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.

A Portfolio selected using Graham’s techniques

In his book The Intelligent Investor (first published in 1949 and updated in three further editions the last of which was published in 1973), Benjamin Graham detailed his criteria for selecting common stocks.

While I don’t intend reproducing those criteria here, (anyone who is interested can buy or borrow the book), I did use Graham’s filters to screen every company and trust listed on the ASX and selected a portfolio (using 5 December 2008 data).

Graham never tried to deeply analyse the business in which a particular company was in or attempt to forecast its earnings/growth rate etc. As he states in The Intelligent Investor:

“… stock valuations are only dependable in exceptional cases. For most investors it would probably be best to assure themselves that they are getting good value for the prices they pay, and let it go at that.”

Later in that same book, he states:

“… those who emphasise protection are always especially concerned with the price of the issue at the time of the study. Their main effort is to assure themselves of a substantial margin of indicated present value above the market price – which margin could absorb unfavourable developments in the future. Generally speaking, therefore, it is not so necessary for them to be enthusiastic over the company’s long-run prospects as it is to be reasonable confident that the enterprise will get along.”

What Graham was concerned about was having a “margin of safety” between the price he paid and the intrinsic value of the company. He used measures like the price-earnings ratio, the price-to-book ratio, a sound track record, the payment of dividends over a long period of time, sufficient size of the company and long-term debt being less than current assets minus current liabilities as his filters.

Graham’s criteria are very stringent. For example, the requirement that long-term debt be less than current assets minus current liabilities excluded the vast majority of companies listed on the ASX at 5 December 2008. Of the remaining companies, many were eliminated based on Graham’s other filters.

What I was left with were only 10 companies. Three of those 10 companies were more or less illiquid. Those companies also had wafer-thin profit margins (even though they all had sales of more then $500m in the last annual reporting period – a measure that I used to filter out companies that were not of an adequate size). For these reasons those three companies were eliminated.

Seven companies are too few for adequate diversification so I added four more that didn’t meet Graham’s criteria but are sound businesses available at (what I think) are reasonable prices: ASX, Austereo, WA Newspapers and Milton Corporation:

Company	Price	No. of shares	Sector
Caltex	$6.18	14,710	Oil & gas
Harvey Norman	$2.35	38,685	Retailing
Soul Pattinson	$8.33	10,913	Diversified financial
Sims Metal	$11.74	7,744	Metals & mining
Flight Centre	$8.30	10,953	Consumer services
Hills Industries	$2.90	31,348	Capital goods
Beach Petroleum	$0.75	122,026	Oil & gas
ASX	$31.60	2,877	Diversified financial
Austereo	$1.11	82,271	Media
WA Newspapers	$4.70	19,342	Media
Milton Corporation	$14.02	6,484	Diversified financial

The portfolio value is $1m with $90,909 invested in each company.

While there are only 11 companies in the above list, they represent seven different sectors of the market (which is very important in terms of not being over-exposed to one or two sectors). And of course, someone with $1m to invest would not put all of it in the share market, it would be prudent to put 50% of it in the bank.

I know that practically none of those companies listed above have robust outlooks for 2009 (tell me which companies do), but that’s the whole point – you can only buy at sensible prices when pessimism pervades the market. At other times you are normally buying at too high a price.

You don’t need to be a genius to know that some of these companies are going to experience reasonably significant earnings declines in 2008-09 – but for the most part that would already appear to be reflected in the depressed share prices.

The portfolio has an average price-earnings ratio of 9.6 (sure to go up as earnings decline), an average dividend yield of 7.8% (sure to go down as earnings decline) and an average price-to-book-ratio of 1.92 (which is distorted upwards by WAN, a company with a grossly under-stated book value, without WAN this would be 1.07).

The portfolio earnings yield (100 divided by the price-earnings ratio) is 10.4% versus a rate of 4.28% (as I write this) for the 10 year Government bond – that would appear to be a very significant margin of safety.

Let’s see what happens over the next few years.

