Investing strategy; Tech and cloning

Mohnish Pabrai is used to making investment pilgrimages. The ace investor is a regular at Warren Buffett’s annual Berkshire Hathaway meeting as well as at the Value Investing Congress that is held every year in New York. His cloning strategy, which almost anyone can implement but not many do, has made Pabrai a multi-millionaire many times over.

What prompted you to get into investing? You were a techie and then you had your own business before you became an investor.

I was an entrepreneur and I really enjoyed running my business. What happens is that as an entrepreneur perhaps 3-5% of your time goes in figuring out your strategy and direction and what you want to do; 90-95% of your time goes in the heavy lifting of your execution, getting after people and motivating them, and getting all your structures in place. I definitely enjoyed the 5% more than the 95% — getting things right in terms of direction is much more interesting. When I first encountered investing and Warren Buffett, it was as if in investing, that 5% increased to 80%. That is what I enjoy so much about investing.

Buffett says, “I am a better investor because I am a businessman and I am a better businessman because I am a better investor.” You need the same skills in investing as when you are an entrepreneur. The good news in investing is there are no HR problems. If there are no humans, there are no problems! And, you get massive leverage on your time, on your thoughts. Your brain cells can effectively be leveraged almost infinitely, almost as if I have huge amounts of capital. People want to pay for thoughts and I can give them some thoughts.

Despite starting off as a techie, you haven’t invested in technology at all. Why is that?

I don’t invest in technology stocks because I understand it. Basically, Buffett would say that he doesn’t invest in tech businesses because they are subject to change. Industries with rapid change are the enemy of the investor. Tech businesses, particularly biotech, is a problem from that point of view. All industries work with change but you should ideally be investing in businesses with a low rate of change, not a high rate of change.

What lessons did you learn as an entrepreneur and by spending time with your father?

When we buy distress bonds, most of my time is spent on why it will not work, not on why it will work

I think the human brain goes through two periods of very rapid change: the first, in the first five years of life and the other is during teenage. There are scientific studies that have proven that the experiences you have during your teenage have a lasting impact on you. Luckily for me, this was a period of great learning. I was lucky that my father ran a whole bunch of businesses, started, grew and bankrupted them. Many of these businesses were very highly leveraged. My father was always optimistic and he was maximising leverage on the businesses. But they would blow up because there was no stability in them. From the age of 12 or 13, my brother and I were like the board of directors. He and I would sit down, looking at details of cash flows, trying to figure out how to get past the next day, just one day, every single day. On many occasions when my father travelled, my brother and I actually ran the company. Sometimes we dealt with the staff. I didn’t realise it then, but when I started to work and talked to a lot of people, I realised that I had finished many MBAs before the age of 18. So that period with my dad helped me crack business models much faster than others of my age who were much smarter than me. I was lucky in that regard. That experience was also useful in starting my own business and it is extremely useful now in what I do.

What are the investing mistakes that you have made and what did you learn from them?

Mistakes are the best teachers. One does not learn from success. It is desirable to learn vicariously from other people’s failures, but it gets much more firmly seared in when they are your own. I can give you a couple of examples of permanent losses of capital and my critical learning from those mistakes. One is Sears Holdings. I made this investment because the vast real estate and brand assets of this company are worth multiples of the stock price. But I learnt that those are virtually impossible to monetise because one would need to liquidate the business and lay off tens of thousands of workers. That is gut-wrenching and highly unlikely.

When you stare at losses, how do deal with it at an emotional level?

Actually, my funds were down from peak to bottom 65% or so. But my wife mentioned to me that she didn’t realise the funds were down that much because throughout that period, she saw no change in my behaviour pattern or my sleep pattern or anything like that. You have to keep things in context. There is a famous quote: if wealth is lost, nothing is lost. If health is lost, something is lost and if character is lost, everything is lost.

We don’t believe in inheritance and we intend to pretty much give away everything we have. But I would be deeply concerned if I lost money for people who entrusted it to me. That was one of my biggest concerns while setting up the funds. But now my family is the second-largest investor in the funds and if the funds go down, we suffer more than anyone else. I am pretty much eating my own cooking.

The other important thing is I am not bouncing up and down with stock prices. I don’t even know what the markets or my stock did today. All of that is just irrelevant.

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How do you avoid a value trap? in 2008, some of the US financials looked like value buys but turned out to be traps...

There is no such thing as a value trap. There are investing mistakes. If you bought financials in 2008 and lost money, you lost money for a very good reason. Basically, the books had liabilities that unfolded, which were not in the projections; they were not in your analysis. John Templeton used to say that there is no investment manager who is going to be right more than two times out of three. Even if you look at Buffett, Berkshire Hathaway owns 80 companies. If you look at each of the 80 buy decisions, which are independent decisions, at least 40% of them have not met his expectations. They are perhaps an outright loss of capital or they are producing such poor returns that it was a mistake. If you look at it from the point of view of dollar weighted, probably 90% of them have been good decisions. But if you look at each of the 80 decisions as each being equal weighted, the error rate exceeds the one-third that Templeton talks about. There are other mistakes like mistakes of omission where we should have bought something and we didn’t. We sell something, it goes up in price. What we buy doesn’t go up in price as much. These are all mistakes.

The good news is that, unlike brain surgery, we can be wrong 40% of the time and still do fine. I think from that point of view investing is a great business. The second thing is that investing mistakes are part of the landscape.

You invest in distressed bonds. How do you decide which ones to buy?

The bonds we buy aren’t your grandmother’s bonds! Typically we have bought level-3 bonds. We bought into a telecom company and did not pay more than 40 cents for a dollar. Generally, when we buy bonds they tend to have equity-like characteristics. Sometimes it is better to be on the debt side because you get more protection and still have an upside. Most of my time is spent on why will this idea not work, not on why it will work. I will look very hard at what will kill this company. That is what I get paid for.

Do you also look for the same quality of moat that Buffett professes?

Both of us would prefer something that can grow for a long time. You are always better off buying a business that has a lot of future growth in it because you can hold it for a long time. There are no taxes. He will always be willing to do opportunistic trades when he gets the chance. For example, Goldman Sachs came to him during the financial crisis. And he gave them money at 10% interest and any time they wanted to pay off the loan, they had to pay off another 10%. That was a short term trade for him in the sense that he knew that the moment Goldman got back to health they would want to pay that money back, and they did. It was the same with GE when he gave them money. So there are many investments Buffett makes that by their very nature might not last more than a year or two or three. There are plenty of other investments he makes that may last for 10 years or more.

How successful will a cloning investment strategy be, going forward? Which investors apart from Buffett would you like to clone or follow closely?

Cloning to me is the best and the most amazing strategy. The investors that I closely follow include Baupost, Longleaf Partners, Greenlight Capital, Pershing Square, Third Avenue and Fairfax Holdings.