?
You know that's a very funny question. The most successful company I ever invested in is Satyam. I invested in 1995, and I was completely out by 2000. When I invested the stock was at Rs 40, and Satyam's earnings at that time were about at Rs 12 a share, so you were buying a business for three-and-a-half times earnings. And the more interesting thing for me was that property the company had in Hyderabad exceeded the market capitalisation as it was carried at a value that was bought a long time ago.
The only reason I knew about Satyam was because I was in the IT services space. These guys had actually visited us to see if they could do business together. And I had been pretty impressed by the way the business operated and the people I had met.
I looked at it from my investment point of view after was amazed that such a business could trade at such a price. So I invested in Satyam. In 2000, it was trading at Rs 7,000, that is about a 150 times the price I bought it at. This was in the days before demat, and actually when I bought the stock with an account through Kotak that I had in Mumbai, I was given physical delivery of these shares that looked like tattered pieces of paper that were falling apart.
Satyam from less than a PE of 3 to more than PE of 100. I just said I am out of it because now I owned a bubble stock even though I did not buy it at bubble price. I sold my entire position within 5% of the peak. Within six months it had dropped from Rs 7,000 to Rs 1,000, and continued on the sidelines for a while. That was the best deal that I ever made.
I also happened to read somewhere that you wear shorts to work and do not as a matter of habit short stocks?
Well, I am wearing shorts right now ... the math for for shorting is really bad. When you are long on a stock, as it goes down in price, the position is going against you and it becomes a smaller portion of your portfolio. In shorting, it is the other way around: if the short goes against you, it is going to become a larger position of your portfolio. When you short a stock, your loss potential is infinite; the maximum you can gain is double your value. So why will you take a bet where the maximum upside is a double and the maximum downside bankruptcy?

Also, any time you short a stock, you are hooked to a (stock price) quote machine for life support because you have to watch what is happening all the time. Many a times, when I am travelling in India, it could be several days when I don't have a quote for any positions that I hold. So I don't want to be a in a situation where I have an umbilical cord linked to some quote machine ... and blood pressure going up and down.
Do you have investments in emerging markets like India and China or do you stick to the stocks in the US market?
I would say that most times a very large portion of our portfolio has a lot of exposure to the global market. I have (shares in) several companies in Canada. I own (shares in) one Chinese company and an Egyptian company, I don't own any Indian companies right now, but I use to own Satyam. Also Pabrai Funds use to own Dr Reddy's.

You have said in the past that investment ideas come to you by reading a lot...
An investor should think of himself as a gentleman of leisure. Don't think that you are in some profession. You just think that you are a person who is focused on enjoying and living life well. If you focus on yourself as a gentleman of leisure what is going to happen is that you do not feel any compelling reason to act. It has been several months since I have bought any new stock. And that is not a problem because we went through a period in December when we bought ten stocks. The first thing is that we are in a profession were you don't pay for activity, you get paid for being right. So there should be no compelling reason to act. Basically, the thing you do is you take out the reason to act.
The second thing you do is you focus on acquiring worldly wisdom. I read an enormous amount of stuff and relate to what different investment managers who I respect are saying. So, at times, things become no-brainers.

In the fourth quarter of last year, when everything was going to hell, one part of the market that went to extreme hell was commodity-related stocks. Commodity-related stocks absolutely got crushed. 95% down. 90% down. And if you simply keep in mind that you look at the growth rates of India and China, you can get an insight.
Through our foundation Dakshina I spend a good amount of time in rural India. I can see nuances about India, that most people would not see. You can see that the pressure on the few commodities in the earth's crust is tremendous.
China has severe problems with fresh water and you really have big problems with agriculture with those type of water issues. When you have growth rates of 7-8%, people will want to eat the best. Generally it is proven that protein consumption climbs very high when economies do well. It is absolutely a given that 10 years from now the amount of agriculture and protein needed will be much higher from today. And getting there will not be easy.

So the thing is there are certain businesses that serve as toll bridges in that space. For example, one toll bridge is if you look at Latin America. It has a lot of land and it is flooded with fresh water rivers. South America can basically take that land and convert it into producing corn and soybean or whatever and export the hell out of it to China. And that is exactly what will end up happening. Latin American agricultural companies with large land holdings today are not excessively priced, they are very cheap. But there is absolutely no way for India and China to satisfy the consumption demand that is coming without going to Latin America. So we will just own the toll bridges and wait.
How much of Warren Buffett's success can be attributed to his investment prowess and how much to the fact that he is Warren Bufett?