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

Investors lose faith in Macquarie Satellites

Macquarie Group controls the management of eight ASX listed entities that have performed abysmally in recent times as the following table shows:

Name	2007 Price High	2008 Price Low*	Percentage Decline
Macquarie DDR	$1.395	$0.053	-96.2
Macquarie Countrywide	$2.300	$0.200	-91.3
Macquarie Communications Group	$6.910	$0.740	-89.3
Macquarie Office	$1.750	$0.225	-87.1
Macquarie Media	$5.200	$0.675	-87.0
Macquarie Leisure	$3.890	$0.875	-77.5
Macquarie Infrastructure Group	$3.990	$1.310	-67.2
Macquarie Airports	$4.390	$1.785	-59.3
Average decline (high to low)			-81.9
Decline in S&P 200 (high to low)*			-53.0

* Low to 28 November 2008.

Macquarie Group itself may have been run prudently (it’s what they keep telling us), but even in the current environment, no prudently managed company or trust has experienced losses of the magnitude shown in the above table. As can be seen, average declines were well in excess of the S&P 200 index.

Then of course there was also BrisConnections. This toll road is being constructed between the Brisbane CBD and the airport and was floated by Deutsche Bank and Macquarie Group during 2008 at $1 (with two more installments of $1 to be paid during 2009 and 2010). It’s currently trading at one tenth of a cent. It would be trading at zero if the ASX did not have a rule prohibiting listed securities from trading at less than one tenth of a cent. It’s a disaster of monumental proportions.

What’s worse is that Macquarie strongly encouraged broking clients to buy units in BrisConnections. Disgruntled investors are now contemplating legal action. Stay tuned.

Macquarie Group reportedly received a fee of $100m for the float of BrisConnections and I predict that it will eventually cost Macquarie in excess of $100m – i.e. they will have done the work for free. (Macquarie and Deutsche Bank will have to provide the unpaid installments for every unit holder who cannot pay – and that’s a good percentage of them).

Macquarie Countrywide and Macquarie Office are typical of the manner in which many of these Macquarie entities were run. Both started out as 100 percent Australian based REITs with good assets and low debt. However, over the years, they were taken on a wild international expansion phase using ever increasing levels of debt. That debt is now being partially paid down by selling US properties (purchased in boom times) into one of the worst real estate markets in memory. The end result of all of this for investors is evident in the above table.

Total remuneration of executive key management personnel at Macquarie Group during the 2008 year was $124.8m – shared between 13 people. That’s an average of $9.6m per person or the equivalent of $184,600 per week. Think about that for a minute. That amount of money would have paid the annual salaries of approximately 2,200 Australians earning an average wage.

When a company decides to remunerate its executives at those sorts of levels they must perform all the time – there is absolutely no excuse for the non-performance we have seen from the entities that I’ve listed above and from Macquarie Group itself.

Macquarie’s logo is often described as the “silver doughnut” but it seems that their executives have consumed the doughnut and left their investors with the hole.

The above facts raise some very serious questions:

1. How on earth does an executive team that has presided over the annihilation of value in these satellite entities justify such wantonly excessive remuneration?

2. Will any of the investors who experienced severe losses in the above entities ever trust Macquarie with their money again?

3. How does a provider of funds management services who has lost the confidence of retail investors (and some institutional ones as well) not avoid a material shrinkage in the size of its business? Is it true that 3000-4000 staff will be retrenched during 2009?

4. When does Macquarie intend writing down the asset valuations in the above entities to realistic levels? The market is much more accurately reflecting what these entities are really worth than the book values reported by Macquarie. In particular, the capitalization rates used to value US properties in the REITs appear to be pure fantasy in the current environment.

An added question for the Macquarie Capital division of Macquarie Group: How many more deals can you continue to do between yourself and other Macquarie controlled entities?

I’ve always thought that buying something and then selling it to another entity controlled by that same buyer and booking a profit on the sale (as well as taking a fee) was pure chicanery. Surely this level of wheeling and dealing within the Group is not sustainable and is a key vulnerability for Macquarie Group because Macquarie Capital generates most of its (so called) profit.

Macquarie has now switched its focus to unlisted investment vehicles, but the problem remains – 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.