Pabrai had a very easy run for his first half decade of fund management. I think 2008/2009 taught him a lot about investing and he has tweaked his approach to incorporate what he has learned. That is what a humble smart investor does. Here he addresses using a basket concept and outperforming the S&P 500 :
Q: Can you also explain to me the basket concept. When you buy a basket of stocks, do you buy them all in the same industry because you want to own that industry? Or do you buy a basket amongst diversified industries?
A: A basket could be different things. For example, in 2008, I thought of the commodities, metal and mining space as a single basket. Currently for example, I'm looking at Japanese stocks. I can't read Japanese and I can't find enough English to read on these companies, but they're ridiculously cheap. I'm still getting my arms around it. We probably will end up with a basket if we go down that path.
If we end up with a basket, it will probably be across many Japanese industries. It'll be across industries but the common theme is that they will all be Japan. It might be Japanese exporters versus Japanese consumptions. I haven't figured the whole thing out. In the end we might do nothing. But if we do, that would be an example of a basket which is not in an industry. It would be more of a country.
Q: What attracts you to a stock initially? How do you initially identify it? Then what causes you to decide to sell it? Then where does the checklist fit in there? At the beginning? The end? Throughout?
A: That's a good question. My steady state model on stocks is that there's nothing to buy. So when I encounter a stock, let's say I'm looking at Value Line, my starting point is that there's nothing that will be attractive enough to really do anything with. I'm a skeptic. I'm really asking Value Line to prove me wrong. I'm looking for is Value Line to tell me something is trading at a P/E of 2, and it's not some weird nuance that's causing that.
I might understand a little bit about the business such that I might want to dig into that. Or if Value Line tells me something's lost 80 percent of value and it's something I can get my arms around, I can look at it. I'm looking for extreme valuation to get me intrigued to go beyond the first couple of minutes. I'm not looking for them to tell me that P&G is trading at 12 times earnings and historically it's been at 16 times earnings, so we should be orgasmic about it. That's really of no interest to me. I think it should be of no interest to you, as well.
Basically, what we're really focused on are things that have a significant distortion from where they ought to be priced. It has to be a significant distortion. It also has to be a distortion that I can understand. I mentioned Japan. If you look at the Nikkei, it hasn't moved in 27 years. 27 years is a long time. Just think of the simple math. Let's say I've got a Coke bottler in Japan. In fact, a couple of these companies are Coke bottlers. I can look at the Coke bottler and let's say it's trading at 15 times earnings.
If you go 27 years forward in that business and it has no dividends and the price doesn't change, it's going to be below cash because in 27 years at 7 percent yield it would exceed its market cap in cash flows as long as the business was doing fine. It is a very significant anomaly when a market doesn't move for that long. Sometimes you have huge run-ups and then it takes a while. For example, the NASDAQ hit 5,000 in 2000. I don't think it's hitting 5,000 anytime soon because that was, what I would say, extreme euphoria.
The same thing with the Nikkei. The Nikkei is at about 10,000 or so now. It was at 10,000 about 27 years ago. It went up to 40,000 in the middle of all that. If you ignore the 40,000, it's been at about 10,000 over 27 years. This is a very long period of time to have no movement in stock price. That's an interesting thing to think about. That's how we go about it.
Selling, that's pretty straightforward. If you're buying, we should know what it's worth. When it approaches that value, we should sell.
Q: And what about the checklist? How does that fit in throughout?
A: The checklist comes in at the end. We do the analysis and we do all the work. We're ready to pull the trigger. Just before we pull the trigger, then we run the checklist.
Q: Thank you for the great performance that we obviously all benefit from that. I echo the appreciation of other investors. A question about performance. Warren publishes an interesting table of the differential versus the S&P annually. Have you done that kind of analysis? Underlying my question is, as the funds have become larger, has your differential declined? Is that of concern?
A: That's a good question. We've got that data in all the slides here. If you wanted to compare for example, every year with the S&P, you can do it right here as in Slide 3. You can do every single year exactly like you do in the Berkshire reports. There's a correlation between size and performance. But PIF2 is a good case study because PIF2 basically stopped taking new investors in 2003. From 2003 onwards, the amount of new capital that came into PIF2 is very small. It's just existing investors adding money.
There are redemptions and there are additions. There hasn't been much change in the capital. If you look at it, what happened is PIF2 has done well for 2004, 2005, 2006, 2007. Even when the capital didn't change. The same with the others. 2008, 2009, we did poorly. We did poorly because we had several things that declined a lot in value like Ternium. The performance reflects Ternium at $4 or $5 a share. Also we had mistakes. We had mistakes at Delta Financial where we lost a lot of money.
We can also look at something like PIF4; PIF4 would be a good example to look at. This is a situation where you had funds coming in over the years because PIF4 is still open. But we haven't had much inflow in 2009, 2008 or even 2007. But we had plenty of inflow before then. It still did fine in terms of vs. the index. I don't think with the amount of capital we are managing, the performance drops in the last few years are related to the size of capital in the management or the amount that came in.
It relates to number one, stupidity on my part on some mistakes we've made, and secondly, the huge distortions the economy went through. That will flush itself out in the next year or two once we are able to get back to reasonable valuations. We still have a number of stocks that are deeply undervalued. Just like Ternium was. They'll come around and we'll get back to reasonable valuations on those. They'll get reflected in the NAV. What I'm saying is that if I don't do any additional investments, I would just kept those funds absolutely frozen the way they are today.
