Q: I am here from Minneapolis. Most of the declines in your holdings in the last couple of years have happened because of the bad market conditions. So using the checklist you have created now, do you pay any attention to the current market conditions when you are picking up an investment? How do you get a feeling for the market and where
the market is headed?
A: Well, that's a good question. Actually, most of the mistakes in the funds occurred because I was stupid. They didn't happen because of market issues. What I'm saying is that we did not lose money on Sears because of the market. Yes, you can argue that real estate is down etc., but there were red flags that I should have paid more attention to. The same goes for CompuCredit, for Delta Financial, for a whole bunch of things. Yes, market conditions, maybe, aggravated the situation or accelerated some of the issues, but not all of them. In fact, what is surprising to me about the checklist is that if I look at even Buffett and Monger's mistakes, most of those mistakes could have been avoided. In retrospect, it was very clear before each investment was made what the failure was likely to be. And if you ask them, they will tell you, "Yes, we should have seen this before we made the investment." So I don't believe the failures were market related, but they were probably enhanced or aggravated a little bit by the market. But mostly, it was just human error.
Q: [Inaudible] A: Well, I'll have to go back and look at the individual items. But one of the things I'm concerned with -- and this is not even on the checklist; it comes even before the checklist -- is that in the 2008 or 2009 or 2010 world, I just assume that a lot of things are shot. They're not going to be good investments. So the direction I've taken is to focus on absolute human necessities. There is no Tiffany's. I'm not confident that Tiffany's will be here years from now. But Costco, probably, will be doing just fine. We don't own Costco; I'm just using it as an example.
So the directional shift I've made is not so much based on market conditions as it is on economic conditions. I'm much more concerned with what the economy is doing. The market is not relevant, but the economy is very relevant. So economy macro-shifts are very critical. We are nowhere out of the woods yet -- we have a long, long way to go, a lot of wood to chop.
Q: Don Samuels from New York. With the U.S. dollar being so weak, have you looked particularly at making investments in the BRIC countries?
A: In what countries?
Q: The BRIC: Brazil, Russia, India and China. The question becomes, is there investment offshore now? And if so, what percentage of the portfolio is offshore?
A: Yeah, that's a good question. The dollar has yet to exhibit its weakness. We ain't seen nothing yet, so we have to go there. We haven't been there yet. I'm not a macro economist, and I can't tell you which currency is going to do better than which other currency. A lot of currencies are going to have problems because this is not just a U.S. crisis. There's a lot of people printing currencies in a lot of places. So that's why my gravitation is not so much towards one currency over another; it's more towards hard assets.
For example, if I own a mine, the critical thing is that the mine doesn't have much future CAPEX; they've done their CAPEX in 2007 dollars. But they will hopefully sell at elevated market prices in 2010, 2012, 2014; then you'll do quite well. Now, if they have high CAPEX in 2014, in current dollars, that's not so good. I've tried to look at businesses that are asset heavy, that are light on the need to upgrade or enhance those assets, and they produce things that are very much basics that humans cannot do without.
Now the world is very interconnected. So if I buy a, let's say, an iron ore producer; quite frankly, it doesn't matter where it's based and what it's selling into. But it's going to be impacted by the iron ore price, and that price is driven by China and India and other things. So I'd prefer to own an iron ore mine to an almond farm -- we can do without almonds for quite a while. That's the shift. And the currencies get taken care of because we own productive assets. So whatever things we trade in, those productive assets, I believe have value. And hopefully, they will protect.
Now, time will tell whether this is the best way to deal with inflation, or to deal with currencies, or to deal with weakening situations. But as I talk to you right now, at least, I have a great deal of comfort, on that front.
Q: [Inaudible]
A: Yeah, that's a good question. I don't like to talk about current holdings, so I'll talk in generalities. First of all, Venezuela nationalized its oil industry many decades ago, that already happened. In effect, I believe it has extracted the pound of flesh. I think, in general, people who look at the world from a U.S. perspective tend to have very black and white impressions of different countries. Cuba is black, Venezuela is black, Germany is white, and so on. So it's a very black-and-white approach.
