Mohnish Pabrai (Trades, Portfolio) founded his hedge fund business, Pabrai Investment Funds, in 1999. The dot-com bubble gripped the stock market at that time, and many asset managers were chasing high-growth tech stocks.
When the bubble burst, Pabrai avoided the worst of the fallout because, when he set up his firm, he set out with a deep-value mentality. He wanted to buy $1 for $0.50, following in the footsteps of value investors Benjamin Graham and Warren Buffett (Trades, Portfolio).
This strategy has served him well during the past two decades. However, last year, he decided to change direction. Writing in his fourth-quarter and full-year 2020 letter to investors, Pabrai explained that one of his biggest lessons last year was that buying and holding quality businesses works.
He noted that one of his biggest mistakes was selling Pabrai Funds' Ferrari (RACE, Financial) holding. The investment firm received nearly 1.2 million shares of Ferrari as part of its spinoff from Fiat, an investment worth $101 million for an effective $23 million investment. Shortly after the spinoff, Pabrai decided to sell, believing the stock was overvalued and there were better opportunities elsewhere. "Had we held on, our stake would be worth north of a quarter billion today," he lamented in his 2020 letter.
Very few businesses have the qualities that can help them grow year after year. So, it makes sense to hold on to the ones that do, Pabrai wrote. Capitalism is destructive and very brutal. It can be challenging to keep up with every business and try to figure out what is around the corner.
Adapting to this mindset "shift" changes the "nature of businesses one should be interested in owning." He went on to add, "They need to have strong moats, long runways, and great management."
Another criterion is the price. The value investor is not willing to pay over the odds for a business just because it looks as if it will do well in the future.
He gave the example of Snowflake (SNOW, Financial). For this stock to produce high returns for its investors from current levels, the sort of returns that might attract a value-hunter like Pabrai, it would have to have the potential to generate a five to 10 times return.
To get from its current $83 billion valuation to $830 billion, Pabrai explained, "it would need to be generating cashflows ranging from $20 billion to $200 billion a year." That suggests revenues would have to rise from $500 million to $500 billion "for investors to have a real shot at 10x returns from here," Pabrai summarized. He went on to add, "I'd rather fish in other ponds."
This example exemplifies how challenging it is for investors to find securities that might have a decent chance of making a high return in the current market.
For companies like Snowflake, which are trading at 20 times revenues or more, it would take vast amounts of growth to produce high returns in the years ahead. That's if these valuations made sense. At 20 times revenue, it would take 20 years for the company to earn investors' money back, and that's assuming no research and development, no cost of sales, no costs at all.
That's not to say that these businesses won't grow or that they're not high quality. They may earn high returns on capital and achieve high growth rates in the future. But that's not the point.
The point, in Pabrai's opinion, is that the market is now factoring in such unrealistic growth prospects, it has become virtually impossible for these businesses to grow into their valuations. Thus, the definitions of what qualifies as "value" and "growth" investing have changed, with the overvalued stocks still qualifying as neither.
Disclosure: The author owns no share mentioned.
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