Mohnish Pabrai: Guru No More

In a post last year “Is Mohnish Pabrai the Real Deal”, I raised a few concerns regarding Pabrai’s core investing principles as enunciated in his book The Dhandho Investor.

My two concerns were his advice to readers to buy distressed businesses in distressed industries and to run concentrated portfolios (i.e. portfolios lacking what would be considered conventionally adequate diversification).

In addition, I made the following comments:

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 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).

Pabrai’s result for 2008 was a loss of 60% against a loss of 37% for the S&P 500 (as reported in the Pabrai Investment Funds letter of January 16 2009).

Now, I’m no genius and I’m sure that many readers of this blog were also able to arrive at the same conclusions that I did. The mistakes that I referred to above were mistakes that Pabrai was making all along, but it took the events of 2008 to expose them for all to see.

As far as I’m concerned, that result revokes Pabrai’s “guru” status for the time being. Wiping out 60% of investors’ funds in a year and under-performing the S&P 500 by 23% is just not acceptable.

The Pabrai Investment Funds letter of January 16 2009 actually reveals several things that are disconcerting to me.

Firstly, Pabrai had no grasp of how the effects of the financial crisis were to impact his portfolios. Rather than moving significant funds out of equities in early 2008, Pabrai remained close to fully invested with portfolios that had 80% of their funds in only 10 positions! Pabrai admits this was a mistake, but how can someone who is supposedly as savvy as Pabrai is not have realized that a long time ago?

Very concentrated portfolios are usually the hallmarks of misplaced confidence by the portfolio manager. Lots of these money managers think they have skills that are on a par with the truly great investors of this world. Therefore, they reason, it would be a mistake for them to adequately diversify – it would only reduce their returns. Well, we’ve all seen plenty of people who thought like that brought back down to Earth with a resounding thud!

Secondly, the average aggregated annual compound return from the three Pabrai funds is only 1.3% (since inception of each fund). If you had put equal amounts of money into each of Pabrai’s three funds at their inception, you would have got 1.3% per annum. Investors would have made better returns investing in risk free government bonds.

I’m reminded of one of the investing rules that appeared in the book Contrarian Investment Strategies: The Next Generation by David Dreman:

Don’t be influenced by the short-term record of a money manager, broker, analyst, or advisor, no matter how impressive.

The law of averages indicates that many experts will have excellent records – usually playing popular trends – often for months and sometimes for several years, only to stumble disastrously later. If you buy the record just after a period of spectacular performance, chances are the letter writer or manager will not sustain it.

There is enormous wisdom in those two quotes that is all too often forgotten by investors.

Thirdly, Pabrai appears to have changed from a bottom-up stock picker to a macro-economic forecaster. Pabrai believes that inflation will increase significantly and believes that investing in mining companies and commodities in general will keep his portfolios insulated from the effects of inflation, he says:

If someone has a printing press running on overdrive, the best way to protect one’s wealth is to own hard assets (low-cost oil barrels in the ground, low-cost iron-ore reserves etc.). We now own loads of these types of assets.

Many of these commodities are scarce and face very high demand growth from India, China etc. Those growth engines have slowed down temporarily, but they will be back on track in the next few years.

Obviously there is no guarantee that these countries will “be back on track in the next few years” and to say so unequivocally is a very brave call. Does anyone think Japan (an enormous market for commodities) will be back on track in the next few years?

Someone recently said on an investing blog: “When everyone thinks something is certain to happen, it normally doesn’t.” How true.

But of equal importance is the subtle shift in strategy. Pabrai is now designing his portfolios based on a macro-economic view of the world (which may or may not be proven correct). This is in contrast to the traditional process of analyzing individual companies on their own merits and generally ignoring economic predictions.

I also wonder what skills Pabrai brings to the valuation of iron ore mines, zinc miners, molybdenum producers and the like? How does he know he’s buying them at low cost? Valuing these types of assets requires very specialist knowledge and skills and I’m not convinced that someone with no background in the industry has those skills.

As is widely known in my country (with its plethora of mining companies), low price-earnings ratios in the mining sector are much more indicative of over-valuation than under-valuation because low price-earnings ratios are normally achieved at the peak of the earnings cycle.