But the world has many shades of gray; it's not black or white. So we wouldn't want to have 14 investments with the same political risk. But we can live with one with political risk because we can try to say, "Okay, what are the odds, what are the probabilities?" And like I said, they've already extracted all the flesh they want to extract. We look at it as a basket, and we also look at the other side and what happens in the event that things just play out where the partners do what they're supposed to do and whatever. And if the risk-reward ratios look attractive, then that's fine.
So in general, if the whole world hates Venezuela and doesn't want to go there, chances are you're going to have inefficient pricing and markets around those assets. Value investors should at least study that to see if there is some meat on the bone there. They can take a pass, but they should study it first. So that's the approach.
Q: Hey, it's Stephane Fitch from Chicago. I don't think of you as a "distress" guy, but are you interested in distress? Level 3 looked a little like a distressed-type investment to me. There will probably be a lot of distress around. Will you buy some stocks or bonds in companies that are teetering on the edge of bankruptcy or may be already bankrupt? And will you buy stock in companies that you think will take advantage of the distress of other companies in the same sector?
A: Okay, good question, Stephane. Yeah, we often buy all kinds of things that are distressed. In fact, that's generally what we like to do. I have learned not to invest in a business that I know is going to go bankrupt because that is a mess that I don't want to deal with. But I will look at things that are already bankrupt. I will look at the debt of post-bankruptcy companies like Lampert did with Kmart. There can be quite a bit of value in those types of situations.
The ideal situation is that when there's a great business that is under temporary distress, where everyone hates some nuance about it, you can hopefully see beyond and then take it from there. I have learned that you're better off at a high level having some tailwinds of good management and good business.
You could say Level 3 is a case of that. They're extremely well managed. They have a pretty formidable position, in terms of what they own in assets, yet it's a difficult company to understand. It tends to go through all kinds of gyrations in valuation. So that is of some interest to us. But again, if I'm making debt-type investments, by definition, I'm not going to be around for that long. And also by definition I won't make that much money. A 16 percent annualized return on debt investments is fantastic. We also try to look at situations where we can get greater discounts than that and go on the equity side. So that's what we try to do.
Q: [Inaudible]
A: Well, okay, that's a good question. There are many examples of 20-to-30 stock portfolios that have done okay, like this Baupost portfolio. There probably are a few that have not done okay as well. Berkshire is an example of a 20-to-30 stock portfolio. The one thing that became clear to me in a post-checklist world is that I'm not going to find investments that don't have hair on them. They're going to fail on some issues, almost all of them fail. Not almost all, all of them fail on some issues. And so if you're going to make investments, you're going to be forced to accept that there are some risks in some of these things.
And given that situation, I'm just less comfortable investing at 10 percent than I used to be. I've seen a 10-percent investment go down 70 percent, 80 percent, 100 percent, and it takes quite a bit to come back from that. So my take has been that if we spread our assets out some more, we get a little bit of protection against these big hits. And the other side is that we are not forced to make these very difficult calls when, given three opportunities, we only pick one, as we have done historically. I can pick two, or pick all three, actually. I prefer, especially when I can't make the call, to have the flexibility to do that.
So I agree with you that Baupost is a very different animal than most other portfolios that are around; and it spans many asset classes, you're right. I don't think the cash level is as high as you're suggesting. It's gotten up to those levels periodically, but it's not averaging out of those levels, it's less. My sense is that we'll have more success than we've had. I'm not ready to go down a path that I'm not comfortable with. So I'm not ready to go into new territories or hedge things or do those sorts of things, unless I'm a master at it, and I'm not a master at this point. So we'll stick to what we're good at and take it from there.
