Mohnish Pabrai’s comparative returns are misleading

The other day I was reading through the Pabrai Investment Funds Annual report for last year when it suddenly occurred to me that the comparative returns that Pabrai publishes there (i.e. his funds’ returns versus the various indexes) is misleading. Why you ask? Well, it all has to do with taxation.

Let’s have a look at the Pabrai investment funds:

Pabrai Investment Fund 2 (an Illinois Limited Partnership) – Commenced operation on 1^st October 2000 when units were issued at $10 each. As at 30 June 2012, the net asset value (NAV) of a unit was $43.36, an average annual compound return per annum of 13.3%.

Pabrai Investment Fund 3 Ltd (a British Virgin Islands corporation) – Commenced operation on 2^nd February 2002 when shares were issued at $10 each. As at 31^st December 2012, the NAV of these shares was $33.21, an average annual compound return per annum of 9.7%.

Pabrai Investment Fund 4 (a Delaware Limited Partnership) – Commenced operation on 1^st October 2003 when units were issues at $10 each (Pabrai must have a fondness for the figure of $10). As at 31^st December 2012, the NAV of these shares was $18.85, an average annual compound return per annum of 7.1%.

Now, the British Virgin Islands Corporation (Pabrai Investment Fund 3 Ltd) pays no income tax or capital gains tax in the British Virgin Islands and also pays no income tax in the United States. This is the reason that Pabrai domiciled this company in that jurisdiction. It’s also a fund for non-US investors. There is nothing wrong with this, it’s good tax planning. 

But when Pabrai compares the returns of Pabrai Investment Fund 3 to the returns of the Dow Jones Industrial Average (DJIA), the NASDAQ or the S&P500, he is comparing the returns of a fund which pays no tax with an index whose constituents must pay tax. 

For a moment, imagine that the US Federal and State Governments legislated to exempt all constituents of the DJIA from paying tax. What affect would that have? It would immediately increase the value of all the constituents of that index. Rationally, the percentage increase would be by approximately the tax rate divided by one less the tax rate multiplied by 100 or (TR% / (1-TR%) )*100. Of course, it’s not quite that simple, but you get the gist of it.

When Warren Buffett (or any other person running a US domiciled tax-paying investment corporation) compares their corporation’s returns to an index, it’s a fair comparison because like is being compared with like.

When an individual running a non-tax paying corporation compares their returns to an index which consists of tax-paying corporations, the comparison is not fair. A fair comparison would be to take the returns generated by the non-tax paying entity and then apply a notional tax rate based on the average tax rate paid by the constituents of the index being compared to and then compare the returns.

For example, if we applied a notional 25% “tax” to Pabrai Investment Fund 3, that 9.7% average return (mentioned above) might become about 7.3% - hardly returns to write home about. Incidentally, Pabrai Investment Fund 3 is the only vehicle currently open to new investors.

But what about Pabrai’s limited partnerships? They too pay no tax. All tax is paid by the individual unit holders.

So I would put it to you that any performance comparisons between any of the Pabrai funds and the various US indexes are misleading because any reported out-performance will always be skewed unfairly in Pabrai’s favour.

Pabrai has talked at some length in the annual letter about how he has compounded his own net worth at close to 26% per annum (since about 1995). That’s great for Pabrai, but the funds mentioned above haven’t achieved anywhere near this figure and as I’ve explained here, even those returns are misleading when compared to any index. So why mention your own much better individual performance?

My own net worth has increased at an average annual rate of 16.1% (post tax) from 1995 to 2012. On a pre-tax basis (if I had never had to pay income or capital gains taxes) it would have been roughly 23% per annum. That statistic alone demonstrates the difference between pre-tax and post-tax returns. 

So, finally, to have some fun, if I had issued shares at $10 each (Pabrai’s favourite number) on 31 December 1995 in “The Stock Scribe” (me), as at 31 December 2012, those $10 shares were worth $127.

Nathan Tinkler’s troubles are mounting

On 21 May, Blackwood Corporation (BWD.AX) announced that liquidators acting on behalf of the creditors of Mulsanne Resources had made an application in the Supreme Court of New South Wales to freeze the assets of Nathan Tinkler.

Nathan Tinkler’s story is an incredible one. I don’t really know of anyone who had made so much money as quickly as Tinkler did from scratch. But as they say: “Easy come, easy go.”

Tinkler was originally a coal mine electrician working in the Hunter Valley of New South Wales. He formed a company called Custom Mining which eventually purchased the Middlemount coal deposit in Queensland. Custom Mining paid $A30m for that deposit (although I believe Tinkler only used about $A1m of his own money and did a deal with a well known law firm to do all the legal work for an equity interest, most people would have been shown the door).

Now here is the unbelievable part, within one year of purchasing Middlemount, Macarthur Coal bought it for $A275m from Custom Mining delivering Tinkler an enormous profit.