Well the thing is you could have invested even after Buffett had invested and you could have made six times the money out of it.
In fact there are a couple of professors in Ohio, who studied any stock that Warren Buffett bought, if you bought on the last day of the month, when it was public that he owned that stock, and you sold it after it was public that he had started selling it, you would have generated north of 20% annual rate of return.
I would say that we will never see another Warren Buffett. Just like we will never see any Albert Einstein or another Mahatma Gandhi. Buffett is a very unique individual. His skillsets outside of investment are phenomenal but they get dwarfed by his investing skills. The main thing that makes Warren Buffett Warren Buffett is that he is a learning machine who has worked really hard for, let's us say seventy years, and is continuously learning every day.
So the thing is if you want to be like Buffett, there is no short cut. First of all, you have to be deeply interested in investing and you have to be very willing spending tens of hours, hundreds of hours, reading the minutiae. There is a very famous value investor called Seth Klarman. He is into horse racing. And his famous horse is called Read the Footnotes.

We often talk about profit margins on this site. Analyzing the profit margins of a company can help you determine its profitability relative to its competitors. For example, if two competitors have equal net incomes but one has twice the profit margin of the other, then over time we may see the more efficient company steal market share and grow at a faster rate. (This can happen for several reasons, one being that it can simply lower its prices until its competitors are no longer profitable, thus dominating the market.)

One type of profit margin is a company's gross profit margin, which is its gross profit divided by its revenue. Gross profit gives a pretty good indication of a company's pricing power versus its product costs. In a previous post, we saw that Coke has a gross profit margin of 64%, indicating
people are willing to pay quite a bit more for Coke's products than it costs Coke to produce them.

While Coke has been able to sustain a strong margin for a long period of time, for most companies, attractive margins don't last long. This is because competitors are attracted to industries where profitability is high. To illustrate this, consider the net profit margins of the industries depicted below as they were in 2005:

Notice the high profitability of financial and energy companies. This high profitability in the finance industry is likely one reason that all sorts of new financial products and structures came into being: profits were high, and therefore the industry grew by pushing product proliferation to new heights. In the energy sector, the strong profits depicted above helped spur new oil exploration and new investment in alternative energies. In the past, this has led to increased oil supplies and reductions in the cost of energy, though these changes have taken time. While it remains to be seen if this process will occur once more in the next few years, it remains a distinct possibility.

When analyzing a company, be sure not only to consider its net income, but also the profit margins that contribute to that income. Compare the margins to competitors, and consider whether the company has a "moat" that can protect its margins from the competition. While margins are important, note that they are not the end-all be-all when it comes to profitability, as they don't consider asset utilization. A company able to generate revenue and income on fewer assets is preferable to one that constantly needs capital infusions to grow.

A Quote from Seth Klarman

“So if the entire country became securities analysts, memorized Benjamin Graham’s Intelligent Investor and regularly attended Warren Buffett’s annual shareholder meetings, most people would, nevertheless, find themselves irresistibly drawn to hot initial public offerings, momentum strategies and investment fads. People would still find it tempting to day-trade and perform technical analysis of stockcharts. A country of security analysts would still overreact. In short, even the best-trained investors would make the same mistakes that investors have been making forever, and for the same immutable reason – that they cannot help it.” – Seth Klarman

One of the most important factors in determining whether a company is worth an investment is the quality of its management. Unfortunately, this assessment can at times be highly subjective. Reading interviews or comments from management can often be of little value. After all, management may have great communication or oratory skills, but that doesn't necessarily translate into good business execution. In fact, many value investors even prefer not to meet managements to avoid being influenced by factors unrelated to execution.

So how then to evaluate management? One way is to simply evaluate the financial results of their companies. Unfortunately, certain factors which manifest themselves in the financials may be out of management control. For example, competition in an industry and/or time period might be fierce, or a company may be at a brand disadvantage - not necessarily the fault of current management, so how do we differentiate across managements?

