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).