Pabrai says:

… the best assets to own in an inflationary world are businesses whose products are inflation

indexed – where prices can be raised at or above the rate of inflation. In addition if a

business has done large amounts of capex using old dollars and does not have much

need for capex at new dollars, yet can sell products at inflated prices, it is likely a home

run. Such a business has a minimal need to take on additional debt. It is a beneficiary

of both high interest rates and high inflation.

There are few if any businesses that are beneficiaries of both high interest rates and high inflation.

Once again this is probably just Pabrai attempting to copy Buffett. In the 1970s and very early 1980s, Buffett purchased several companies in the mining/metals sector as a perceived inflation hedge – Handy & Harman, Alcoa, Kaiser Aluminum & Chemical Corp, Cleveland-Cliffs Iron Company etc.

With the exception of Handy & Harman, these investments didn’t really serve the purpose for which they were intended despite the high inflation rate of the period and the fact that they were hand picked by the best investor we have ever seen.

For anyone who is truly convinced that commodity prices will rise, history shows that they would be much better served by investing in the commodities directly rather than trying to select individual companies that may or may not do well (even if they prove correct in their analysis). Commodity prices themselves can never go to zero – prices of shares in commodity producers can and sometimes do!

Pabrai still seems incredibly confident despite having wiped out 60% of his investors’ funds, which when combined with redemptions has seen Pabrai’s funds under management shrink from $600 million at the beginning of 2007 to only $209 million at the beginning of 2009.

It strikes me that for someone with such a small amount of money under management and such a short history as a money manager, Pabrai has certainly attracted far more attention to himself than is actually warranted. Of course the media will continue to report Pabrai’s magnificent record without having realized that he no longer has a magnificent record.

I will continue to follow Pabrai’s progress with much interest. I hope that 2009 turns out to be a better year for him (and his investors).

Gold as an Investment: The Risks

In my last post on the investment consultant Harry Schultz, I noted that Schultz had advised investors to place half their funds in blue chip gold mining stocks and gold bullion.

The reasons for this were the massive spending programs instituted by governments around the world which Schultz (and many others) expect to eventually result in significant inflation. Significant inflation generally means currency devaluation and corresponding gold price appreciation.

But what are the risks of following Schultz’s advice? There are a few risks that investors should be aware of.

Gold is an inherently volatile commodity. Commodities tend to do things that people don’t expect them to do. Just think of the oil price falling all the way from $147 a barrel to the $30-$40 range. Who would have thought that would happen and who would have thought it would happen so quickly? If you’re going to dabble in commodity markets you have to expect (and have a tolerance) for significant volatility.

But more importantly, we are currently in a gold price appreciation cycle that has already been underway for approximately seven years. How much longer that cycle will run is anyone’s guess. The important thing to be aware of though is that the cycle is already mature and the really astute investors have already made large profits in gold because they were buying 5-7 years ago.

Lots of people who don’t understand the dynamics of the gold market are currently buying gold for the sole reason that it has gone up significantly in recent times. Than in itself is not a reason to buy anything.

In my opinion, gold prices are just beginning to show some of the hallmarks of a bubble, and I readily acknowledge that the bubble may get a lot bigger yet before it deflates.

It should be remembered that practically all bubbles form initially for sound fundamental reasons. But as the bubble takes shape and grows, the fundamental reasons are gradually swept away as market participants attempt to profit from rises that are not based on real demand. In so doing, market participants interfere in an otherwise “natural” process and cause much more severe peaks and troughs to occur than would otherwise be observed. When the bubble pops, it usually happens very quickly and dramatically.

This of course is one of the foundations of George Soros’s theory of reflexivity and the recent fluctuations in the oil price are a textbook example of what Soros refers to. Reflexivity of course should be obvious to any reasonably intelligent investor and I don’t think that Soros needed to write books on the subject.

However, reflexivity as applied to commodities is especially important because commodity prices are determined by global supply and demand fundamentals with significant interference from speculative trading activity in order to attempt to manipulate outcomes (i.e. make outsized profits).

Speculative traders have no use for the underlying commodities that they trade - their demand is artificial. Therefore, speculative traders can artificially increase (and decrease) prices to levels that they would never reach if these traders were absent from the market (once again, oil is a good recent example).

