Mohnish Pabrai – Value Is Its Own Catalyst – The Market Is a Weighing Machine

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One of our favorite investors at The Acquirer’s Multiple is Mohnish Pabrai.

Mohnish Pabrai is the Founder and Managing Partner of the Pabrai Investments Funds, the founder and CEO of Dhandho Funds, and the author of The Dhandho Investor and Mosaic – Perspectives on Investing.

He’s one of the smartest guys on the planet when it comes to investing.

One of my favorite Pabrai interviews was one he did with The Graham & Doddsville Newsletter, it’s a must read for all investors.

Here’s an excerpt from The Graham & Doddsville interview:

Question: How did you get started with value investing?

Until I was 30 years old, frankly, I had never heard of Mr. Buffett. I had never heard of value investing. This was 1994 and I was vacationing in London with my wife. I was looking for something to read on the flight back to Chicago, and I picked up one of Peter Lynch’s books. I am an engineer by training, so this was a different field for me. I read that book on the flight and I loved it.

It made all the sense in the world to me, in  terms of how to and how not to invest. I thought this was an interesting area and I wanted to know more about it, so I found that Peter Lynch had another book and I read that one too. I wanted to learn even more, but I ran out of Peter Lynch books to read. I remembered that in one of the books, Peter Lynch mentioned Warren Buffett and told a story of how Buffett had called him to get his permission to use a quote.

This was the first time I had ever heard of Warren Buffett. I figured since Lynch was talking to Buffett, I should learn more about who Buffett is. I looked around, and found the first two biographies that had just been published: Lowenstein’s The Making of an American Capitalist and Hagstrom’s The Warren Buffett Way. I read those books and I just had an epiphany. They resonated strongly with me.

The thing that I found very strange was that if there is such a thing as the laws of investing, Warren Buffett has pretty much laid them out. What I couldn’t understand was that when I looked at the entire mutual fund industry at the time, which were the professional managers that I had exposure to, I saw that these guys not only did not follow the fundamental laws of investing, but most of them didn’t even know what they were.

At the same time, their results reflected sub-par performance. So I thought there must be a correlation between these guys not following the rules and having poor performance. The second thing I found very strange was how you can have an entire industry which does not function with a solid framework. To me, it is like people doing brain surgery by just ‘winging it’.

That is how I saw mutual funds work – they were just winging it, or they come up with any nuance or ‘flavor of the day’ they want to pursue. I had a thought that if novices like me simply adopted Buffett’s approach and invested in the equity markets with a concentrated portfolio, etc. that I was likely to do better than most of the industry professionals. So I said it was worth testing this hypothesis out. I was lucky at the time in 1994; I had about $1 million in cash. I had just sold some assets of my business and I decided to go ahead and manage that in a Buffettstyle concentrated portfolio, buying things I understood, etc. That is how I got into value investing.

Question: You have managed Pabrai Funds since 1999. That must have been quite a time to open a value fund.

Actually, 1999 was very interesting. I think it was a great time to start as a value investor because the market in 1999 and 2000 had segregated. As a matter of fact, on the day that the NASDAQ hit its peak, Berkshire hit its 52-week low. What happened is that a lot of money had gone into these frothy dot-com type stocks, but effectively it had come out of brick-and-mortar, normal businesses. A lot of brick-and mortar, real-world businesses were trading really cheap. So it was actually a great time to go into the equity markets as long as you didn’t drink the same Kool Aid that everyone else was drinking. In fact, after Pabrai Funds’ first year, in June 2000, we were up approximately 38% after fees. Then the second year we were up by mid- 30% after fees. We did really well in the year when everything crashed and burned, for that reason.

Question: Over the past 10 years, how have you seen the value investing landscape change?

There isn’t much of a change. The good news is that there is now more of a community with things like Whitney’s newsletter (Value Investor Insight), conferences, and the Columbia Value Investing Program. Clearly there is now more interest. However, if you look at all of the people involved with investing in the equity markets worldwide, the percentage of them that focus on true value investing is still a very, very miniscule percentage. I think that, in general, the opportunity to do value investing is almost as good as it was 10, 20 or even 30 years ago.

Question: Where do you hunt for your ideas?

When I look for ideas, I look in places like the 52-week-low list, Value Line, as well as stocks with low P/E ratios, low P/B ratios, or large discount-to-book value. Now I have Joel Greenblatt’s Magic Formula; I look at that on a daily basis as well. I also subscribe to Portfolio Reports, published by Outstanding Investor Digest, which gives a listing of all the buying of major value investors every few weeks. I also look at 13F filings of the usual suspects such as the Fairholme Fund, Marty Whitman, Einhorn, and all of those folks. That is basically where I go fishing.