Q: Hi Mohnish, Jefferson Lilly from San Francisco. I asked you this question a couple of years ago and at the risk of repeating myself, I'm going to repeat myself. Joel Greenblatt has his Magic Formula investing website I think, just in the past couple of weeks, there've been some updated numbers that basically show that very mechanistic, quantitative way of picking value -- just off the ratios on the balance sheet and income statement -- has roughly approximated your returns, and of course with greater liquidity. There's no lock up just for picking stocks off that list. So I'm wondering, again if in light of recent market trends and whatnot, you have any other thoughts on that sort of mechanistic, non-thinking investment by the numbers versus what you're doing, which is obviously thinking about what you're doing when you invest. That means less liquidity, I guess for us as limited partners.
A: Jefferson, good to see you in Chicago instead of Irvine. I'm not sure why you made the switch. You asked a very good question. In fact, most active managers would probably be challenged to match Magic Formula type returns. what Joel has put together is very simple but also very powerful. So I would say the simple math is that if you were a know-nothing investor investing in index funds, you would do better than most of humanity if you used that formula. That's a no-brainer for most people. We've had a lot of studies that say if you are buying based on different types of very mechanistic filters, like low price to book and low price to earnings, you'll tend to do better than the indices. Joel just uses two variables, and he gets to pretty interesting numbers. In fact, I've been a big fan of Magic Formula investing. I would suggest that it's worthwhile. Any index fund investor would be better off with a Magic Formula type approach than with other methods.
Now Joel has a fund offering to make it even simpler. You can go on the Magic Formula website and see that they have a fund set up. I have not checked the fees. They are pretty reasonable, I would bet, if Joel is involved. You don't even need to do the work yourself. Pardon? One percent - one percent is pretty good. That Joel's is a very valid method, and you're right, the jury is out whether Pabrai Funds does better long-term than someone who uses that approach. We'll see. It's a tough bar to compare against. That's why I don't have the Magic Formula as one of my metrics. So go ahead.
Q: When you talked a bit about getting involved in things that people need, you mentioned iron ore. I don't know if you have an iron mine anywhere, but you get close to commodities. So how does an iron mine have a moat? That's one of the big topics, there.
A: Yeah, actually, they have moats. I don't have a whiteboard here, but I'd show for you, if I could. Let me try to illustrate it. Let's say the world has 100 iron ore mines. And let's say that they fall into nice buckets of 25, each with equal capacity. One-fourth of those mines produces at, let's say, $25 a ton, one-fourth produces at $50 a ton, onefourth produces at $75 a ton, and one-fourth produces at $100 a ton.
Now, in a booming economic situation like we saw in 2007, all engines are firing, people are building all kinds of things, and there's a lot of demand, generally speaking. At such a time, the marginal price of iron ore would be set close to the $100 per ton level because otherwise, those producers would just shut the mines or they'd be below cost. So if you owned a mine that cost $25, you would have a damn good moat. And those types of cost differentials amongst the miners tend to persist.
In Alaska, for example, there's a zinc mine called Red Dog that produces a huge amount of zinc. They can only ship for about three or four months a year. And the cost of producing zinc at that mine is, I think, probably the lowest in the world. It's about 30 28 cents per pound. And in the most distressed of times, zinc hasn't gotten to below, say, 45 cents a pound, and it's gone up to as much as $2 or $3 a pound. So as long as humans are consuming zinc that Red Dog mine is going to make money, because everything else would shut down before that one shut down.
So when you're buying a mine or a commodity producer, cost of production becomes the moat and consistent low cost of production is the way to go about it. And so what I try to do, when I look at the miners -- because obviously, with commodities, you have no moat -- is to create a moat by choosing a consistently low-cost provider. That's what I looked at very carefully for some of the investments we've made. In general, now, we're not in an ideal world where everything is in the first core tile at Pabrai Funds. But I would say that most of the stuff in our portfolio, as far as miners go, is in the bottom half of cost curves. So hopefully, that protects us long-term.
