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Pabrai’s Perfect Portfolio

June 25, 2007

Evan Vanderveer

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Mohnish Pabrai’s portfolio is not perfect because of what is inside, but rather because of how the fund is assembled. Pabrai is the managing partner of the Pabrai Investment Funds, a partnership with $500 million under management. Besides the 29% returned annually to partners, Pabrai has designed brilliant portfolio concepts.

Incalculable amounts of time are spent studying which investments to buy, but very little time is spent thinking about how much. The decision is usually left up to the investor’s confidence in the investment, something that has been shown to be unstable. The truth is, deciding how much to buy can have a large impact on a portfolio, occasionally just as much as what is bought. There are copious amounts of information on what to buy, but very little on how much.

To combat his untrustworthy feelings of self-confidence, Pabrai developed a new “portfolio theory.” I will call it the ten by ten portfolio. Ten investments that each make up ten percent of the portfolio. Pabrai holds between seven and fifteen different investments, but appears to stay close to the ten by ten benchmark. The fund is difficult to proportion perfectly, because a stock can run up before a full lot has been purchased or because a previous position has already advanced.

The proportioned ten by ten portfolio has other, less obvious effects. The benchmark percentage ensures the investor is confident enough to place 10% of their holdings in the investment. If they aren’t, then they should not invest at all. Simply put, the portfolio attempts to ensure only the best ideas get in.

As Buffett says repeatedly:

“ When making investments, pretend in life you have a punch-card with only 20 boxes, and every time you make an investment you punch a slot. It will discipline you to only make investments you have extreme confidence in.”

Additionally, a portfolio with ten stocks is focused enough to be able to beat the market, but not so focused that one wrong pick means the death of the whole fund. Pabrai admits he knows he is not as good a judge as Warren Buffett, who put nearly his entire wealth into GEICO stock at a young age. Therefore, if Pabrai is wrong, his fund can still do quite well. He has been wrong in the past ten years, while still returning nearly thirty percent per year after expenses.

Pabrai gave the following portfolio as an example at his 2005 annual meeting. He provided the following information to demonstrate how the ten by ten portfolio will do well even with some bad investment decisions.

 

Invested

Returned

Holding 1

$100

$10

Holding 2

$100

$50

Holding 3

$100

$100

Holding 4

$100

$100

Holding 5

$100

$180

Holding 6

$100

$180

Holding 7

$100

$180

Holding 8

$100

$200

Holding 9

$100

$200

Holding 10

$100

$300

 

$1,000

$1,500

 

He went on to explain that if the above returns took three years to achieve; the fund would have an annual return of 14.5%. If the returns took two years to achieve, the fund would have returned 22.5% per year and if only one year passed, the return would be 50%.

Another Pabrai concept is the “placeholder.” He contends that money sitting in the bank is actually risky because of the potentially declining dollar. Economically speaking, this is true. To combat the risk, Pabrai believes one should invest the cash in something safe, yielding enough return value. Currently, he is using Berkshire Hathaway as a placeholder until he finds other cheaper investments. Putting the money in the hands of the world’s greatest investor seems like a better idea than leaving dollars in the bank.

A past placeholder returned an annualized rate of about 116%. In mid October of 2004, Pabrai began buying Canadian Oil Sands, a company that owns 35% of Syncrude, when oil was forty dollars a barrel. The stock price was still undervalued by over 25% in comparison to the price of oil at the time, and appeared to value the company as if oil was never going to rise. In essence, Pabrai decided to take his cash and buy crude oil reserves at thirty dollars instead. He believed this to be a “productive commodity hedge against a declining dollar.”

He began buying the stock at forty-eight dollars and eighty one cents. Over an average of fourteen months, Pabrai had realized a gain of 145%.

His rational was stunningly simple. If oil prices did not rise, Pabrai did well from the dividend he was collecting. If prices rose to forty or fifty dollars a barrel, then he won big. Oil as it turned out climbed around sixty dollars and Pabrai began selling. He had invested in a stock that appeared to have little risk, was already selling at a decent discount, and had a catalyst to rise a great deal in the future.

Pabrai knows the dollar over time will likely decrease in value, and he has developed a concept to protect his portfolio from the risk. He has chosen to buy commodities or other safe companies that will be a better steward of his cash.

The last part to Pabrai’s portfolio is actually the first concept he addresses when researching an investment and is unique to the Pabrai Investment Funds.