Question: What are characteristics of the companies that attract you?

In general, I look for industries with a slow rate of change, companies with some type of moat, and companies with hard assets. I look to buy businesses where I can rest my hat on the hard assets of the business. Other times, I look at businesses that have more of a franchise value, so the intrinsic value is made up more of intangibles such as brand, etc. Basically, what I’m trying to do is find businesses that I can buy well below what they are worth. I usually try to make one bet per industry, and I typically put 10% of the fund’s assets into each idea. An ideal portfolio would be comprised of 10 positions from 10 different industries all priced at a discount to what they are worth. In terms of what exactly I focus on is determined by what is on sale.

Question: Once you identify a potential investment idea, what is your process for determining whether it is in fact a good investment?

After I identify an interesting company, I begin to drill down reading the 10K’s and 10Q’s. When I first come across a business, I generally ask myself within the first few minutes: Is this something I understand well? Is this a relatively straight-forward business to understand? If I am not getting a clear idea in my head of how the business works and how it makes money, then I will generally stop and move on to the next business.

In fact, I often move on if I can’t answer that question right way. So the first question you have to ask yourself is: In general, is this a business I can understand? I made an investment in 2001 in a company called Stewart Enterprises which is in the funeral services business. I can understand that business. You bury people, cremate them, you get paid, etc.

Then you can start to think about understanding the finer points, such as the brand, and what people think about the community of funeral service providers. It is not a business where a competitor can open up overnight with cheaper pricing and just take your business away. Then, there is the fact that it is rare for someone to aspire to go into the funeral business. In general, it is not an attractive business for a 25-year-old to think about entering, so it keeps the number of new entrants down.

Finally, all humans eventually die. They may live longer, but eventually we die, so you also have a steady stream of customers coming in. So these are the kinds of things to think about when you start thinking about a business. If they all make sense, then you can begin to look further into the business at things like value, why it is trading where it’s trading, what it is really worth and so forth and so on.

Question: You have often said that you look for dollar bills that are selling for much less than a dollar, then you need to have the strength to be patient and wait for the rest of the world to realize it is worth a dollar. As MBA students, we are often asked for stock ideas when we interview for summer internships or full-time positions. The first question that we are often asked is “what is the catalyst for your idea to reach its intrinsic value?” How do you think about catalysts when you are making an investment?

I don’t focus on catalysts. I have always felt that value is its own catalyst and that eventually the stock market becomes a weighing machine and will weigh stocks correctly. I recently bought into a European company that trades at about 1/3 of its hard asset liquidation value. I can’t see any real catalyst in that business. I couldn’t tell you when or what event will make that value converge, but if something is trading at 1/3 of what it’s worth, I think that if you are just patient for a few years, it is highly likely that you will make money and it is highly unlikely that you will lose money.

Question: How do you think about downside risk?

At Pabrai Funds, I have made several mistakes in the past and I’m sure I’ll make several more in the future. You always need to protect the downside risk. I think margin of safety is one of  the most important tenets that Ben Graham talked about. You always want to ask yourself “What is my downside?” You also want to get some comfort that you have some protection.

In some cases, you can get that comfort from liquidation value or hard assets minus liabilities. In other cases, you may get comfort from somewhere else. For example, if you look at a company like Moody’s or American Express, you couldn’t invest in these based on liquidation value. If their brands were permanently impaired, you would probably be losing money. However, as long as the brand continues to grow in value, you can end up making a lot of money. When you are looking at the margin of safety you can look at it in terms of hard assets like Ben Graham used to, or you can look at it in terms of more intangible assets which can be very valuable.

Question: As a value investor, you have mentioned you look out over the 3-5-year period. Wall Street obviously has a much shorter horizon. How do you maintain the temperament to hold a security the time it takes to realize its value?

I’m very blessed with the investors I have at Pabrai Funds. I have about 400 families across the five funds I manage at Pabrai Funds with over $550 million in assets and on a typical day, I never hear from any of them. I have an annual shareholder meeting that many of my investors show up to. It is a great group of investors. Even recently, with the market turmoil, I really haven’t had many e-mails or calls. I love to partner up with these types of folks. So I don’t really face much pressure from the investor base.

Second, I generally don’t discuss the existing portfolio positions. That keeps a lot of the noise down.

