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Rupert Hargreaves
Rupert Hargreaves
Articles (1448)  | Author's Website |

Mohnish Pabrai: Even With Great Companies, Valuation Matters

Mohnish Pabrai on why investors need to focus on valuation as well as quality

July 20, 2020 | About:

Legendary value investor Mohnish Pabrai (Trades, Portfolio) struggled, like many other investors, during the first half of 2020. In his most recent letter to investors of the Pabrai Investments Funds, Pabrai reported that his flagship investment fund had underperformed the S&P 500 by more than 10% in the first half of the year, taking its underperformance in the past 12 months through the end of June to more than 20%.

Despite this lackluster performance, Pabrai remains positive on the outlook for his portfolio heading into the second half of the year. He thinks there are plenty of opportunities in the market to take advantage of, despite the recent market rally.

Pabrai also used his second-quarter letter to warn about the risk of overpaying for stocks, no matter how profitable or successful the underlying businesses might appear.

Buying expensive stocks can be costly

Pabrai presented the example of Microsoft (NASDAQ:MSFT) in the early 1990s. At the time, the company was the most valuable business in the world. Investors rushed to buy shares in the tech giant as demand for tech stocks exploded.

Microsoft was just one of the many tech businesses investors rushed to get involved with despite ever-increasing valuations that made little to no sense in some cases. As Pabrai went on to explain in his letter, there was nothing particularly wrong with Microsoft. The group had an established monopoly in a growing market, and it was investing significantly in research and development, which would help the business maintain its monopoly and reputation with customers.

Looking back at the company's success over the past two decades, it is difficult to argue that this might have been a bad investment to buy at the turn of the century, but it was.

The reason why the company has been a bad investment is not that it is a bad business. It is, in fact, a terrific business. Earnings increased from $8 billion in 1999 to more than $43 billion today. At the same time, it has invested tens of billions of dollars in its operations, returned tens of billions of dollars to investors and built a world-leading gaming and cloud franchise.

However, investors who ignored the company's valuation in 1999 have seen terrible returns ever since. As Pabrai wrote in his Q2 letter:

"From 1999 to 2016, the stock delivered zero returns. It was at $59 a share in 1999 and $59 a share in 2016. But that wasn't the worst of it. By 2009, Microsoft had lost 75% of the value it had in 2000. It was a very bumpy ride with huge drawdowns."

This example, as he went on to explain, is why valuation matters. No matter how fantastic a company might look, and no matter how bright its prospects might appear to be, buying a company at a high price can be risky. Just because a business is a good business does not mean that it is worth the price the market is currently placing on it.

Unfortunately, at the time, it is challenging to tell if a business is overvalued. As we've seen over the past few decades, some companies, like Amazon.com, (NASDAQ:AMZN), for example, can remain overvalued on traditional valuation metrics for years. Investors who avoided the company for this reason in the past have missed out on one of the greatest investments of the past few decades.

So, avoiding overvalued stocks does not guarantee success. However, it does help improve your odds, and that's one of the few ways we can improve outcomes as individual investors.

I think Pabrai's insights on this matter are worth considering, especially in the current market environment, where investors seem to be happy to overlook valuations in favor of the story.

Disclosure: The author owns no share mentioned.

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About the author:

Rupert Hargreaves
Rupert is a committed value investor and regularly writes and invests following the principles set out by Benjamin Graham. He is the editor and co-owner of Hidden Value Stocks, a quarterly investment newsletter aimed at institutional investors.

Rupert holds qualifications from the Chartered Institute for Securities & Investment and the CFA Society of the UK. He covers everything value investing for ValueWalk and other sites on a freelance basis.

Visit Rupert Hargreaves's Website


Rating: 4.0/5 (1 vote)

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jibjob
Jibjob - 8 months ago    Report SPAM

Can you advise what he says about Micron in his letter? Anything noteworthy/new? Thanks

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