I had the honor of attending the Pabrai Investment Funds annual meeting in Chicago this past Saturday. It was a great learning experience. Mohnish Pabrai did a fantastic job, and it was really fantastic of him to take the time to answer investors' questions both during and after the meeting. Truly a remarkable man!
Here are my notes:
General Comments:
Pabrai commented on the performance of the funds first. Most of the funds handsomely beat the best index by a considerable margin (except for PIF 4, still beat the best index but by a small margin). Only 1 out of 200 fund mangers can beat the S&P by more than 3% annually, and Pabrai has certainly done that. The funds have done better than the market this year both as of June 30 and as of Aug. 31.
Value Proposition:
The Pabrai funds invested in a basket of Japanese net-nets starting October 2010. Pabrai has exited all the positions with a realized gain of 2.2% including dividends, or 1.4% annualized. To me, this is surprising as the Japanese market has advanced significantly since October 2010. In search of explanation, Mornish referred to a few quotes from Ben Graham from the 1940 edition of "Security Analysis." Here is one:
"It may be pointed out, however, that investment in such bargain issues needs to be carried on with some regard to general market conditions at the time. Strangely enough, this is a type of operation that fares best, relatively speaking, when price levels are neither extremely high nor extremely low."
Pabrai expanded on this by stating that when the market bottoms it's much better to buy quality companies that have fallen precipitously with the market than focus on net-nets. When the market flies, net-nets are also ignored because investors shift their focus to both quality companies and story stocks.
Examples include Hibiya Engineering (TSE:1982) and Ryoyo Electro (TSE:8068). Both were trading below NCAV at the time of his investment, generating profits as well as positive and consistent cash flows. Managements of both companies were also repurchasing shares. Hibiya ended up just a little bit profitable, and Ryoyo turned out be a 15% loss.
Question and Answer:
1. Further comments on the Japanese net-net investments. Why did the funds exit all net-net positions? Is Ben Graham right about the net-net strategy not working in a trending market?
Pabrai said he wanted to have the optional of cash, and he wasn't comfortable with the level of cash holdings. Therefore, he exited the net-net basket. He also mentioned that the market is skeptical about Japanese companies' managements' willingness and ability to unlock value for shareholders.
2. Question on the equation Pabrai used in net-nets: Net Asset + Long Term Bond - All Liabilities. Is the long-term bond double counted?
The long-term bond here is not long-term debt. It refers to the fixed income investments on the balance sheet as assets. They can be converted to cash easily.
3. Question regarding the commercials played during the meeting.
There are two more commercials coming up. He can't answer this one.
4. Thoughts on the market for the rest of 2013? What is the minimum investment for the funds?
No idea what the market will do for the rest of 2013, and he won't even try. Minimum investment in the Pabrai funds now is $2.5 million.
5. Question regarding concentration versus diversification.
Mohnish moved from an 10/10 allocation model (10 ideas, each 10%) to 10/5/2. During December 2008, so many stocks are trading at a bargain price, and they were coming in so fast and furious he didn't have the time to figure out which ones to pass up. The funds invested 2% in each. Then as the market advances, his 14th or 15th position will not be as good as his top positions. He wants to have the flexibility to make those 2% and 5% bets but generally will limit the position size to 10%.
6. In a recent book about John Templeton, Pabrai wrote some comments about how he traveled to different business schools and talked to the students about companies with amazing financials. What are the companies?
Mohnish said he is clueless about that. Maybe he needs to reread what he wrote. [laughter]
7. As a result of the Japanese net-net investment, did you add anything to the checklist and if so, what is it?
Here he said his learning from net-nets was not to invest at extremes of the pendulum or cycle, i.e not too hot and not too cold.His rationale was that at panics the net-nets may get crushed after you buy and may never recover. (the above notes is generously shared by Itzarjuna). He found it very hard to believe that the net-net investments only resulted in a 2.2% gain including dividends. It seems so obvious at the time of the investment.
8. Question on the net-net and checklist: Do you look a lot into management and if so, what do you look at? What's your thought on management's capital allocation decisions?
The checklist is created by looking at his mistakes and other investors' mistakes and coming up with ad-hoc questions that should've been asked prior to the investment. He then categorized these questions into a few baskets such as leverage and management. In terms of management, he looks at factors such as ownership percentage, alignment of interest and management compensation. He also looks at management's capital allocation record, but management rarely allocates capital perfectly, and it's okay if the investment is compelling. He's made a lot of investments in companies whose management is not very good at allocating capital.
9. It seems like most of your holdings are large cap blue chips stocks. Going forward, are you planning to switch to more small cap and mid caps?
