Tuesday, September 28, 2010

Pabrai Investment Funds Annual Meeting Notes

I attended the Pabrai Investment Funds annual meeting in Chicago last Saturday. Mohnish did a great job answering questions, as usual. I've been lucky enough to get to know Mohnish over the past few years. Mohnish is one of the best fund managers in the country. He is one of the most genuine people I know and like Buffett he is always enjoying his job and cracking jokes.

Here are my notes from the 2010 Pabrai Investment Funds Annual Meeting in Chicago:

Prepared Comments:

The meeting started with an overview of how the fund has performed. Since the fund was started in 2001, it has returned 15.1% annually compared to -1.5% for the S&P 500.

$100,000 invested in the fund in June of 2000 would be $408,000 today.

Mohnish’s goal is to beat the index by 3% annually.

This past summer 3 interns worked part time on the checklist 2.0. They identified mistakes by great investors that resulted in a permanent loss of capital and analyzed why the mistakes occurred. They looked for commentary by the fund managers on these mistakes. They found that these investors almost never discussed their mistakes.

The biggest mistake was an investment in AIG by the Davis Fund which resulted in a $2 billion loss for the fund.

Mohnish said that the checklist is a great weapon in the Pabrai Funds arsenal.

Mohnish then went through one winner and one loser in the portfolio.

The worst investment during the period was Ternium which was actually sold at a small gain.

The winner he discussed was Teck cominco. This is the best investment the fund has ever made. The Pabrai Funds made an 8x return in only 3 months. Mohnish invested because they have some of the lowest cost mines in the world. The reason they were so cheap was because of a liquidity mismatch on the balance sheet. It had a large amount of debt coming due in a year. Mohnish felt that if they weren’t able to refinance the debt that they could sell assets piecemeal because of their highly diversified operations. In the worse case, the company would be worth a lot even in reorganizations because its book value was so high.

Question and Answer:

How Long did you follow Teck Cominco before buying?

Mohnish said he spent less than 5 days researching Teck because there were so many bargains at this time. Teck had a very solid moat because it was the lowest cost producer. To find Teck he looked at industry cost curves and paid attention to the lowest cost producers. The most important question to figure out was the liquidity mismatch.

Thoughts on Fairfax?

He doesn’t discuss current holdings.

Why don’t you discuss current holdings?

If investors get in the habit of discussing their investments they may end up suffering from commitment bias. If they constantly talk about how great a company is, they may suffer from a bias that could impair their judgment.

What are your views on position sizing?

His allocation policy changed in 2008 to reflect slightly elevated investment risks of his investment baskets and prior mistakes. If he has 10% positions it’s very hard to recover from a mistake. He discussed his new allocation framework with Charlie Munger who disagreed at first. After Mohnish explained it further, Charlie agreed that Berkshire Hathaway has achieved success with a more diversified portfolio. Mohnish talked about basket bets. When the risk is slightly elevated he will buy a basket of companies with small weightings. For example, he said he is currently researching companies in Japan. If he ends up buying companies there, he will buy a basket of companies each with small weightings in the portfolio. He said stocks there are very cheap.

What attracts you to a business?

When he finds a company that looks interesting he starts by thinking as a skeptic. He looks for something that will prove him wrong. He looks for areas of extreme mispricing. It has to be very undervalued but he also has to be able to understand it. He thinks there may be value in Coke bottlers in Japan. The Nikkei has done nothing for 27 years.

Has the increasing size of the fund negatively affect performance?

The performance of the fund has not been affected by size or fund inflows. He said that the fund is sitting on a lot of undervalue assets.

Has the economic turmoil changed your model?

Mohnish said he has more of an appreciation for macro issues than he has in the past. He also said that some macro trends make sense to base investments on. But the majority of macros trends such as inflation and interest rates are very difficult to predict and he doesn’t make judgments on those.

What are your thoughts on the financial industry?

Understanding management is key. You want to look for competent and honest managers. Because of the high leverage, management cannot make any mistakes in reserving. Also, it’s very difficult for outsiders to understand reserving. He couldn’t understand Citibank.

How much time do you spend on the balance sheet of companies you invest in?

Before he invested in Teck Cominco he read the last 8 years of annual reports. He spends a lot of time on the balance sheet.

What’s your philosophy on timing buying and selling?

He expects to be wrong in the future on selling. He said its fine to sell to early. If a stock goes down after he buys it that’s fine as long as he is still right about intrinsic value and he has dry powder to invest.

What did you identify with the checklist project?