And we could well get to a situation where even the high-cost producers would do fine because demand is so high. But we're not counting on that. If that happens, great.
the market is headed?
A: Well, that's a good question. Actually, most of the mistakes in the funds occurred because I was stupid. They didn't happen because of market issues. What I'm saying is that we did not lose money on Sears because of the market. Yes, you can argue that real estate is down etc., but there were red flags that I should have paid more attention to. The same goes for CompuCredit, for Delta Financial, for a whole bunch of things. Yes, market conditions, maybe, aggravated the situation or accelerated some of the issues, but not all of them. In fact, what is surprising to me about the checklist is that if I look at even Buffett and Monger's mistakes, most of those mistakes could have been avoided. In retrospect, it was very clear before each investment was made what the failure was likely to be. And if you ask them, they will tell you, "Yes, we should have seen this before we made the investment." So I don't believe the failures were market related, but they were probably enhanced or aggravated a little bit by the market. But mostly, it was just human error.
Q: [Inaudible] A: Well, I'll have to go back and look at the individual items. But one of the things I'm concerned with -- and this is not even on the checklist; it comes even before the checklist -- is that in the 2008 or 2009 or 2010 world, I just assume that a lot of things are shot. They're not going to be good investments. So the direction I've taken is to focus on absolute human necessities. There is no Tiffany's. I'm not confident that Tiffany's will be here years from now. But Costco, probably, will be doing just fine. We don't own Costco; I'm just using it as an example.
So the directional shift I've made is not so much based on market conditions as it is on economic conditions. I'm much more concerned with what the economy is doing. The market is not relevant, but the economy is very relevant. So economy macro-shifts are very critical. We are nowhere out of the woods yet -- we have a long, long way to go, a lot of wood to chop.
Q: Don Samuels from New York. With the U.S. dollar being so weak, have you looked particularly at making investments in the BRIC countries?
A: In what countries?
Q: The BRIC: Brazil, Russia, India and China. The question becomes, is there investment offshore now? And if so, what percentage of the portfolio is offshore?
A: Yeah, that's a good question. The dollar has yet to exhibit its weakness. We ain't seen nothing yet, so we have to go there. We haven't been there yet. I'm not a macro economist, and I can't tell you which currency is going to do better than which other currency. A lot of currencies are going to have problems because this is not just a U.S. crisis. There's a lot of people printing currencies in a lot of places. So that's why my gravitation is not so much towards one currency over another; it's more towards hard assets.
For example, if I own a mine, the critical thing is that the mine doesn't have much future CAPEX; they've done their CAPEX in 2007 dollars. But they will hopefully sell at elevated market prices in 2010, 2012, 2014; then you'll do quite well. Now, if they have high CAPEX in 2014, in current dollars, that's not so good. I've tried to look at businesses that are asset heavy, that are light on the need to upgrade or enhance those assets, and they produce things that are very much basics that humans cannot do without.
Now the world is very interconnected. So if I buy a, let's say, an iron ore producer; quite frankly, it doesn't matter where it's based and what it's selling into. But it's going to be impacted by the iron ore price, and that price is driven by China and India and other things. So I'd prefer to own an iron ore mine to an almond farm -- we can do without almonds for quite a while. That's the shift. And the currencies get taken care of because we own productive assets. So whatever things we trade in, those productive assets, I believe have value. And hopefully, they will protect.
Now, time will tell whether this is the best way to deal with inflation, or to deal with currencies, or to deal with weakening situations. But as I talk to you right now, at least, I have a great deal of comfort, on that front.
Q: [Inaudible]
A: Yeah, that's a good question. I don't like to talk about current holdings, so I'll talk in generalities. First of all, Venezuela nationalized its oil industry many decades ago, that already happened. In effect, I believe it has extracted the pound of flesh. I think, in general, people who look at the world from a U.S. perspective tend to have very black and white impressions of different countries. Cuba is black, Venezuela is black, Germany is white, and so on. So it's a very black-and-white approach.