One method analysts like to use is to evaluate the number of days inventory a company has on hand. The lower the number, the more efficient management is (as cash is freed for other purposes, like paying shareholders) long as there are no stock-outs hurting revenues! The number of days of inventory a company has on hand can be estimated with the following formula:

inventory * 365 / COGS = days of inventory on hand

This number can be compared to that of competitors or the industry, with the caveat that differences in product mix must be taken into account. Below are average days of inventory for several industries as per the IRS:

A high days inventory doesn't necessarily mean bad management, however. But this concept can be extended to a company's days receivable and days payable. This can offer a clue as to how effective management is at running an efficient operation, which can translate into other facets of the business.

It turns out that value investing is something that is in your blood. There are people who just don’t have the patience and discipline to do it, and there are people who do. So it leads me to think it’s genetic. – Seth Klarman
Markets go up and down. It’s unavoidable, but how do you handle it?
Over the past couple of weeks, one aspect of investing that has frequently come up in my discussions has been related to price but ultimately it all leads to volatility.

Value Investor’s Guide to Volatility

  • The higher the beta, the more chances you get to pick up stocks at cheaper prices and the quicker you can realize the intrinsic value of your stock.
  • Volatility is just another day. Focus on the business. The taste of a Coca-cola doesn’t change every second as it tries to follow its stock price.
  • Price is useless on its own. Compare it to intrinsic value.
  • Volatility reveals how focused and confident you really are.
  • Conquer volatility and it will make you a better investor.
Even if all of the above is attributed to genetics as Klarman states, it’s nothing that can’t be trained.

On Investing

  1. “Rule No.1: Never lose money. Rule No.2: Never forget rule No.1.”
  2. “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”
  3. “Only buy something that you’d be perfectly happy to hold if the market shut down for 10 years.”
  4. “We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.”
  5. “Why not invest your assets in the companies you really like? As Mae West said, “Too much of a good thing can be wonderful”.”

On Success

  1. “Of the billionaires I have known, money just brings out the basic traits in them. If they were jerks before they had money, they are simply jerks with a billion dollars.”
  2. “The business schools reward difficult complex behavior more than simple behavior, but simple behavior is more effective.”
  3. “You do things when the opportunities come along. I’ve had periods in my life when I’ve had a bundle of ideas come along, and I’ve had long dry spells. If I get an idea next week, I’ll do something. If not, I won’t do a damn thing.”
  4. “Can you really explain to a fish what it’s like to walk on land? One day on land is worth a thousand years of talking about it, and one day running a business has exactly the same kind of value.”
  5. “You only have to do a very few things right in your life so long as you don’t do too many things wrong.”

On Helping Others

  1. “If you’re in the luckiest 1 per cent of humanity, you owe it to the rest of humanity to think about the other 99 per cent.”
  2. “It takes 20 years to build a reputation and five minutes to ruin it. If you think about that, you’ll do things differently.”
  3. “I don’t have a problem with guilt about money. The way I see it is that my money represents an enormous number of claim checks on society. It’s like I have these little pieces of paper that I can turn into consumption. If I wanted to, I could hire 10,000 people to do nothing but paint my picture every day for the rest of my life. And the GNP would go up. But the utility of the product would be zilch, and I would be keeping those 10,000 people from doing AIDS research, or teaching, or nursing. I don’t do that though. I don’t use very many of those claim checks. There’s nothing material I want very much. And I’m going to give virtually all of those claim checks to charity when my wife and I die.”
  4. “It’s class warfare, my class is winning, but they shouldn’t be.”
  5. “My family won’t receive huge amounts of my net worth. That doesn’t mean they’ll get nothing. My children have already received some money from me and Susie and will receive more. I still believe in the philosophy – FORTUNE quoted me saying this 20 years ago – that a very rich person should leave his kids enough to do anything but not enough to do nothing.”

On Life

  1. “Chains of habit are too light to be felt until they are too heavy to be broken.”
  2. “We enjoy the process far more than the proceeds.”
  3. “You only find out who is swimming naked when the tide goes out.”
  4. “Someone’s sitting in the shade today because someone planted a tree a long time ago.”
  5. “A public-opinion poll is no substitute for thought.”

Funny Ones

  1. “A girl in a convertible is worth five in the phonebook.”
  2. “When they open that envelope, the first instruction is to take my pulse again.”
  3. “We believe that according the name ‘investors’ to institutions that trade actively is like calling someone who repeatedly engages in one-night stands a ‘romantic.’”
  4. “When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.”
  5. “In the insurance business, there is no statute of limitation on stupidity.”

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