You can always assess an industrial company’s balance sheet and look at the type of industry it operates in and assess the reliability of its cash flows, but how do you determine what a fair price for a commodity is? It’s much more difficult.

An average investor has far more chance of predicting the cash flows for a stable business (a difficult task in itself) than they have of determining what the demand and supply fundamentals for the gold market are (or any other commodity market for that matter).

Investing in gold mining stocks has its own unique set of risks.

Firstly, there is geopolitical risk associated with gold mines in many parts of the world. Countries like the United States, Australia and Canada are very safe and stable; many parts of Africa (for example) are not. Of course, you can limit your investments to companies that only operate mines in politically stable parts of the world. This seems sensible to me.

Secondly, gold mining companies usually use derivatives to decrease the risk of their operations. However, it’s quite possible for gold miners to make serious mistakes with their hedging and derivative strategies and this can lead to adverse results for companies that get it wrong. In extreme cases, a company can end up collapsing as a result (it has happened).

Thirdly, many gold mining stocks do not pay dividends. You are therefore totally dependent on capital appreciation for your return – it’s a risk. (Investing in gold bullion not only provides no income, it actually incurs storage costs.)

Fourthly, production costs at mines can vary widely from one year to the next due to factors that the mining companies can’t control. For example, when the price of oil skyrocketed, most miners also watched their production costs skyrocket because many use diesel generators for their power source (they have to in remote areas where most mines are located). The recent falls in the oil price are of course of great benefit to gold miners.

I think the arguments put forward by Harry Schultz and others for an increased gold price are logical. However, I also realize that macro-economic forecasts are difficult to make with accuracy. Many economists get things wrong (often dramatically so) and anyone who places their faith in such forecasts (or forecasters) does so at their own risk.

While I said in my last post that I would be prepared to allocate a small percentage of my portfolio to gold, this still has to be assessed against what is available to me in the equities markets (non-gold sectors). I believe that there are still more attractive opportunities in the non-gold sectors of the equity markets.

While Schultz has a lot of credibility, I wouldn’t want to go betting half my portfolio on a rising gold price (as Schultz suggests his readers do). It’s just too much of a risk to take. A little in gold is fine, but gambling half my funds is not something I would ever do.

Note: None of the above constitutes financial advice. You need to do your own research and consult appropriately qualified people for advice (where necessary).

Harry D. Schultz: Buy Gold

Most people have never heard of Dr. Harry D. Schultz. I first heard of him many years ago when I was flicking through a copy of the Guinness Book of Records where he was listed as the highest paid investment consultant in the world (he appeared in many subsequent editions).

In 1981 he was charging $US2,000 for a one hour consultation on weekdays and $US3,000 for an hour on weekends. He currently charges $US3,500 on weekdays and $US4,900 on weekends. Harry Schultz is still the highest paid investment consultant in the world. He has published 23 books (most of which are now out of print).

Harry Schultz writes an international investment newsletter (the Harry Schultz Letter) that was first published in 1964. Each newsletter contains a great deal of information and you can subscribe to it for $US382 for one year. Apparently he has subscribers in 80 countries.

Dr. Schultz himself is based in Switzerland but has lived in no fewer than 18 countries.

Some quotes from his 9 December 2007 letter (on his web site):

Fannie Mae & Freddie Mac will crash.

This is not a time to seek profits, but to protect what you have. Profits will come from precious metals & the Swiss Franc. The Swiss Franc is the safest currency. Don’t worry about interest, worry about safety.

Biggest danger to you is having cash, time deposits, CD’s in banks, as warned before. They can be lost in bank closures, or at best frozen for 6 months to 3 years. Some banks already quietly closed. It’s govt policy not to reveal any bank vulnerability in case it scares off possible buyers of a bank—so you will never get a warning. Safest is switch to shortest-term govt bonds (90-day if possible) of any 1st world country.

Huge profits possible in mid-08-09 buying foreclosed homes at 15-20% (?) of value. If you buy them, be prepared to hold them for a long while.

CNBC & Bloomberg swing from saying things are getting better or worse every 2 hours. Don’t expect wisdom. Remember the saying: “If a jackass looks into a mirror, a jackass looks back out.” Judge the source. Trust not easily.

