Note: This book review was originally published in the March 2015 edition of our premium newsletter Value Investing Almanack. To know more and subscribe, please click here.
I am sure the author of this book needs no introduction, but for the benefit of people who don’t know much about him, I am going to start with an interesting trivia.
How much would you pay to have lunch with Warren Buffett? How about Rs 4 crore?
Don’t be surprised because that’s the amount Mohnish Pabrai (along with his friend Guy Spier) paid to have a private lunch with Warren Buffett in 2006.
Mohnish manages US$ 850+ million US based fund called Pabrai Funds and is a hardcore Buffett disciple. He has written another popular book called The Dhandho Investor. However, the book I am talking about here is a rare one.
Mohnish has built 3 successful businesses in the last 25 years, including a technology company, a Buffett style hedge fund and a very successful philanthropic organization called Dakshana Foundation, which educates talented underprivileged children to qualify for IITs. With this kind of experience, I am sure he has some interesting insights for us.
Mosaic – Perspectives on Investing is a collection of 26 essays that Mohnish published between 2001 and 2004. I find his ideas very simple to understand and he has a knack of making the art of value investing look simple. He is a natural story teller. Let’s take a look at few selected ideas from the book.
1. Don’t Lose Money
The heart of value investing, as described by Warren Buffett, is minimizing the downside risk. Mohnish writes in his book –
Even the most seemingly resilient businesses, by their very nature, are extremely fragile…there isn’t a single business on the planet whose future is assured…Whenever I look at any investment opportunity, I first focus upon what factors may cause the investment to result in a significant permanent loss of capital…the usual suspects – war, terrorism, fraudulent financial statements, dishonest management, disruptive innovation, etc.
He then provides ballpark figures for the likelihood of some of these factors, e.g. the probability of war or terrorism affecting your investment is less than 1%. Similarly, after having done your due diligence about management quality, the probability of discovering an accounting fraud or dishonest management is again less than 1%.
2. Steer Clear of the Short Side
In investing and in life, you would do far better if you knew what to avoid. Says who? Charlie Munger. And being a Munger fan, Mohnish too doesn’t hesitate in telling you what to avoid. He declares –
Odds are very high that I’ll go to my grave without ever having shorted a stock. My quality of life would go down dramatically if I were forced to watch every wiggle in the market.
Mohnish has strong reasons to avoid shorting. Theoretically, when you short sell a stock, your best case (upside) is 100% return but the worst case (downside) is potentially unlimited. Even if you strongly feel that a company is highly overpriced, you can’t predict when the market will realize the correct price. Here, I am reminded of the following words of wisdom attributed to the economist John Maynard Keynes – “The market can remain irrational longer than you can remain solvent.”
3. Business of Investing
Having run a technology services business as CEO, when Mohnish came into the profession of managing money, his experience as a value investor confirmed Warren Buffett’s quote –
I am a better investor because I am a businessman, and I am a better businessman because I am an investor.
As a CEO you are aware that it’s futile to predict the earnings too far into the future, and as an investor you learn to deal with the uncertainty by building margin of safety.
4. Death and Taxes are Certain
I hope you aren’t thinking that this is another book full of typical value investing style ideas and rehashing of Buffett’s quotes. Because if you are then let me surprise you. Mohnish does mention quite a few specific business ideas.
One of the interesting ideas I found in the book was on the discussion about “corporate death care” businesses. Mohnish calls them low risk, high return businesses. These are the businesses which specialize in purchasing and marketing inventory from various distressed situations like bankruptcy, buybacks etc. Mohnish figured –
…as you look at various businesses to invest in, take a hard look at businesses that are involved in the burial of the million-odd companies that go out of business each year…Death and taxes are for sure. And it’s always good to make bets that are for sure.
5. Danger of Buying the Biggest
According to Mohnish, large businesses have their own upper limit to which they can grow. He says that one would be best off never making an investment in any business that is considered a blue chip. These businesses are very unlikely to be able to endlessly grow cash flow.
This reminds me of one of the mental models that come from biology. The size of biggest mammal on land/water is determined by a simple idea of heat loss. When size of an organism grows, its volume grows faster than the surface area and there comes a point where the heat generated by the body (which is proportionate to volume) cannot be dissipated by the available surface area (which is proportionate to heat loss). That’s one of the reasons why the biggest mammal on land i.e., elephant is smaller than the biggest mammal in water which is whale, since heat loss is faster in water, whale can afford more volume per unit of surface area.