In an article published on February ninth, 2004, Pabrai explains what he calls the “Yellowstone Factor”. He explained that Yellowstone national park is actually one large volcano that statistically speaking erupts every six hundred thousand years, with enough force to kill everyone within 700 miles. An eruption has not occurred in six hundred and thirty thousand years.

Therefore Pabrai explains, no matter how small the probability an event might occur, the risk must be taken into consideration. He goes on to point out that no business on earth is totally risk free. There is always a Yellowstone.

Before Pabrai makes any investment, he will “first fixate on what factors can cause the investment to result in a significant permanent loss of capital”. He believes simple estimations or “back of the envelope accounting” is all that is required. Similar probabilities can be assigned to other kinds of risk such as accounting fraud.

While the analogy of Yellowstone erupting is interesting, the message is paramount. Consider all possible risks of loss and ascribe a probability of the event occurring.

To reduce risk as much as possible, Pabrai ensures his holdings have little overlap. For instance, he will usually only hold one investment in the oil industry. He can minimize industry specific risk effectively by isolating his holdings.

Pabrai has simplified portfolio design with straightforward concepts. He has whittled Buffett’s ideas into easily followed rules. By limiting holdings, hedging against the declining dollar, and estimating risk, Pabrai has developed a portfolio that will certainly improve any investor’s performance.

About the author:

Evan VanderveerGuruFocus - Stock Picks and Market Insight of Gurus

Rating: 3.8/5 (55 votes)

Comments

realbleps
Realbleps - 6 years ago
this article is a gem because it refines the true successful art of investing into its essence. simple rulebook to follow. the KISS principle at its finest
amehta
Amehta - 6 years ago
Mohnish is simply brilliant !
justint
Justint - 6 years ago
Is there any place to access notes or transcripts from Pabrai's past annual meetings?
kapil007
Kapil007 - 6 years ago
Great write up. Love to see more stuff from Evan Vanderveer

Edgar729
Edgar729 - 6 years ago
I am with Justint, is there any place to find that information? Also, how are pabrai funds structured? As an LLP?
vooch
Vooch - 6 years ago
Good thing I'm 1,734 miles from Yellowstone. hehehe

- Vooch
holmes
Holmes - 6 years ago
Strategic ETFs can be good placeholders too.
Gangstarr
Gangstarr - 6 years ago
Interesting stuff!
tamiki
Tamiki - 6 years ago
Posting for all would be preferred.
justint
Justint - 6 years ago
I have seen alot of people criticizing Mohnish for his investments in CCRT and DFC. In his 10 stock portfolio he fully contemplates losing 90% of an investment yet still generating a great portfolio return. In addition I saw an estimate that his overall portfolio was only down 3.5% for the 3Q with big positions in Farifax and Berkshire offsetting CCRT and DFC. -3.5% in a quarter is far from disatarous
murphy
Murphy premium member - 6 years ago
absolutely i think the number one thing i learnt from monish is the yellowstone event , actually allow myself up to 15 stocks , 2 financials hurt me bad but im still ahead of the sp 500 by small
DaveinHackensack
DaveinHackensack - 6 years ago
"I have seen alot of people criticizing Mohnish for his investments in CCRT and DFC."

There is a valid criticism of Pabrai: Even if one considers the credit crunch to be a "Yellowstone" event (many will disagree with that characterization), it had already hit when Pabrai increased his stake in DFC in August. It's one thing to buy a ranch house outside of Yellowstone, but it's another thing to add an addition to it when you find out the foundation's cracked and lava is starting to come out of the big volcano.
jaxphy
Jaxphy - 6 years ago
Important fact is Mohnish Pabrai is a true and humble person and like any other human always allowed to make mistakes. Only that when having a following it is impportant to take on higher responsibility. Mr. Pabrai is learning while we continue to monitor!

I guess it is important to ponder buying great companies at fair prices! DFC's model was fleecing subprime. I have reservations on the sustainability on such models. Hence not great. I trust Mohnish Pabrai at some point will address on what was irresistable with DFC.
litch17
Litch17 - 6 years ago
hes hot stuff
downrightstupid
Downrightstupid - 5 years ago
Monish Pabrai is a fraud. Great investors do not need marketing and pump their picks- Bernie Maddock needed that- watch out he and his friend Srivastav in Seattle have no clue about investing and are basically bullshitters.

BEWARE!

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