But the world has many shades of gray; it's not black or white. So we wouldn't want to have 14 investments with the same political risk. But we can live with one with political risk because we can try to say, "Okay, what are the odds, what are the probabilities?" And like I said, they've already extracted all the flesh they want to extract. We look at it as a basket, and we also look at the other side and what happens in the event that things just play out where the partners do what they're supposed to do and whatever. And if the risk-reward ratios look attractive, then that's fine.
So in general, if the whole world hates Venezuela and doesn't want to go there, chances are you're going to have inefficient pricing and markets around those assets. Value investors should at least study that to see if there is some meat on the bone there. They can take a pass, but they should study it first. So that's the approach.
Q: Hey, it's Stephane Fitch from Chicago. I don't think of you as a "distress" guy, but are you interested in distress? Level 3 looked a little like a distressed-type investment to me. There will probably be a lot of distress around. Will you buy some stocks or bonds in companies that are teetering on the edge of bankruptcy or may be already bankrupt? And will you buy stock in companies that you think will take advantage of the distress of other companies in the same sector?
A: Okay, good question, Stephane. Yeah, we often buy all kinds of things that are distressed. In fact, that's generally what we like to do. I have learned not to invest in a business that I know is going to go bankrupt because that is a mess that I don't want to deal with. But I will look at things that are already bankrupt. I will look at the debt of post-bankruptcy companies like Lampert did with Kmart. There can be quite a bit of value in those types of situations.
The ideal situation is that when there's a great business that is under temporary distress, where everyone hates some nuance about it, you can hopefully see beyond and then take it from there. I have learned that you're better off at a high level having some tailwinds of good management and good business.
You could say Level 3 is a case of that. They're extremely well managed. They have a pretty formidable position, in terms of what they own in assets, yet it's a difficult company to understand. It tends to go through all kinds of gyrations in valuation. So that is of some interest to us. But again, if I'm making debt-type investments, by definition, I'm not going to be around for that long. And also by definition I won't make that much money. A 16 percent annualized return on debt investments is fantastic. We also try to look at situations where we can get greater discounts than that and go on the equity side. So that's what we try to do.
Q: [Inaudible]
A: Well, okay, that's a good question. There are many examples of 20-to-30 stock portfolios that have done okay, like this Baupost portfolio. There probably are a few that have not done okay as well. Berkshire is an example of a 20-to-30 stock portfolio. The one thing that became clear to me in a post-checklist world is that I'm not going to find investments that don't have hair on them. They're going to fail on some issues, almost all of them fail. Not almost all, all of them fail on some issues. And so if you're going to make investments, you're going to be forced to accept that there are some risks in some of these things.
And given that situation, I'm just less comfortable investing at 10 percent than I used to be. I've seen a 10-percent investment go down 70 percent, 80 percent, 100 percent, and it takes quite a bit to come back from that. So my take has been that if we spread our assets out some more, we get a little bit of protection against these big hits. And the other side is that we are not forced to make these very difficult calls when, given three opportunities, we only pick one, as we have done historically. I can pick two, or pick all three, actually. I prefer, especially when I can't make the call, to have the flexibility to do that.
So I agree with you that Baupost is a very different animal than most other portfolios that are around; and it spans many asset classes, you're right. I don't think the cash level is as high as you're suggesting. It's gotten up to those levels periodically, but it's not averaging out of those levels, it's less. My sense is that we'll have more success than we've had. I'm not ready to go down a path that I'm not comfortable with. So I'm not ready to go into new territories or hedge things or do those sorts of things, unless I'm a master at it, and I'm not a master at this point. So we'll stick to what we're good at and take it from there.