Pabrai said that most of his investments are not in large cap blue chips stocks. He would love them to convert to blue chips though. His approach is opportunistic because he is not pursuing after a specific asset class. It happens to be during the past year or so he has invested in a few blue chips, but that could change a year from now.
10. Two-part question. What's your thought on post-crisis ROE of banks? How do you incorporate macro into your investment analysis?
There are both headwinds and tailwinds for the banks. The tailwinds include less competition for big banks and technology advancement that cut labor cost. The headwind is higher capital requirement and stricter regulation, but he thinks that's good for the banks in the long run.
In general, you will always better off focusing on the micro than the macro. For example, there's a McDonald's close to his house, and he's fascinated by the efficiency of the drive through operation. If you look at that business, does an increase in the interest rate or unemployment rate impact that business as much as an opening of an In & Out next door? Obviously the latter has a larger impact.
11. What are your thoughts on activism? Do you follow any activist investors?
Pabrai said he's always been skeptical about the activist's impact on business. He thinks in general, activism is overrated. It's not easy to force changes in public companies. It's an acrimonious way to go through life. He will be much better off without being involved in activism. He does not follow any activist investors.
12. When you invested in Delta Financial, the sentiment for mortgage business was high, how do you balance investor enthusiasm with true value of the business?
Investing in Delta Financial is a straight stupid mistake, not sentiment driven. He basically made a basic mistake by not appropriately assessing the downside. You'll make errors all the time in this business. You have to focus on the specific of business, not the sentiment and macro.
13. Would you taper or not taper? What are your thoughts on Indian rupees?
Pabrai said, "So you ask me to be the Fed chair? Good thing I'm not." All jokes aside, he would be on the side of Bernanke. The fall of rupee is interesting. To some extent, he thinks it is an overdose to skepticism. But it doesn't matter what the rupee does. If you invest in India, you still want to focus on micro.
14. Questions on Japanese net-nets: Did you factor in the liquidity issue before your investment?
The net-net investments he made in Japan were not the absolute cheapest, and they are not very liquid. It took the funds a year to get in and another year to get out. The problem is, most net-net situations are with micro-cap and small-cap companies, and they are inherently not as liquid as large caps.
15. How did you get started in the investment management business?
Pabrai said prior to his launch of the partnership he had a few years of good returns with his money, and he was giving stock tips to his friends. His friends suggested him to start a partnership to make it more official. So Mohnishhe started the partnership with eight other friends' money. He was still running a business and a day job back then. To him, managing a million does not requirement too much extra work. When he set up the partnership, he wanted to set it up in the fairest way possible. He actually guaranteed the principle for his early investors, and he took it out later. If you are interested in creating an investment business, you should start by creating a track record that is audited so you can show it to your investors. If you beat the indices consistently, people will swim to you.
16. If you were to go back to when you started, what would be the things you advice to read? And if you don't look at the macro so much, how did you come up with these international investments.
Each person is different. But he found "Manual of Ideas" and "Corner of Berkshire and Fairfax" very helpful. There are other good resources out there, and it's better to copy others' ideas. Japanese net-net was his original idea, and we all know how it ended up [laughter].
17. At this time last year, Apple (AAPL, Financial) was going up everyday up to around $700, and someone during the meeting last year asked you if you would buy Apple. Why did you not buy Apple?
Apple is a fantastic business with an incredible franchise. What keeps him away from Apple is because it is in an industry with rapid changes. The second thing that dissuades him: Apple is a super large cap and you are not going to find 2x, 3x returns in large cap blue chips. You will find better opportunities in smaller caps.
18. Do you use options and futures? How do you make the decision, based on fundamental analysis or technical analysis because fundamental tells you what to buy and technical analysis tells you when to buy and when to sell?
Don't use options or futures. Makes decisions based on fundamentals only.
19. I was wondering in general, what is your take on Europe (especially the financials)?
In general, it is very likely that many opportunities exist in Europe. There are many opportunities out there, but he doesn't understand the country dynamics or the businesses. It may not be a bad place to start if the country is going through stress, especially European companies with revenues from all across the globe.
20. What is your thought process behind keeping your funds closed?
The funds are closed because he can't find anything to buy, and he thinks he has more capital than ideas. If that shifts sometimes in the future when he has more ideas than capital, he'll open up the fund. Furthermore, he has no incentives to increase the asset under management, unlike the other investment managers. The other thing he would prefer to do is to raise money at the right time. Historically when the funds got massive inflows and when the funds were performing well and had no inflows when the funds were performing poorly. He was desperate to raise capital back in late 2008 and early 2009 and was not successful. However, at the peak of 2007, investors were throwing money in. The less, be patient and be ready when opportunities arrive.