Now, I’m a conservative character and if it was me, I would have realized how lucky I was and not put any of this new found wealth in jeopardy. But Tinkler didn’t make all that money by being conservative or risk averse and he was after even more. Deal-making on a grand scale has seen the demise of many an entrepreneur in this country.

Tinkler got more, a lot more. Tinkler made hundreds of millions more from seemingly miraculous  deals in the coal sector with the end result being that he was apparently worth $A1 billion by the time he was 35 years old (in 2011). But it wasn’t to last.

Tinkler indulged himself with his new found wealth, he bought race horses, interests in a rugby league team and a soccer team as well as plenty of flashy cars. The well trodden path of many a nouveau riche.

It all came unstuck when Tinkler made a deal with Blackwood Corporation (a coal mining minnow), to purchase approximately $A28m in equity at around 30 cents per share (via Mulsanne Resources). A very ill-timed agreement as Blackwood shares were set to start a steep descent shortly after the agreement was entered into, proving that not everything Tinkler touched turned to gold.

Now, $A28m for someone supposedly worth around $A1 billion shouldn’t have caused any concerns whatsoever. But after Mulsanne Resources missed a few payment deadlines, it started to become apparent that Mulsanne wasn’t going to pay up and the liquidators of Mulsanne allege that it was insolvent when it entered into the agreement.

Now, I’m not about to speculate on the reasons that this whole deal went sour, that will be discussed in court. But suffice to say, this episode has done enormous damage to Tinkler’s reputation – you simply shouldn’t enter into agreements that you can’t consummate.

Mathews Capital – Are they really skilled or just lucky risk takers?

How do you assess whether a money manager is truly skilled or just lucky?

There is only one answer to this question – time. Lucky money managers will eventually fall by the wayside, just give them enough time and their initially impressive returns will revert to the mean or worse.

Money mangers with long track records of impressive returns are truly skilled. Think of Warren Buffett, Seth Klarman, Ed Thorpe, Ken Griffin, Paul Tudor Jones, Jim Simons and so on. Money managers with short track records of impressive returns are either skilled or lucky but you won’t know which until sufficient time has passed.

As I have previously written here, I once thought that Kerr Neilson was a truly skilled investor. I no longer believe that. I believe Kerr simply got lucky early on (with the help of one of the longest bull markets in financial history) and has been able to “dine out” on those earlier returns for a long time. As soon as 2008 came along, Platinum Asset Management’s funds started to struggle – they are still struggling.

Which brings me to Mathews Capital. A Sydney based outfit founded by Phil Mathews in 2001.

Phil Mathews, like so many others who have started funds management businesses in this country had a menagerie of former employers before going into business for himself (County Natwest, Ord Minnett, SPAL, Armstrong Jones, Jardine Fleming and Bell Potter).

Until 2010, Mathews Capital enjoyed spectacular success. Most of which was based on investing in smaller to medium sized resource companies. However, the wheels fell off in 2011 and 2012 is shaping up as another very poor year for the firm (between March and July of 2012 approximately 60% of the value of the Velocity Fund has been wiped out - it’s hard to understand how this could have happened).

One of the things that stands out you when you look at the monthly returns of Mathews Capital’s Velocity Fund is the volatility of those returns. Wild swings from month to month are the norm. This in turn indicates to me that the firm has taken significant risks to achieve their returns and their risk management techniques are not particularly effective.

It is known that Mathews Capital hedges equity positions with short positions over indexes. However, as any novice student of quantitative finance would know, the correlation (or indeed the cointegration) between the types of equities that fill the Mathews Capital fund portfolios and the indexes are very low, indicating that short positions in those indexes are not at all effective hedges for those long positions in equities.

My concerns with the Mathews Capital funds are as follows:

1. The firm attempts to pick the “winners” amongst hundreds of smaller resources companies, this provides spectacular returns if you get it right and appalling returns if you get it wrong. Mathews Capital got it right between 2002-2010 and is now getting it wrong;
2. The portfolios are highly concentrated – there is no room for error with such a strategy;
3. The firm seems comfortable with this level of risk – I don’t believe that they should feel comfortable;
4. The firm’s fees (while normal for most hedge funds) are high for a firm that at present only has funds with very short-term records open for investment and a history of very high volatility;
5. The inability to hang on to most of the spectacular returns achieved between 2006-2010 in the Velocity Fund are very worrying;
6. The firm’s practice of visiting vast numbers of companies is dangerous – most chief executives are optimistic, ego-maniac sales people. Plenty of them will lead you astray;
7. The firm’s investment in Elders a few years ago may be an example of point 5. It has been well known for a long time that Elders is experiencing significant financial problems and yet Mathews Capital were buying the shares;
8. The firm is still clinging tightly to the resources boom theme – but the boom seems to be over for now.

I would expect that the return from Mathews Capital’s funds will continue to decline towards index returns and if they do not get their risk management under control, returns may well eventually go below the index.

Please note that as always, none of the above constitutes financial advice. You need to do your own research and consult appropriately qualified people for advice (where necessary).