Soon one or all of the Middle East oil exporters will end their US$-peg or $-oil pricing, & switch to a basket of currencies or euros. They must, for survival. That will unofficially end US$ status as a reserve currency. On that date the $ will probably fall 10-15% in a day.

During 2008 a lot of what Harry Schultz predicted in 2007 actually occurred. Many other commentators were still very bullish in late 2007 – they were wrong and Schultz was right.

In essence, Schultz is a chartist who uses fundamentals, as the following quote reveals:

When investing, don't think in terms of absolutes, think in terms of probabilities. We want to do everything possible to "load the deck" to our advantage. Charts are the pros' secret weapon for doing exactly that. Charts allow us to minimize risk. While we do pay attention to fundamentals, (e.g., industry group, sales, earnings/share, return on equity, profit margins, geopolitics. etc.), they can't tell us when is the best time to "pull the trigger," nor when to take profits or cut losses. If you don't use charts, you're just guessing.

I’ve never embraced charting myself (and I never will). It’s true that price trends can be used to guide the timing of purchases or sales. There is no point buying something if the price is consistently trending downwards, best to wait for the trend to stop and then buy. Of course as you know, that’s much easier said than done and far more difficult to do in real-time than it looks in hindsight.

According to Hulbert Financial Digest, Schultz’s tips have underperformed the US market over the last 10 years – not a good result for the highest paid investment consultant in the world.

However, the very fact that Harry Schultz has so many subscribers means that they are getting some value from his letter. If the comments in his 9 December 2007 letter are any indication of his predictive ability, he certainly has it, but maybe he has trouble capitalizing on it (?).

So what is Schultz saying at the moment?

He’s advising readers to buy gold. He believes that the gold price will rise significantly in the next few years due to the expected inflation caused by massive Government spending globally.

Schultz recommends that readers of his letter put half their money in first world government bonds (but not US bonds) and the other half in blue chip gold stocks and gold bullion. Interesting isn’t it?

Have a look at the table below:

	Compound return per annum
Period	Gold	S&P 500
1950-1959	-1.4%	13.6%
1960-1969	0.0%	4.4%
1970-1979	32.2%	1.6%
1980-1989	-2.9%	12.6%
1990-1999	-4.0%	15.3%
2000-2008	13.5%	-4.8%
Overall	5.4%	7.0%

The table shows quite clearly that when equities do badly, gold usually does well and vice versa.

Gold has appreciated by approximately 5.4% per annum compound over the last 59 years (it’s not a great result). Also note that the return shown above from the S&P 500 doesn’t include dividends.

The big question is: Has gold already had its good run this time round or will it keep going up (if and when inflation starts to become a serious problem?).

If you do decide to bet on gold, you have a few options.

Firstly, you could find a few blue chip gold stocks and allocate some of your portfolio to them (in Australia there are approximately 300 listed companies classified as gold miners – very few of them could be classified as blue chip).

Secondly, in Australia, the Perth Mint will sell and store gold for you (this includes those resident outside of Australia). Gold storage accounts are guaranteed by the Western Australian Government (which has a AAA credit rating).

Thirdly, and perhaps an even better option than the above is to buy Gold Exchange Traded Funds (ETFs) or Gold Exchange Traded Commodities (ETCs) on the stock exchange.

Schultz believes that 2009 will be a year of deflation followed by significant inflation in 2010. If he is in fact correct, gold should increase in price, but who knows for sure?

I may be willing to allocate a small percentage of my portfolio to gold just in case Schultz is right. The arguments for an increased gold price seem reasonably logical to me, what is less clear is where exactly in the gold price cycle we currently are.

For those interested in gold, there are some good articles in the gold markets section of: www.contrarianprofits.com

In case you’re wondering, I’m not a subscriber to the Schultz letter and of course have no financial interest in it.

The Harry Schultz Letter site: www.hsletter.com

Note: None of the above constitutes financial advice. You need to do your own research and consult appropriately qualified people for advice (where necessary).

More Bad News at Macquarie Group

The briefing given by Macquarie Group this week would have provided little comfort to investors in Macquarie Group or any of its satellites.

Macquarie Group provided guidance of $900 million in profit for the year ending 31 March 2009. That’s down from $1.8 billion for 2008.

