Why Ask Me? Ask Mohnish.

October 1, 2007 by Joe Ponzio

I went to the Pabrai Funds annual meeting on Saturday, armed with some of your questions. It is often good to bounce ideas and questions off other business investors, and you can’t argue this Buffett disciple’s 30+% average annual return for the last eight years. Mohnish Pabrai-manager of a $600 million hedge fund, lunch guest of Warren Buffett, business investor, and generally nice (and accessible) guy.

Here’s what he had to say.

Sphere Of Competence

James asked:

“How do you know your sphere of competence?” From my limited experience, what you think you know about a business as a consumer or simply a student of business is far different than really understanding the business.

I asked Mohnish why he feels comfortable investing in steel manufacturers, oil refineries and car seat manufacturers, but not in Google, corn and gold. His response was the same I would have given James.

Look for simple businesses in slow-changing industries. Mohnish doesn’t pretend to understand the daily operations of a car seat manufacturer; still, he can rip apart the annual reports and uncover that Lear is a leader and that its business is generally independent of the cyclical nature of the auto manufacturing business.

Look for opportunities that jump out at you, and then try to learn the business. You don’t need to know everything there is to know about an industry or business. Instead, see if you can figure out the companies strengths and weaknesses. Admittedly, I don’t pretend to know the intricate details of how Johnson & Johnson, Wal-Mart, or Coca-Cola work; still, they’re simple. And with a little digging into their annual reports, they’re generally understandable.

In the end, Mohnish, you and I all have difference spheres-and they seem to be wired into us (and you). Still, straight-forward businesses in slow-changing industries are much easier to value than complex businesses in rapidly changing fields. Take a look at those, keeping in mind what matters in business, and you’ll find that you’ll understand a ton of businesses you originally knew nothing about.

Buy-and-hold Vs. Activity

AF posted:

If the stock is severely overpriced, you should sell it and buy when drops back to a reasonable price (as long as the fundamental business hasn’t changed).

Mohnish commented on the gross difference between today’s Buffett and the Buffett of the early partnerships. In the early days, Buffett was much more active in trading securities. Why? His asset base allowed him to do so. It is easy to dance in and out of positions when you are managing $1 million or $100 million. In the early days, Buffett had more ideas than cash.

Today, the situation is reversed-Buffett now has more cash than ideas. A $1 million investment has such a small impact on the Berkshire portfolio that it doesn’t make sense to him.

Should you sell when the company is overpriced? That depends on your goal. If you want to invest for the long-term and achieve moderate returns above the markets (e.g., your 15% vs. 11% for the S&P 500), you can buy and hold. If you want to crush the markets on a long-term basis, you’ll likely need to find $0.50 dollars and sell them when they are worth $0.90. Then, go find more $0.50 dollars.

One strategy is not better than the other. The question is: How hard do you want to work to achieve high returns? The harder you work, the higher your potential returns. Answer that, and you’ll know what to do.

Discounted Cash Flow

Mohnish and I (and Buffett) agree-the value of a business is the discounted amount of cash that can be taken out of a business during its remaining life. Sometimes that comes in the form of future owner earnings; sometimes it comes in the form of assets. It depends on the situation.

One example of this is Pabrai’s past holding-Tesoro Corporation. Here’s a company that went from $7 to $0.80 to $46 in five years. He bought around $4.50 and sold (for a loss) around $3. A year later, the company was trading for 4 times what he had paid.

Tesoro at $5 was one of those no-brainer asset plays. Looking at the company’s 2001 financials, you would see that Tesoro could have been broken up for roughly $16-$17 a share. It was trading at less than half of that. But Tesoro wouldn’t be broken up-at least it wasn’t likely. Instead, Pabrai realized the value of the business was at least the value of its assets, and possibly any cash that it might be able to generate.

(He jokingly lamented having sold Tesoro for a loss when he could have been slightly more patient and had a huge gain.)

What Books Do I Recommend?

I’ll do a full Strategy Review on Pabrai’s book, but you have to add The Dhandho Investor to your shelf. You won’t get his exact method for every investment ever made; still, you’ll get insight and it is a must read for business investors.

More Gems To Come

As I am getting long winded, I’ll cut it short and continue tomorrow. As an aside, the event was wonderful. There were about 200 people in total. We had an hour long meet-and-greet where Mohnish floated around the room and talked with people (and had to constantly re-answer the question, “What do you think about [this stock, gold, real estate, etc.]?”

After the meet-and-greet, we sat in an auditorium where he discussed some past performance and investments for about 20 minutes, and then opened it up for an hour of Q&A. After the Q&A, there was a cocktail hour followed by dinner (which I missed).

All-in-all, I was honored to be invited and had a great time.

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