21. An investor who had invested in both Pabrai's fund (PIF) and Berkshire asked him if one had to invest in only one which one should he invest and why?(I didn't catch this questions but Gurufocus user Itzarjuna kindly shared his note).
Mohnish said it was good the investor had invested in both. He's glad he's not benchmarked against Berkshire (BRK.A)(BRK.B). Buffett has the disadvantage of size, but he should be able to beat the S&P 500. He hopes Buffett will do better.
22. What is your strategy in terms of picking out the ideas for further research when you go through the holdings of others? And how have you used the checklist to rule out ideas that can potentially turn out to be mistakes? If you had used the checklist, would you have invested in Delta Financials?
That's a good problem to have in the first place. You can trim the list by picking out the ones they have the highest convictions.
There are many examples that the checklist prevented him from investing in an idea but most of his ideas don't even get to the checklist phase. In the last 14 months, he has looked at many many things and for one thing or another, he turned them down. He also has conversation with other money managers and very often, during these conversations, the ideas are killed. The checklist is used to highlight the things that he has not thought about. If he had run the checklist, he wouldn't have bought Delta Financials.
23. Question on the checklist: Are you concerned that you may have raised the bar too high?
He doesn't think the checklist has raised the bar too high. Any companies he runs the checklist on will have some issues. The checklist is not too demanding. He's sure many many things that he passed on will end up doing well. The thing that usually stops him is the downside, which may never materialize. But that's the kind of things you should look at prior to making an investment decision.
24. What are your thoughts on selling? Does the rise or fall of interest rates change the discount rate you use?
Typically he sells at 90% of intrinsic value. The interest rate doesn't really affect the discount rate he uses. In general, a discount rate of 6% to 9% should be okay.
25. This question comes from an equity research analyst. Have you ever been tempted to short?
He said he has not been tempted to short at all. He thinks shorting can be a way to make money, but the timing is too tricky. You can be right, but it can take a long time to prove it. Also the maximum gain you can get is 100%, but the maximum loss is unlimited.
[b][/b]
Here are my notes:
General Comments:
Pabrai commented on the performance of the funds first. Most of the funds handsomely beat the best index by a considerable margin (except for PIF 4, still beat the best index but by a small margin). Only 1 out of 200 fund mangers can beat the S&P by more than 3% annually, and Pabrai has certainly done that. The funds have done better than the market this year both as of June 30 and as of Aug. 31.
Value Proposition:
- No management fees, only performance fees.
- Pabrai family is the second largest investor.
- High watermark.
- No leverage, no margin loans, no short positions.
- Great investor base (worth noting). Most investors did not panic and redeem during bad times.
- HAVEN'T MADE A MISTAKE FOR A FEW YEARS.
- Few big ideas during 2011 and 2012 generated good returns.
- Fully exited the Japanese net-net basket investments (see below).
The Pabrai funds invested in a basket of Japanese net-nets starting October 2010. Pabrai has exited all the positions with a realized gain of 2.2% including dividends, or 1.4% annualized. To me, this is surprising as the Japanese market has advanced significantly since October 2010. In search of explanation, Mornish referred to a few quotes from Ben Graham from the 1940 edition of "Security Analysis." Here is one:
"It may be pointed out, however, that investment in such bargain issues needs to be carried on with some regard to general market conditions at the time. Strangely enough, this is a type of operation that fares best, relatively speaking, when price levels are neither extremely high nor extremely low."
Pabrai expanded on this by stating that when the market bottoms it's much better to buy quality companies that have fallen precipitously with the market than focus on net-nets. When the market flies, net-nets are also ignored because investors shift their focus to both quality companies and story stocks.
Examples include Hibiya Engineering (TSE:1982) and Ryoyo Electro (TSE:8068). Both were trading below NCAV at the time of his investment, generating profits as well as positive and consistent cash flows. Managements of both companies were also repurchasing shares. Hibiya ended up just a little bit profitable, and Ryoyo turned out be a 15% loss.
Question and Answer:
1. Further comments on the Japanese net-net investments. Why did the funds exit all net-net positions? Is Ben Graham right about the net-net strategy not working in a trending market?
Pabrai said he wanted to have the optional of cash, and he wasn't comfortable with the level of cash holdings. Therefore, he exited the net-net basket. He also mentioned that the market is skeptical about Japanese companies' managements' willingness and ability to unlock value for shareholders.