6. Decoding a Company’s DNA
The next topic that Mohnish touches upon is the qualitative aspect of a business. He writes –
From an investment perspective, a lot of useful information can be gained from decoding [the] genetic blueprint [of the company] and understanding what transpired during the very early stage of a given business. If you’re able to decode, you can extrapolate business performance far into the future.
E.g. Microsoft as a company is good at cloning ideas instead of innovating, unlike Apple which is an innovation factory.
Similarly it helps to understand the personality of the CEO. Mohnish adds –
A very gainful exercise for the investor would be to characterize the personality traits of the CEO before making an investment, If you can buy a great business well below its intrinsic value and it’s run by a very low ego, totally truthful, high capability CEO who is deeply in love with his business, back up the truck. Otherwise, keep on driving.
7. Activity Vs Performance
Warren Buffett said in his 1998 annual meeting –
We don’t get paid for activity, just for being right. As to how long we’ll wait, we’ll wait indefinitely.
It shows the absolute necessity for proper temperament and patience in investing rather than acting. Mohnish’s experience is not much different from Buffett’s. He writes –
Compared to nearly any other discipline, I find that fund management is, in many respects, a bizarre field – where hard work and intellect don’t necessarily lead to satisfactory results.
8. Dhandho is Moat
What Buffett calls “moat” and Harvard strategist Michael Porter describes as “sustainable competitive advantage”, Mohnish calls “dhandho” (Gujarati word that literally means endeavours that create wealth).
What should you look for when you are analysing a business? This is what Mohnish writes –
It should be painfully clear how a business generates cash today, how much it is likely to continue to generate into the future and how much you’re paying for that future cash flow. Think about the width and depth of the moat. Think about the knight in charge of the castle.
9. Multidisciplinary Learning
Being a Munger disciple how can Mohnish not talk about latticework? He writes –
The best part about investing is that one can never reach a plateau where the learning stops. It is one of the broadest of all disciplines where all knowledge has a cumulative effect and essentially nothing is wasted…if one continues to delve into a diverse range of disciplines, the latticework of mental models only gets richer.
Mohnish extensively referred the book “Latticework” (we reviewed this book in the Feb. 2015 issue of Value Investing Almanack) for this chapter.
10. Back of the Envelop Calculations
A simple back of the envelop calculation can give a quick idea about the intrinsic value of a company. It could be as simple as 10 year FCF (free cash flow) discounted to present added to the terminal value (10 times of FCF). You don’t need fancy excel macros and complicated formulae to arrive at accurate value of a stock. This is what Buffett says about valuation –
I only get into situations where I know the value. There are thousands of companies whose value I don’t know. But I know the ones that I know. And incidentally, you don’t pinpoint things. If somebody walks in this door and they weigh between 300 and 350 pounds, I don’t need to say they weigh 327 to say that they’re fat.
Or quoting John Maynard Keynes again – “It is better to be roughly right than precisely wrong.”
Of course DCF shouldn’t be the only tool to arrive at valuation. It’s just one of the ways to get an approximate idea about the ‘range of intrinsic values’.
How do you avoid being taken on a ride by accounting gimmicks? Mohnish lists some red flags that you should look for in company financials.
For instance, he writes that if the reported earnings are increasing very consistently without any strong recurring revenue, then it could be a sign of manipulation. And then, when management of a non-predictable business confidently offers an earning guidance, it’s a red flag.
While reading the annual report one should pay close attention to the “related party transaction” section. Try to get feel about management’s attitude by reading the description of business, or how the management deals with Q&A in shareholder meetings and calls.
12. Risk Vs Uncertainty
Markets often get confused between risk and uncertainty. The combination of low risk, high uncertainty and high return possibility at the same time in the same company makes for some very satisfying investing returns.
This confusion between risk and uncertainty can be attributed to “Ambiguity Aversion Bias”, which states that we favour known probabilities over unknown ones. A risk is a known probability, and uncertainty is unknown probability. You can do calculations with risk but not with probabilities.
13. Mutual Funds Vs Stocks
Conventional wisdom says that one needs to concentrate one’s investment when amassing wealth and diversify when preserving wealth. Five out of six mutual funds lag the indices over time. Any portfolio with hundreds of stocks has a very high probability of underperforming the market and infinitesimal probability of outperforming it.
Buffett rarely invested less than 5-10% of his asset value in stocks whenever he made a new investment. Charlie Munger suggests max 3-4 stocks for a stellar portfolio.
There are more such ideas discussed at length in this book including an interesting DCF analysis of Infosys (mind you it was 2001 when this book was written, right after the dot com crash).
There aren’t many people in the hedge fund industry who can match Mohnish Pabrai’s experience as a successful entrepreneur and astute investor.