Q: Hi Mohnish, Jefferson Lilly from San Francisco. I asked you this question a couple of years ago and at the risk of repeating myself, I'm going to repeat myself. Joel Greenblatt has his Magic Formula investing website I think, just in the past couple of weeks, there've been some updated numbers that basically show that very mechanistic, quantitative way of picking value -- just off the ratios on the balance sheet and income statement -- has roughly approximated your returns, and of course with greater liquidity. There's no lock up just for picking stocks off that list. So I'm wondering, again if in light of recent market trends and whatnot, you have any other thoughts on that sort of mechanistic, non-thinking investment by the numbers versus what you're doing, which is obviously thinking about what you're doing when you invest. That means less liquidity, I guess for us as limited partners.
A: Jefferson, good to see you in Chicago instead of Irvine. I'm not sure why you made the switch. You asked a very good question. In fact, most active managers would probably be challenged to match Magic Formula type returns. what Joel has put together is very simple but also very powerful. So I would say the simple math is that if you were a know-nothing investor investing in index funds, you would do better than most of humanity if you used that formula. That's a no-brainer for most people. We've had a lot of studies that say if you are buying based on different types of very mechanistic filters, like low price to book and low price to earnings, you'll tend to do better than the indices. Joel just uses two variables, and he gets to pretty interesting numbers. In fact, I've been a big fan of Magic Formula investing. I would suggest that it's worthwhile. Any index fund investor would be better off with a Magic Formula type approach than with other methods.
Now Joel has a fund offering to make it even simpler. You can go on the Magic Formula website and see that they have a fund set up. I have not checked the fees. They are pretty reasonable, I would bet, if Joel is involved. You don't even need to do the work yourself. Pardon? One percent - one percent is pretty good. That Joel's is a very valid method, and you're right, the jury is out whether Pabrai Funds does better long-term than someone who uses that approach. We'll see. It's a tough bar to compare against. That's why I don't have the Magic Formula as one of my metrics. So go ahead.
Q: When you talked a bit about getting involved in things that people need, you mentioned iron ore. I don't know if you have an iron mine anywhere, but you get close to commodities. So how does an iron mine have a moat? That's one of the big topics, there.
A: Yeah, actually, they have moats. I don't have a whiteboard here, but I'd show for you, if I could. Let me try to illustrate it. Let's say the world has 100 iron ore mines. And let's say that they fall into nice buckets of 25, each with equal capacity. One-fourth of those mines produces at, let's say, $25 a ton, one-fourth produces at $50 a ton, onefourth produces at $75 a ton, and one-fourth produces at $100 a ton.
Now, in a booming economic situation like we saw in 2007, all engines are firing, people are building all kinds of things, and there's a lot of demand, generally speaking. At such a time, the marginal price of iron ore would be set close to the $100 per ton level because otherwise, those producers would just shut the mines or they'd be below cost. So if you owned a mine that cost $25, you would have a damn good moat. And those types of cost differentials amongst the miners tend to persist.
In Alaska, for example, there's a zinc mine called Red Dog that produces a huge amount of zinc. They can only ship for about three or four months a year. And the cost of producing zinc at that mine is, I think, probably the lowest in the world. It's about 30 28 cents per pound. And in the most distressed of times, zinc hasn't gotten to below, say, 45 cents a pound, and it's gone up to as much as $2 or $3 a pound. So as long as humans are consuming zinc that Red Dog mine is going to make money, because everything else would shut down before that one shut down.
So when you're buying a mine or a commodity producer, cost of production becomes the moat and consistent low cost of production is the way to go about it. And so what I try to do, when I look at the miners -- because obviously, with commodities, you have no moat -- is to create a moat by choosing a consistently low-cost provider. That's what I looked at very carefully for some of the investments we've made. In general, now, we're not in an ideal world where everything is in the first core tile at Pabrai Funds. But I would say that most of the stuff in our portfolio, as far as miners go, is in the bottom half of cost curves. So hopefully, that protects us long-term.
And we could well get to a situation where even the high-cost producers would do fine because demand is so high. But we're not counting on that. If that happens, great.