2. Question on the equation Pabrai used in net-nets: Net Asset + Long Term Bond - All Liabilities. Is the long-term bond double counted?
The long-term bond here is not long-term debt. It refers to the fixed income investments on the balance sheet as assets. They can be converted to cash easily.
3. Question regarding the commercials played during the meeting.
There are two more commercials coming up. He can't answer this one.
4. Thoughts on the market for the rest of 2013? What is the minimum investment for the funds?
No idea what the market will do for the rest of 2013, and he won't even try. Minimum investment in the Pabrai funds now is $2.5 million.
5. Question regarding concentration versus diversification.
Mohnish moved from an 10/10 allocation model (10 ideas, each 10%) to 10/5/2. During December 2008, so many stocks are trading at a bargain price, and they were coming in so fast and furious he didn't have the time to figure out which ones to pass up. The funds invested 2% in each. Then as the market advances, his 14th or 15th position will not be as good as his top positions. He wants to have the flexibility to make those 2% and 5% bets but generally will limit the position size to 10%.
6. In a recent book about John Templeton, Pabrai wrote some comments about how he traveled to different business schools and talked to the students about companies with amazing financials. What are the companies?
Mohnish said he is clueless about that. Maybe he needs to reread what he wrote. [laughter]
7. As a result of the Japanese net-net investment, did you add anything to the checklist and if so, what is it?
Here he said his learning from net-nets was not to invest at extremes of the pendulum or cycle, i.e not too hot and not too cold.His rationale was that at panics the net-nets may get crushed after you buy and may never recover. (the above notes is generously shared by Itzarjuna). He found it very hard to believe that the net-net investments only resulted in a 2.2% gain including dividends. It seems so obvious at the time of the investment.
8. Question on the net-net and checklist: Do you look a lot into management and if so, what do you look at? What's your thought on management's capital allocation decisions?
The checklist is created by looking at his mistakes and other investors' mistakes and coming up with ad-hoc questions that should've been asked prior to the investment. He then categorized these questions into a few baskets such as leverage and management. In terms of management, he looks at factors such as ownership percentage, alignment of interest and management compensation. He also looks at management's capital allocation record, but management rarely allocates capital perfectly, and it's okay if the investment is compelling. He's made a lot of investments in companies whose management is not very good at allocating capital.
9. It seems like most of your holdings are large cap blue chips stocks. Going forward, are you planning to switch to more small cap and mid caps?
Pabrai said that most of his investments are not in large cap blue chips stocks. He would love them to convert to blue chips though. His approach is opportunistic because he is not pursuing after a specific asset class. It happens to be during the past year or so he has invested in a few blue chips, but that could change a year from now.
10. Two-part question. What's your thought on post-crisis ROE of banks? How do you incorporate macro into your investment analysis?
There are both headwinds and tailwinds for the banks. The tailwinds include less competition for big banks and technology advancement that cut labor cost. The headwind is higher capital requirement and stricter regulation, but he thinks that's good for the banks in the long run.
In general, you will always better off focusing on the micro than the macro. For example, there's a McDonald's close to his house, and he's fascinated by the efficiency of the drive through operation. If you look at that business, does an increase in the interest rate or unemployment rate impact that business as much as an opening of an In & Out next door? Obviously the latter has a larger impact.
11. What are your thoughts on activism? Do you follow any activist investors?
Pabrai said he's always been skeptical about the activist's impact on business. He thinks in general, activism is overrated. It's not easy to force changes in public companies. It's an acrimonious way to go through life. He will be much better off without being involved in activism. He does not follow any activist investors.
12. When you invested in Delta Financial, the sentiment for mortgage business was high, how do you balance investor enthusiasm with true value of the business?
Investing in Delta Financial is a straight stupid mistake, not sentiment driven. He basically made a basic mistake by not appropriately assessing the downside. You'll make errors all the time in this business. You have to focus on the specific of business, not the sentiment and macro.
13. Would you taper or not taper? What are your thoughts on Indian rupees?
Pabrai said, "So you ask me to be the Fed chair? Good thing I'm not." All jokes aside, he would be on the side of Bernanke. The fall of rupee is interesting. To some extent, he thinks it is an overdose to skepticism. But it doesn't matter what the rupee does. If you invest in India, you still want to focus on micro.
14. Questions on Japanese net-nets: Did you factor in the liquidity issue before your investment?
The net-net investments he made in Japan were not the absolute cheapest, and they are not very liquid. It took the funds a year to get in and another year to get out. The problem is, most net-net situations are with micro-cap and small-cap companies, and they are inherently not as liquid as large caps.