I expect them to do quite well over the next few years because we are sitting on a lot of undervalued assets. I don't need to take any heroic action to make that happen. I also don't think that the inflows make that much difference. Just because the size, 500 million is not that big.
Q: Can you also explain to me the basket concept. When you buy a basket of stocks, do you buy them all in the same industry because you want to own that industry? Or do you buy a basket amongst diversified industries?
A: A basket could be different things. For example, in 2008, I thought of the commodities, metal and mining space as a single basket. Currently for example, I'm looking at Japanese stocks. I can't read Japanese and I can't find enough English to read on these companies, but they're ridiculously cheap. I'm still getting my arms around it. We probably will end up with a basket if we go down that path.
If we end up with a basket, it will probably be across many Japanese industries. It'll be across industries but the common theme is that they will all be Japan. It might be Japanese exporters versus Japanese consumptions. I haven't figured the whole thing out. In the end we might do nothing. But if we do, that would be an example of a basket which is not in an industry. It would be more of a country.
Q: What attracts you to a stock initially? How do you initially identify it? Then what causes you to decide to sell it? Then where does the checklist fit in there? At the beginning? The end? Throughout?
A: That's a good question. My steady state model on stocks is that there's nothing to buy. So when I encounter a stock, let's say I'm looking at Value Line, my starting point is that there's nothing that will be attractive enough to really do anything with. I'm a skeptic. I'm really asking Value Line to prove me wrong. I'm looking for is Value Line to tell me something is trading at a P/E of 2, and it's not some weird nuance that's causing that.
I might understand a little bit about the business such that I might want to dig into that. Or if Value Line tells me something's lost 80 percent of value and it's something I can get my arms around, I can look at it. I'm looking for extreme valuation to get me intrigued to go beyond the first couple of minutes. I'm not looking for them to tell me that P&G is trading at 12 times earnings and historically it's been at 16 times earnings, so we should be orgasmic about it. That's really of no interest to me. I think it should be of no interest to you, as well.
Basically, what we're really focused on are things that have a significant distortion from where they ought to be priced. It has to be a significant distortion. It also has to be a distortion that I can understand. I mentioned Japan. If you look at the Nikkei, it hasn't moved in 27 years. 27 years is a long time. Just think of the simple math. Let's say I've got a Coke bottler in Japan. In fact, a couple of these companies are Coke bottlers. I can look at the Coke bottler and let's say it's trading at 15 times earnings.
If you go 27 years forward in that business and it has no dividends and the price doesn't change, it's going to be below cash because in 27 years at 7 percent yield it would exceed its market cap in cash flows as long as the business was doing fine. It is a very significant anomaly when a market doesn't move for that long. Sometimes you have huge run-ups and then it takes a while. For example, the NASDAQ hit 5,000 in 2000. I don't think it's hitting 5,000 anytime soon because that was, what I would say, extreme euphoria.
The same thing with the Nikkei. The Nikkei is at about 10,000 or so now. It was at 10,000 about 27 years ago. It went up to 40,000 in the middle of all that. If you ignore the 40,000, it's been at about 10,000 over 27 years. This is a very long period of time to have no movement in stock price. That's an interesting thing to think about. That's how we go about it.
Selling, that's pretty straightforward. If you're buying, we should know what it's worth. When it approaches that value, we should sell.
Q: And what about the checklist? How does that fit in throughout?
A: The checklist comes in at the end. We do the analysis and we do all the work. We're ready to pull the trigger. Just before we pull the trigger, then we run the checklist.
Q: Thank you for the great performance that we obviously all benefit from that. I echo the appreciation of other investors. A question about performance. Warren publishes an interesting table of the differential versus the S&P annually. Have you done that kind of analysis? Underlying my question is, as the funds have become larger, has your differential declined? Is that of concern?
A: That's a good question. We've got that data in all the slides here. If you wanted to compare for example, every year with the S&P, you can do it right here as in Slide 3. You can do every single year exactly like you do in the Berkshire reports. There's a correlation between size and performance. But PIF2 is a good case study because PIF2 basically stopped taking new investors in 2003. From 2003 onwards, the amount of new capital that came into PIF2 is very small. It's just existing investors adding money.
There are redemptions and there are additions. There hasn't been much change in the capital. If you look at it, what happened is PIF2 has done well for 2004, 2005, 2006, 2007. Even when the capital didn't change. The same with the others. 2008, 2009, we did poorly. We did poorly because we had several things that declined a lot in value like Ternium. The performance reflects Ternium at $4 or $5 a share. Also we had mistakes. We had mistakes at Delta Financial where we lost a lot of money.
We can also look at something like PIF4; PIF4 would be a good example to look at. This is a situation where you had funds coming in over the years because PIF4 is still open. But we haven't had much inflow in 2009, 2008 or even 2007. But we had plenty of inflow before then. It still did fine in terms of vs. the index. I don't think with the amount of capital we are managing, the performance drops in the last few years are related to the size of capital in the management or the amount that came in.
It relates to number one, stupidity on my part on some mistakes we've made, and secondly, the huge distortions the economy went through. That will flush itself out in the next year or two once we are able to get back to reasonable valuations. We still have a number of stocks that are deeply undervalued. Just like Ternium was. They'll come around and we'll get back to reasonable valuations on those. They'll get reflected in the NAV. What I'm saying is that if I don't do any additional investments, I would just kept those funds absolutely frozen the way they are today.
I expect them to do quite well over the next few years because we are sitting on a lot of undervalued assets. I don't need to take any heroic action to make that happen. I also don't think that the inflows make that much difference. Just because the size, 500 million is not that big.
