Ten or Twenty for Pabrais Portfolio?

Yesterday I argued that Mohnish Pabrai’s recent decision to invest Fund assets in twenty 5% positions rather than ten 10% positions runs contrary to his investors’ interest. And the more I think about this altered strategy, the more convicted I become that it’s wrong. Permit me then to grapple with some of the main lines of defense for Pabrai’s position:

Defense #1 (the paternalistic defense): Investors get scared when positions move substantially lower, and then redeem their funds. It is in the investors’ interest to avoid or assuage such fear, so twenty portfolio positions will alleviate violent downdrafts and encourage more rational investor behavior.

Response: If we assume that Pabrai’s best idea is substantially better than his twentieth-best idea, then future returns will likely be lessened by this paternalistic action. Though it is in the investors’ long-term interest to remain committed despite short-term losses, their irrational behavior shouldn’t bother the manager much (so long as he isn’t levered and forced to liquidate the Fund at market bottoms). Thus, we have an apparent trade-off; either the investor endures market volatility and gets higher returns, or the investor takes less volatility and lower returns. The investors’ long-term interests are clearly best served in the former approach, and the fund manager seems better served in the latter. Keeping invested funds high keeps management fees high through bear markets.

Defense #2 (the “no big deal” defense): Even if this strategy shift trades performance for temperance, future returns won’t sag much. The twentieth-best idea is still a worthy idea.

Response: In the early stages of a secular bull market, one’s twentieth best idea will likely do fine. Cast aside the swim trunks and jump in! But over a three to five year period, it is fair to say that number 20 will lag number 1 by a couple of percentage points per year. In isolation, losing a few points of return is no thing, but compounded over a decade, such a drag will significantly affect one’s overall performance. Also, any additional time spent working on ideas 11-20 will likely detract one’s attention from future opportunities.

Defense #3 (the “diversification lowers risk” defense): Giving up some performance is acceptable because greater diversification entails less risk.

Response: This strikes me as plainly false. The best investment idea is the one with the best prospects and the greatest margin of safety. To diversify capital from one’s best idea to one’s merely ‘good’ ideas means accepting a smaller margin of safety, and in no way can that strategy be less risky. The only way diversification is less risky is if one fears that his inner psyche will compel him to sell his best idea if it declines the overall portfolio too much. In that case, diversification serves more as a psychic crutch rather than a risk-management tool.

Defense #4: (the “loss mitigation” defense) Diversifying fund assets into twenty positions means any mistakes will impact the portfolio returns less.

Response: Though the point is accurate, the other side of the coin is that future successes will also impact portfolio returns less. For managers like Pabrai, future successes will far outnumber mistakes, especially given Pabrai’s method of betting when he can’t lose much. Even when faced with a handful of mistakes, one has to discern whether they signify that his approach is broken, or his fortune briefly turned. If only the latter, mistakes should not consume one’s virtue.

Pabrai, Position Sizes, and Volatility

Equity investors endured some quick sledding in 2008, with the S&P 500 down over 39%. Though the hill was even more icy in 1931 (with the S&P down over 43%), this historic drop has left its mark on both the portfolios and investing habits of even the best investors.

Mohnish Pabrai, managing partner of Pabrai Investment Funds and author of The Dhandho Investor . is one such marked man. In his January letter to investors. Pabrai relayed that he was changing the size of his portfolio positions due to recent market foibles. In the past, Pabrai had sought to put 10% of a Fund’s assets into 10 investments. In practice, this was difficult to achieve, as market prices would move higher before the position was filled, some investments were too illiquid or thinly traded, or the market capitalizations of the target company were too small. Most often the Funds held 80% of their assets in 10 positions, with the remaining 20% invested in a handful of smaller positions. This strategy of concentration has served Pabrai well, and it coheres with the advice of his mentors Buffett and Munger, who counsel professionals to concentrate their investment portfolios.

However, Pabrai has now decided to size his normal positions at 5% of a Fund’s total assets. Strongly correlated positions will only warrant 2% of the portfolio, to prevent sector weakness from inordinately depressing annual results. In the rare case, perhaps every couple of years, Pabrai will size a position at 10%, but only “if seven moons line up.”