The mistakes were concentrated in 08-09 and included a lot of financials. A lot of the mistakes were similar so he just picked a few. He analyzed Longleaf’s investment in GM. Longleaf’s management discussed the GM thesis in its reports. The mistake they made was they missed the forest from the trees. They missed the big picture. They figured that because GM did so well in the truck market that that would carry them through. They missed the fact that gas prices would rise to $3. He also said that he greatly respects these managers but that it’s important to learn from them. Longleaf also made the mistake of looking at the wrong variables.

How do you know where the edge of your circle of competence is?

If you have to ask yourself that question when looking at a company, then it’s probably beyond your circle of competence. You have to be honest with yourself. In the case of the Japanese companies he is researching, he has no interest in American listed Japanese companies. He will use the basket approach to Japanese companies because of the unfamiliarity. He also said that these Japanese companies are extremely cheap.

A business owner in the audience said after analyzing his own mistakes he noticed many of his mistakes were repeated. He asked if Mohnish had made a mistake more than once and was susceptible to reoccurring mistakes in one area?

Chris Davis wrote about a mistake he made in 2002. He ended up making the same mistake again in 2008 with AIG. Buffett made the same mistake twice as well with the original Berkshire Hathaway purchased and later on, with the Dexter Shoe purchase. Leverage is a very important factor to consider. One item on the check list is whether or not he suffers from any personal biases. The checklist forces him to take a step back.

Do you see any bubbles today?

Bubbles are hard to spot. Real estate in certain parts of China is probably a bubble. There are many bubbles around all the time. He mentioned a book called Trendwatching.

What’s your philosophy on investing in foreign markets?

He said that investing in US and Canadian companies that are driven by Chinese factors would be of interest to him. It’s important to understand foreign growth. You have to watch out for bubbles. China and India have good prospects but there may be an overall bubble. He’s very reluctant to invest in China but he’s interested in benefiting from Chinese growth. He skips Chinese companies because of accounting.

What does he think about natural gas companies?

The industry may be subject to a disruptive shift because of technological changes. The low prices may be permanent but he has no idea. The only good way to invest would be at the bottom of the cost curve and he can’t find one. There is no choke point in natural gas unlike iron ore. Natural gas also has substitutes. Mohnish recommended the book, Rational Optimist. He talked about how cheap energy allows countries to create more fresh water which will allow more agriculture.

How do you prevent macro issues from blinding investments?

He’s learned to appreciate macro issues more than in the past. As an investor you can’t get a handle on all factors. So it makes sense to spread ideas out more. The micro factors trump the macro factors. The company has to be able to control its destiny. He looks for staying power so the company can withstand shocks.

This question came from an investor who has to pull out money for living expenses. He asked how he can get more visibility on what taxes will be?

Mohnish practices tax planning in the funds. He sells holdings between the funds to cancel capital gains. The statements sent to shareholders should give them a good idea what the expected tax rate will be. Mohnish is a big tax payer so he is very sensitive to tax issues.

Is your philosophy on portfolio allocation shifting more towards preserving wealth instead of growing it?

The Kelly Formula is only correct when making many bets. He always under bet the Kelly Formula. Since Mohnish is making few bets, the Kelly Formula doesn’t work. He never fully used the Kelly Formula because it would have told him to bet more heavily. Return of capital is more important than return on capital. If people redeem their money during down times that is permanently lost capital for those people.

Can you name some great companies that you’d love to own at the right price?

Ikea, In and Out Burger, Costco, the low cost mines owned by BHP and Rio Tinto. Great companies are all over the place across the world. There are great companies in India and China but and ownership issues exists over there. Pricing is also an issue. Ben Graham’s approach was to go to the store and buy what was on sale and Charlie Munger’s approach is to go to the store and wait for quality items to go on sale. He likes Charlie’s framework.

What extra work do you do to analyze financials?

He’s reluctant to own most financials. They do own Goldman Sachs. He’s read two books on Goldman. It’s a great business. He doesn’t have a problem with management ethos but it’s improving. It’s a very complex business. They have the potential to grow huge overseas because they have few offices overseas right now. Since it has opaque parts to its business he made it a basket bet.

Does checklist address good portfolio strategies?

No. The checklist deals with analyzing companies. Mohnish recommended that this person read the fundamental value investing books. Mohnish always tries to learn from others.

Would you be more interested in a more certain intrinsic value or a cheaper price?

Currently the fund holds a lot of cash as there is less cash in the fund he demands higher discounts for new investments. I wasn’t able to too write down most of his answer.

What’s your average cash level since 1999?

In a crisis, cash plus courage is priceless. Next times a crisis strikes, he wants more cash. Instead of jumping from his second best to his best idea he instead lets investments play out and clings to ideas instead of jumping around.

How does Mohnish spend his free time?

He does plenty of other things. He has a daily nap, plays racquetball and plays bridge.