Third, I think the temperament or patience comes in part from the way we are wired or the way we can learn, or not learn, from Ben Graham, Warren Buffett, etc. You know, Warren Buffett has said many times that people either get value investing in five minutes or they won’t get it in five years. So, there is something in the human wiring of our brain that, for some of us, makes all the difference in the world right away and the patience that it requires is part of that wiring process. For others, they may buy into the concept completely, but they temperamentally just don’t have the patience.

Question: We were fortunate to have heard you speak in Professor Greenwald’s Value Investing Seminar, where you used an analogy about smoke-filled theaters and spectacular waterfalls. Can you discuss this concept?

I was recently discussing this concept with a bunch of value investors and they all said they never heard Buffett use this analogy, but I could swear that I heard it from Buffett. So for now, I will continue to say that I got it from Warren Buffett. Here is the basic concept. Let’s say you go to see a movie and you pay $10 to buy a ticket. Every seat in the theater is occupied – the house is full. Suddenly, the smoke alarm goes off in the middle of the movie and as smoke begins to fill the theater, people run for the exit.

Now, this movie theater has special rules, and the rule is that you can only leave the theater as long as you find someone from outside the theater who will take your ticket and seat. You must enter into some type of transaction where that person pays you for your ticket. So the question that comes up is at what price will that $10 ticket sell for now that there is this alarm and smoke in the theater, and the answer is that it probably doesn’t sell for very much, or you might have to give it away for free, or you may even have to pay the guy to take it off of your hands.

That theater is the New York Stock Exchange, because on the stock exchange every share of any business is owned by someone at all times. If there is an event which is a distressing event for a company which leads people to say I no longer want to own the stock, that is like the smoke in the theater and people wanting to exit the theater. The person who you want to sell the stock to, which is the person who wants to enter the theater, has access to the exact same information that you do. He also knows there is smoke in the theater.

Therefore, for him to still be willing to buy it, the price at which the transaction takes place, is likely to be a significant discount at what the stock was trading at before the smoke. If you enter selected smoke-filled theaters, and you later find that the smoke is really nothing to  worry about, or it has been put out, then there is a chance you have gotten a great investment and you can do quite well with it.

The second part of this is when you have smoke in theaters, you are going to have these huge collapses in stock prices. If you look at the stock’s chart, these will look like a waterfall. So what this means is that smoke-filled theaters are likely to lead to spectacular waterfalls. As a value investor, you don’t want to enter every smoke-filled theater.

What you want to do is carefully analyze these smoke-filled theaters to try to find one where the smoke is not real, or the fire alarm is not real, it went off for no reason, and then buy those tickets at hugely discounted prices, then sit back and watch the rest of the movie. I think this is a good way to summarize the framework.

One example I spoke about at Columbia was Wellcare (NYSE: WCG). I generally don’t talk about stocks that I own, but I felt that Wellcare was such a pure textbook example. I couldn’t come up with a better example, even looking at the history of stocks. I also think people learn a lot more with Ben Graham’s technique of talking about current stocks since they can relate better.

Here is an event that is still playing out; there is still some smoke in the theater. Wellcare is a situation where you have a company that is trading at over $120 a share when 200 federal agents show up at their doorstep, unannounced, holding search warrants. The stock is halted and when it resumes trading, there  is no data other than news of the 200 agents.

That is clearly a theater with an alarm going off, with all kinds of smoke in it. The people sitting watching the movie had signed up for this high-growth, high-momentum stock, and they had signed up to see a certain kind of movie.

When the federal agents showed up, they could clearly see that this is not the kind of movie they want to see. They don’t want to be hanging around with all the smoke and they want to leave. When they try to leave the theater, they needed to sell those tickets to someone else and the clearing price that they exchanged their Wellcare tickets for was $20 a share.

This was 50% of just the cash on their balance sheet. Forget about the business, the earnings engine, and everything else; people were not even willing to pay for the hard assets of the business at that point – not even the liquid assets of the business at that point. So you got a very spectacular, real-world case of logic going out the window, just because of the stampede out of the theater.

Question: What advice would you give to MBA students who aspire to a career in investing?

I think that the best thing to do is to actually set up a small portfolio of your own and start making real investment bets. Don’t run these virtual portfolios – take real money that you actually have, and invest it like you would invest a $5 million portfolio. Be rigorous about it because I think you learn when you make mistakes that actually cost you money. From my point of view, that is the best way to learn. Going to Columbia is a great idea! If you are already at Columbia, follow Buffett’s advice and try to find a shop that is run by people you admire and have principles you believe in, and try to convince them to bring you on board without focusing on compensation.

Thank you, Mr. Pabrai.

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