While they may well report a profit in that range, I remain highly skeptical of that $900 million figure. I think they should be reporting a loss – yes, a loss.

Macquarie still refuses to write-down certain investments to realistic values and they continue to transact between various Macquarie entities (generating so called profits). These two things mean that the quality of the earnings reported are as poor as one could get and are simply not a reliable indicator of the true state of affairs at Macquarie Group.

In December I wrote a post questioning a number of things that seemed amiss to me (see the post here).

The bottom line is that the so called “Macquarie Model” was based on using high levels of leverage to generate temporary (if not somewhat illusory) profits during a cycle of significant asset price inflation. That’s it in a nutshell. That’s all that was ever going on with the real estate and infrastructure assets.

Macquarie employees pocketed half the profits generated each year even though subsequent events have shown the folly of the model, the very temporary nature of the profits and the devastating affect it’s had on long-term investors in Macquarie Group’s listed satellite entities.

Just think about that for a minute – the ultimate result for investors in these listed satellites was the near total destruction of their investment and yet Macquarie took large fees from these entities for their “professional” management – fees which went into the pockets of Macquarie staff and still remain there. It beggars belief. And they continue to take fees!

Macquarie Office unit holders have now forked out a reported $12 million in fees to Macquarie Group for a recent capital raising that would have been totally unnecessary had Macquarie Office maintained prudent debt levels.

Macquarie Group has two things to be very thankful to the Australian Government for: The ban on short selling of their stock (it would be trading at much lower levels if this was allowed) and secondly, the Government guarantee on deposits and debt.

It’s tragic that Governments around the world have been forced by circumstance into protecting millionaires (with tax payers’ funds) from facing the full consequences of their reckless behaviour. I believe that Obama’s salary cap is a move in the right direction.

The Australian guarantee on deposits is scheduled to be removed in October 2011 and if we are still in the same economic environment there will be a flight to quality, that is, billions will be pulled from any bank that has an S&P rating of less than “AA”. And that means Macquarie, all regional banks and all credit unions.

They will want to really hope that we’re still not in the same economic environment in October 2011, because the results may be very ugly (in the absence of an extension to the guarantee).

As I said in my original post:

There has been a loss of confidence and significant damage to reputation from the terrible results experienced by investors in Macquarie branded entities. That loss of reputation is not immediately quantifiable but it is nevertheless very real.

I also asked in my original post whether 3,000-4,000 staff would end up being retrenched. Macquarie this week admitted to firing more than 1,000 staff – have no doubts, it will increase.

While Macquarie Group will probably go on, it will be as a much diminished entity. The damage to reputation has been significant and that’s a serious problem for a company that requires the ongoing trust and goodwill of investors.

Cash or Equities: Inflation or Deflation?

Interest rates in the developed world have fallen to historically low levels and if you are holding significant amounts of cash in your portfolio you are seeing your income reduce dramatically.

I entered 2008 with 70% of my portfolio in cash. By the end of January 2008, I had moved to 80% cash. As a result of this very conservative allocation, I avoided the worst effects of the 2008 crash. I still have a very significant weighting towards cash, but it’s making me increasingly uncomfortable.

The reason that I’m now feeling uncomfortable with my cash investments is that I know I’m effectively “lending” my money to banks at a negative real interest rate. That is, the interest rate that I’m receiving is now less than the inflation rate.

Anyone that does this over time will ensure that his or her standard of living declines. It will happen slowly and as a result is not immediately noticeable, but as sure as night follows day, the investor’s financial position will steadily deteriorate.

Here is what Warren Buffett said on this issue in The New York Times (October 2008):

Today people who hold cash equivalents feel comfortable. They shouldn’t. They have opted for a terrible long-term asset, one that pays virtually nothing and is certain to depreciate in value. Indeed, the policies that government will follow in its efforts to alleviate the current crisis will probably prove inflationary and therefore accelerate declines in the real value of cash accounts.

The threat of high inflation (after a period of deflation) is a very real risk due to the wanton spending of Governments around the world. The bad news for investors in equities is that equities will not do well in a deflationary environment and they will also not do well in an environment of high inflation. Equity markets like low levels of inflation – they don’t like much else.

