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Robert Stephens, CFA
Robert Stephens, CFA
Articles (386) 

Mohnish Pabrai on Using Value Investing to Outperform the Market

A simple strategy could help you to capitalize on low valuations

June 18, 2020

The S&P 500’s recent volatility has confirmed that it is impossible to accurately predict the stock market’s movements, in my view.

However, it is possible to outperform the stock market over the long run through adopting a value investing strategy such as that used successfully by Mohnish Pabrai (Trades, Portfolio).

His patient approach, self-discipline during periods of market uncertainty and a willingness to learn from his mistakes are likely reasons for his long-term outperformance of the stock market.

A patient approach

There have been 14 bear markets in the past 75 years. Therefore, an investor is likely to experience a bear market approximately every five years during their lifetime. This provides them with infrequent but regular opportunities to buy stocks while they are undervalued.

A prerequisite of taking advantage of low stock prices during bear markets is patience. Even though a bear market may take place twice in each decade on average, sometimes they occur far less frequently. For instance, a bear market did not take place between 1987 and 2000.

Waiting for a bear market to occur can be a difficult experience. It is tough to watch stock prices rise when your portfolio is generating low returns from cash or fixed-income securities. However, by waiting for wide margins of safety, you can obtain more favorable risk/reward opportunities.

Pabrai has previously highlighted the importance of patience when investing in stocks: "You don’t make money when you buy stocks. And you don’t make money when you sell stocks. You make money by waiting.”

Learning from your mistakes

Even though the stock market experiences bear markets fairly regularly, no two are ever exactly the same. This is likely to mean that value investors regularly make mistakes when apportioning their capital, since their past experiences will not be exactly replicated in future.

However, learning from your past mistakes can improve your capacity to take advantage of buying opportunities during bear markets. For instance, you may have avoided purchasing stocks during previous bear markets because of short-term risks. This may mean that you are more active during bear markets, in terms of buying stocks, so that there is no opportunity cost in missing out on low valuations.

Pabrai has highlighted his willingness to learn from past mistakes to become a better investor who is more likely to outperform the stock market: "Mistakes are the best teachers. One does not learn from success. It is desirable to learn vicariously from other people's failures, but it gets much more firmly seared in when they are your own.”

Buying during uncertain periods

Buying stocks when they are undervalued and selling them when they are overpriced is an obvious means of outperforming the market. However, risks facing businesses are often at elevated levels when their valuations are most attractive.

For instance, sectors such as energy and leisure contain companies that offer wide margins of safety at the moment. They could deliver large capital gains in the long run, but face uncertain operating environments that put their short-term survival at risk in some cases.

A potential solution is to buy quality businesses with wide economic moats when they face an uncertain operating environment. They may offer wide margins of safety due to risks facing the sector, but are likely to overcome them to improve on their current market position.

Pabrai has previously discussed his desire to buy stocks when they face uncertain outlooks: "Wall Street sometimes gets confused between risk and uncertainty, and you can profit handsomely from that confusion. The low-risk, high-uncertainty (scenario) gives us our most sought after coin-toss odds: Heads, I win; tails, I don't lose much.”

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