15. How did you get started in the investment management business?
Pabrai said prior to his launch of the partnership he had a few years of good returns with his money, and he was giving stock tips to his friends. His friends suggested him to start a partnership to make it more official. So Mohnishhe started the partnership with eight other friends' money. He was still running a business and a day job back then. To him, managing a million does not requirement too much extra work. When he set up the partnership, he wanted to set it up in the fairest way possible. He actually guaranteed the principle for his early investors, and he took it out later. If you are interested in creating an investment business, you should start by creating a track record that is audited so you can show it to your investors. If you beat the indices consistently, people will swim to you.
16. If you were to go back to when you started, what would be the things you advice to read? And if you don't look at the macro so much, how did you come up with these international investments.
Each person is different. But he found "Manual of Ideas" and "Corner of Berkshire and Fairfax" very helpful. There are other good resources out there, and it's better to copy others' ideas. Japanese net-net was his original idea, and we all know how it ended up [laughter].
17. At this time last year, Apple (AAPL, Financial) was going up everyday up to around $700, and someone during the meeting last year asked you if you would buy Apple. Why did you not buy Apple?
Apple is a fantastic business with an incredible franchise. What keeps him away from Apple is because it is in an industry with rapid changes. The second thing that dissuades him: Apple is a super large cap and you are not going to find 2x, 3x returns in large cap blue chips. You will find better opportunities in smaller caps.
18. Do you use options and futures? How do you make the decision, based on fundamental analysis or technical analysis because fundamental tells you what to buy and technical analysis tells you when to buy and when to sell?
Don't use options or futures. Makes decisions based on fundamentals only.
19. I was wondering in general, what is your take on Europe (especially the financials)?
In general, it is very likely that many opportunities exist in Europe. There are many opportunities out there, but he doesn't understand the country dynamics or the businesses. It may not be a bad place to start if the country is going through stress, especially European companies with revenues from all across the globe.
20. What is your thought process behind keeping your funds closed?
The funds are closed because he can't find anything to buy, and he thinks he has more capital than ideas. If that shifts sometimes in the future when he has more ideas than capital, he'll open up the fund. Furthermore, he has no incentives to increase the asset under management, unlike the other investment managers. The other thing he would prefer to do is to raise money at the right time. Historically when the funds got massive inflows and when the funds were performing well and had no inflows when the funds were performing poorly. He was desperate to raise capital back in late 2008 and early 2009 and was not successful. However, at the peak of 2007, investors were throwing money in. The less, be patient and be ready when opportunities arrive.
21. An investor who had invested in both Pabrai's fund (PIF) and Berkshire asked him if one had to invest in only one which one should he invest and why?(I didn't catch this questions but Gurufocus user Itzarjuna kindly shared his note).
Mohnish said it was good the investor had invested in both. He's glad he's not benchmarked against Berkshire (BRK.A)(BRK.B). Buffett has the disadvantage of size, but he should be able to beat the S&P 500. He hopes Buffett will do better.
22. What is your strategy in terms of picking out the ideas for further research when you go through the holdings of others? And how have you used the checklist to rule out ideas that can potentially turn out to be mistakes? If you had used the checklist, would you have invested in Delta Financials?
That's a good problem to have in the first place. You can trim the list by picking out the ones they have the highest convictions.
There are many examples that the checklist prevented him from investing in an idea but most of his ideas don't even get to the checklist phase. In the last 14 months, he has looked at many many things and for one thing or another, he turned them down. He also has conversation with other money managers and very often, during these conversations, the ideas are killed. The checklist is used to highlight the things that he has not thought about. If he had run the checklist, he wouldn't have bought Delta Financials.
23. Question on the checklist: Are you concerned that you may have raised the bar too high?
He doesn't think the checklist has raised the bar too high. Any companies he runs the checklist on will have some issues. The checklist is not too demanding. He's sure many many things that he passed on will end up doing well. The thing that usually stops him is the downside, which may never materialize. But that's the kind of things you should look at prior to making an investment decision.
24. What are your thoughts on selling? Does the rise or fall of interest rates change the discount rate you use?
Typically he sells at 90% of intrinsic value. The interest rate doesn't really affect the discount rate he uses. In general, a discount rate of 6% to 9% should be okay.
25. This question comes from an equity research analyst. Have you ever been tempted to short?
He said he has not been tempted to short at all. He thinks shorting can be a way to make money, but the timing is too tricky. You can be right, but it can take a long time to prove it. Also the maximum gain you can get is 100%, but the maximum loss is unlimited.
[b][/b]