This is a significant change for a successful investor to make, and it contradicts the specific advice of two of his esteemed mentors, Buffett and Munger. And the primary reason for the change is “to temper volatility.”

At the risk of sounding disrespectful, I say turkey feathers (or choose your own animal excrement). As Pabrai himself acknowledges, this change will lower future returns for the Funds, though he assures that “we’ve given up a modest amount of the upside to gain a meaningful drop in volatility going forward.” Despite reassurances, the change runs directly contrary to his long-term investors’ interests. As Pabrai knows, volatility is a statistical device, and not a reliable proxy for risk. Volatility is the effect of Mr. Market’s manic-depressive behavior. Volatility is the intelligent investor’s best friend, for without volatility (particularly the depressive side of it), bargains would be less cheap.

The truth of the matter is that Pabrai has opted to allocate some funds from his best ten ideas to his second best ten ideas, in order to moderate the effect of any “mistakes” on his overall returns. This “solution” strikes me as far worse than volatility or mistakes. Even worse it suggests that Pabrai no longer fully appreciates the difference between his best idea and his twentieth best idea.

The Dhandho Investor Review

Mohnish Pabrai begins his The Dhandho Investor: The Low-Risk Value Method to High Returns (Wiley, 2007) with a stunning observation: “one in five hundred Americans is a Patel… [but] over half of all the motels in the entire country are owned and operated by Patels” (1). For those less worldly, Patels are from a tiny area in Southern Gujarat, which resides in the Indian state of Gujarat, the birthplace of Mahatma Gandhi. Having only started arriving in the United States as refugees in the early 1970s, Patels today own over $40 billion in motel assets. How was this quick concentration of wealth possible? Dhandho.

“Dhandho” is a Gujarati word that, most literally, means “endeavors that create wealth.” But more specifically, Pabrai observes that Dhandho is the pursuit of wealth in low risk, high return business opportunities. Pabrai’s father was an early practitioner of the Dhandho way, when, in 1973, he staked all his savings and some borrowed money on a 20 room motel. According to Pabrai’s calculations, if his father failed, he would only be out his original stake of $5000; if he succeeded, he would have an investment whose net present value was worth $93,400. And the odds of success Pabrai puts at 90%. This is pure Dhandhothe no-brainer bet that all investors seek, “Heads, I win; tails, I don’t lose much” (12).

Pabrai uses this Dhandho way in managing his Pabrai Investment Funds. That means, more specifically, that he seeks simple businesses, with durable competitive advantages, in industries with an ultra-slow rate of change, often in situations of temporary distress. When Pabrai finds such businesses, he bets heavily, so long as the odds are favorable, and the price falls significantly below the business’ intrinsic value. Such investments offer low risks and high returns—investing the Dhandho way.

Given our interests at Wide Moat Investing, I found Pabrai’s discussion of durable economic moats fairly brief. Noting that few moats are permanently durable, Pabrai highlights Charlie Munger’s observation that “of the fifty most important stocks on the NYSE in 1911, today only one, General Electric, remains in business… That’s how powerful the forces of competitive destruction are. Over the very long term, history shows that the chances of any business surviving in a manner agreeable to a company’s owners are slim at best” (68). Building from this observation, Pabrai concludes that “even such invincible businesses like eBay, Google, Microsoft, Toyota, and American Express will all eventually decline and disappear” (68). Capitalism’s competitive destruction compels Pabrai to never calculate a discounted cash flow stream for longer than 10 years, nor expect the sale of a business ten years hence at more than fifteen times cash flows (69). Though businesses like Chipotle, Coca-Cola, H&R Block, BMW, Harley Davidson, WD-40, and Tesoro have wide economic moats and durable competitive advantages today, the Dhandho investor is unwilling to make investments based on the projection that they will be even wider or more durable in the future.

All told, The Dhandho Investor was a quick, enjoyable read that succinctly describes Pabrai’s nine investing principles, as well as a few successful Dhandho investments (Servicemaster, Level 3 convertible bonds, and Frontline). While Pabrai spends less time analyzing successful businesses than we might like, he does well to habituate his reader into seeing potential investments probabilistically.