Is Mohnish Pabrai the Real Deal?

He has been billed as the “new Warren Buffett” but is this justified?

Mohnish Pabrai first came to my attention in 2007 when he was the successful bidder in an online charity auction the prize for which was lunch with Warren Buffett.

Pabrai is a smart guy and he knew that his lunch with Buffett would achieve at least three things.

Firstly, he got to spend some time with his hero. Secondly, the media attention he attracted would have resulted in increased sales of his second book, The Dhandho Investor (which had been conveniently released shortly before the successful online auction bid). Thirdly, the media attention would also have resulted in an increase in funds inflows to Pabrai Investment Funds. Talk about hitting multiple birds with a single stone!

Before founding Pabrai Investment Funds in 1999, Mohnish Pabrai had founded a company called TransTech. His $30,000 investment in this company was turned into $4.5m in approximately 10 years. That’s impressive, but TransTech was an IT firm and had nothing to do with investing in the stock market.

From 1999 to 2007 Pabrai Investment Funds returned 28% per annum (after fees). This was a great start. I don’t know what the return for 2008 will be, but it’s safe to say that it will be far lower than 28%.

Pabrai Investment Funds was modelled on Warren Buffett’s original 1956-1969 “Buffett Partnership”.

In his book, The Dhandho Investor, Pabrai enunciates nine core principles of his investment framework. (I recommend that you read the book if you haven’t already, you will enjoy it). I have no issue with seven of these principles, but I will take issue with two of them.

Buy Distressed Businesses in Distressed Industries

Pabrai’s idea here is to pick up shares in companies at far below their true worth due to temporary distress in the business and the sector in which the business operates.

This piece of advice from Pabrai is, (in my opinion), terrible advice. Why? Because the vast majority of distressed businesses in distressed industries are going to eventually collapse. The average investor would simply be unable to determine which distressed businesses are going to survive and as such, they would be taking an enormous gamble if they were to try this for themselves.

As an example, lots of people (including those who should have known better) thought that companies like Babcock & Brown, Allco and Centro were very cheap after their initial share price collapses – none of them were, they were all doomed to fail. Unless you have inside information (and it would be illegal to trade on that anyway), Pabrai’s advice is for speculators not investors.

Pabrai also contradicts himself in that he states that investors should buy distressed businesses in distressed industries and also advocates that investors invest in businesses with “durable moats”. The two principles are not compatible. Businesses with genuinely durable moats (i.e. dominant businesses with significant barriers to entry) will not find themselves in a “distressed” situation, that is to say facing bankruptcy and the like.

Bet heavily when the odds are overwhelmingly in your favour

Once again, for the average investor who doesn’t have the superb analytical abilities of a Warren Buffett, this is very bad advice.

In stock market investing, diversification is the only easy thing that an investor can do to gain an advantage (through the protection that adequate diversification offers). All the other things that a successful investor needs to do are much more difficult and require very sound judgement forged from years of experience.

I don’t advocate extreme diversification (as practised by many fund managers) but no diversification or inadequate diversification is a recipe for disaster unless you think that your analytical abilities are on a par with the likes of Warren Buffett!

Unless you have inside information, you will never know for sure that the “odds are overwhelmingly in your favour”. You can know that your chances of success are better than your chances of failure, but it’s very difficult to accurately quantify your likely chances of success – is it 90%, or 75% or 60%?

If you take Pabrai’s advice and place a significant amount of your portfolio in an investment that you assessed as having a 90% chance of success and in reality that investment only had a 55% chance of success, you could wipe out a significant part of your portfolio very easily. It’s just bad advice.

I also feel that Pabrai held quite a bit back in The Dhandho Investor. He just gave us a very brief overview of what he does – the book lacks sufficient detail.

The discounted cash flow valuation (DCF) that Pabrai and many others advocate is flawed unless of course you know with a high degree of accuracy how much a company will earn in the coming years. (Anyone who thinks they can do that can drop me a line – I’ve never known or seen anyone that can do it with accuracy). This will be the subject of a separate post.

So what do we make of Pabrai?

He is a smart guy – there is no doubt about that. But he isn’t Warren Buffett, (Buffett is well beyond smart).

Pabrai only has nine years under his belt as a funds manager and it’s simply not long enough to draw any firm conclusions. I think that those who would write him up as the next Warren Buffett are somewhat premature in their analysis.

I’m sure his actual methods of investment run much deeper than what he told us in The Dhandho Investor. I also feel that if Pabrai keeps loading up on distressed businesses in distressed industries, it’s only a matter of time before he makes some very serious mistakes (if he hasn’t made them already).

Anyway, read the book and judge for yourself.