Nevertheless, the dividend yields on some high quality companies are now well above cash rates (and the inflation rate). Even if the shares prices of these companies remain at current levels for several years (while more or less maintaining current or somewhat reduced dividend levels), the investor who purchases shares in such companies is almost certain to come out ahead of those taking the cash or bond option – provided they can tolerate the volatility.

I‘ve been gradually increasing my exposure to equities. Obviously, I can’t speak for all markets, but it is my belief that my home market will not decline significantly from the lows that have already been seen. Maybe those will be famous last words! However, I’m putting my money where my mouth is.

There have been several companies that I have long admired and always wanted to own shares in. The problem was that these companies normally traded at prices that (in my opinion) were above intrinsic value and this precluded me from buying them. The crash of 2008 changed that and I have been gradually purchasing some of these companies.

At the moment, I’m more concerned about holding large amounts of cash (which is effectively costing me money) than the ongoing weekly fluctuations in my share portfolio (which is comprised of sound dividend paying companies providing goods or services in essential sectors of the economy).

The difference between those that achieve financial independence and those that do not is that the former group are much more willing to take calculated risks when the odds are in their favour. Increasing exposure to equities at this time is a calculated risk, there is definitely potential downside but there is also potential upside (I’m sounding like a business journalist there!).

There is nothing that is certain in life and time will tell. Personally, I‘m prepared to patiently back equities, I think patience will be required. It could take several years for global markets to emerge from the current crisis.

Closed-End Funds: Top 7 Tips for Buying

Closed-End listed funds (or Listed Investment Companies as they are known in some parts of the world) exist only to invest in the shares of other listed companies. There are many of them listed on world markets and the main benefits of an investment in such a fund are generally given as:

1. Instant diversification in a single share (but not in all cases);

2. Professional management (but not in all cases);

3. Low cost structure compared to unlisted funds (but not in all cases);

4. They are closed end, i.e. they don’t accept new money like many unlisted funds, therefore they don’t need to invest new dollars into over-valued markets or worry about redemptions in bear markets (which occur in unlisted funds);

I say “not in all cases” after some of the above points because:

1. Not all funds are adequately diversified – the vast majority are, but some are not;

2. Managements of these funds that have under-performed a benchmark index over the years cannot be called “professional”;

3. Some of these funds have excessive cost structures in terms of fees charged and some have management agreements with an associated management company that are sometimes locked in for many years.

Therefore, you have to be very careful with which closed-end fund you choose to invest.

Top 7 Tips - These are the things that I would be looking at:

1. What shares does the fund hold in its portfolio? What are its largest positions and how do you feel about the outlook for those companies? Would you feel comfortable holding these shares directly yourself?

2. What are your feelings on the general level of the share market? If you feel it’s too high it wouldn’t be the right time to be buying, but if you feel it’s low it could be the right time;

3. Is the fund trading at a discount to its net tangible assets (NTA) – never buy a fund that is trading at a premium to NTA;

4. Does the fund have a long track record (15 years or more)? How has it performed? Funds that have underperformed the relevant benchmark index over time are not worth investing in – it should be obvious, but to many people it’s not;

5. How large are the fees? A fund that has operating expenses (this excludes income tax and any financing expenses) of more than say 0.5% of total assets is charging too much. There are in fact funds out there that are charging 2.0% or more;

6. Is there a long-term locked-in agreement between the fund and an associated asset management company? I would normally avoid these funds because a long-term locked-in agreement means shareholders are powerless to make changes if performance is not satisfactory;

7. Definitely avoid funds where the manager takes some pre-determined percentage of any out-performance of an index as a fee – never reward someone for just doing their job.

Be especially wary of the closed-end funds that have appeared in the last 4-5 years. Lots of them are run by inexperienced managers who charge high fees and have not proven themselves. These people tend to have had a few good years (during a bull market) and managed to develop a following (often through good marketing) which has then allowed them to raise millions through the float of a closed-end fund during boom times.

I would advise that people stick to the old fashioned blue chip investors that have been around for many years (if not decades).

I would still however advise that you look at their portfolios to see if you are comfortable with their positions and then only buy at a discount to NTA (at a time when you feel the market is generally low).