Being able to say "no" is one of the most valuable tools any investor can have.
In a Q&A session with students at the London Business School in mid-June, Mohnish Pabrai (Trades, Portfolio) explained that his investment process is driven by his desire to rule out potential investments as fast as possible.
Saying no as fast as possible
In the lecture, the value investor explained that his model is based not around a desire to find as many investments as possible, but rather to find the flimsiest reason to reject an investment idea.
He went on to explain that he has two criteria he applies to every investment opportunity when it first comes onto his radar — the circle of competence and valuation.
If the stock does not meet either, it is quickly disregarded. Pabrai reckons it takes him as little as 60 seconds to toss out ideas using this checklist.
A "bunch of filters"
At the 1997 Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial) annual meeting of shareholders, Buffett explained that over the years, he had developed a "bunch of filters" in his mind to help him quickly assess and toss out businesses. Specifically, he explained to the audience:
"Then we have a bunch of filters we've developed in our minds over time. We don't say they're perfect filters. We don't say that those filters don't occasionally leave things out that should get through. But they're very — they're efficient."
The Oracle of Omaha went on to explain that that's why he did not have a handle on every single business in the world. Of those businesses that he did understand, he knew about as much as there was to know without actually being part of the business. "The ones we're capable of understanding, we've probably gotten about as far as we'll get already. So we do know in five minutes," he explained.
This is all part of Buffett's aim to streamline his process and make it as straightforward as possible to highlight the best investment ideas.
He went on to say that he was not interested in studies or consultants that tell the client what they wanted to hear. "But we do care about being right about the economic characteristics of the business, and that's one thing we think we've got certain filters that tell us in certain cases that we know enough to assess."
Concentrate your ideas
Buffett and his right-hand man, Charlie Munger (Trades, Portfolio), believe that it is a waste of time trying to understand as many companies as possible. Instead, the duo believes that the best approach for investors is to concentrate on their best ideas, as well as the companies, sectors and industries that they know and understand the best, where the chances of making a mistake are relatively low.
This runs in the face of conventional investment theory, which suggests that investors should use diversified portfolios to minimize risk. However, while you might be able to reduce risk by using a diversified portfolio, there's also a good chance you will reduce returns as well by investing in companies and ideas you don't understand. As Munger explained in 1997:
"I've got nothing to add to that, except that people underrate the importance of a few simple big ideas. And I think that to the extent Berkshire Hathaway is a didactic enterprise teaching the right systems of thought, I think that the chief lessons are that a few big ideas really work, as I think these filters of ours have worked pretty well. Because they're so simple."
All in all, it doesn't make sense to invest in any stock you don't understand, and it is best to try and disregard the idea as soon as possible before you talk yourself into buying it. Pabrai and Buffett both have a process for doing this, and it could be worth following their lead.
Disclosure: The author owns shares in Berkshire Hathaway.
Read more here:
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- Mohnish Pabrai Boosts Holding of Deep-Value Investment in 3rd Quarter
- TCI Fund Bulks Up on Alphabet in 3rd Quarter
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