Mohnish Pabrai on Investing Mistakes

Investors should listen when Mohnish Pabrai speaks.  He recently gave an enlightening interview, in which he discussed his personal experiences as an entrepreneur, and the relationship between being a businessperson and an investor; his "all-in" bet on financial companies; his "two-outta-three-ain't-bad" philosophy of investing errors, borrowed from John Templeton, and, affirmed, he claims (not convincingly, in my view) by Warren Buffett's experience; and the opportunity costs of committing capital, among other things.

I'd like to highlight, though, his candid exploration of his mistakes, a few of which led to substantial and permanent losses of capital.  One was Sears Holdings, which sits on real estate that's worth far more than the company's market cap, but can only be monetized by liquidating the business.  Despite a prominent theory which holds that people act only according to the cold calculus of economics, most CEO's are not hot on the idea of liquidating the firm they preside over (or perhaps this affirms the theory: after all, why dismantle the company that's paying you such an appealing salary?).  Either way, the alternative that's best for shareholders is not always the option that's pursued by management.

A second misstep was his investment in Pinnacle Airlines, a contract operator that flew on behalf of traditional airlines, including Delta.  While Pinnacle had a cushy cost-plus arrangement, shielding it from the challenges of the airline industry, making money from customers that are losing money is not a recipe for long-term success.  When they fall, so do you.  Pabrai concedes that he should have better understood the full economic ecosystem that Pinnacle was operating in (Charlie Munger would greatly respect this lesson, as the ecosystem is among the 100-odd "Big Ideas" that he draws wisdom from).  Finally, his worst failure was his position in Delta Financial, a company that wrote, bundled and securitized mortgages, and was felled by the recent financial crises.  His position, 10% of his portfolio, went to zero.

Nearly all prominent investors will concede that they've made mistakes, but when pressed to provide specific examples, few are keen on discussing them in detail.  Post-mortems are grim, after all.  But kudos to Pabrai for doing so, and allowing the rest of us the opportunity to learn from his mistakes for free, rather than paying to do so first-hand.

Here is a review of Pabrai's book The Dhandho Investor

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Profile - Tim McElvaine

In the 11-year period from 1997 to 2007, Victoria, B.C.-based investor Tim McElvaine returned 21% per year before fees (16% net to investors), compared to 11% for the S&P/TSX index.  Moreover, he didn't suffer a single down year, while the index fell three times.  This impressive result was achieved despite holding large amounts of cash: in fact, on average he was only 82% invested over the period.  In theory, had he been fully invested, McElvaine's gross returns would have exceeded 25% per annum.

But - and with a cutoff year of 2007 you knew there was a "But" coming - in 2008 his fund fell by almost half.  McElvaine was hardly alone in this, of course; unlike many investors, however, he has yet to rebound sharply since the end of the Great Recession.  Indeed, even after a net return in 2012 of 18.3%, McElvaine remains about 30% off his former peak.  In absolute dollars, his fund has shrunk even more dramatically, forcing him to lay off most of his already small group of staff.  Will Tim McElvaine return to his past stellar performance, or was he permanently diminished by the recent turmoil?

An 11-year run of substantial outperformance is likely long enough to rule out pure fluke.  However, in order to determine with confidence if his pre-2008 success was a streak of long-lasting good luck, or the product of skill and experience, it's necessary to look beyond just the numbers and assess the "How" and "Why" of his performance.  

McElvaine's philosophical influences include John Templeton, Ben Graham and Warren Buffett.  Peter Cundill, though, was not only an intellectual influence, he hired the young and persistent McElvaine, and mentored him first-hand.  One of the qualities that Cundill instilled in McElvaine was patience.  This helps explain why McElvaine has steadfastly - and correctly, in this writer's opinion - held on to Glacier Media.  For many years Glacier has been his largest position, but the stock has underperformed lately, and is partly responsible for his restrained post-2008 performance (in fairness, he originally paid around $0.70 for GVC, so the fact that it hasn't done anything for him lately doesn't mean it hasn't done anything for him at all).  In addition, Cundill's interest in Japan wore off on McElvaine.  Most notable North American investors must think the fallen country's nickname is Land of the Setting Sun, if they think of it at all, but McElvaine had 17% of his portfolio committed to Japan at the end of 2011.

In the manner of Graham and Buffett, McElvaine has a disciplined, multi-faceted approach to estimating a company's value, and is sure to only buy at a discount, leaving him a "margin of safety."  His own personal twist is that he likes to buy when sellers are so determined to unload their position that they "don't care about price" (p.36).  Arguably, buyers of Glacier Media have been purchasing from sellers that blindly lump the company together with the newspaper industry in general, without regard for its genuine differences.  Other cases where sellers want out regardless of price may include a stock that has been delisted from an index or distressed securities that funds are not permitted to hold.

In addition to the margin of safety, McElvaine's investing approach is similar to Buffett's in several ways: like the Oracle of Omaha, McElvaine runs a concentrated portfolio, where single positions can constitute 10% or more of his portfolio; when a stock falls, he tends to add to his position, on the reasoning that the upside is higher and the margin of safety larger; when he assesses management and directors, he ensures that they behave in the shareholders' interest, not their own, and occasionally takes a seat on the board to make sure executives don't confuse the two; and he focuses on return on capital and cash flow.

Some of McElvaine's habits and values resemble Buffett's, as well.  In describing a typical day at the office, he cites a poster that reads, "Sometimes I sit and think, and sometimes I just sit," which would delight Buffett, who firmly believes that activity is the enemy of investors.  McElvaine, like the Berkshire Hathaway CEO, has the bulk of his family's money invested in his fund, as they both like to "eat their own cooking."  And McElvaine's letters to partners, while not appointment reading for most of the investing world, are unfailingly candid and humorous.

One important area where McElvaine strays from Buffett, however, is in his willingness to own "duds" (p.45).  As he explains, "What I ideally like is a mediocre business, so to speak, that each year will be worth a little bit more primarily because of cash flow" (p.47).  Buffett, on the other hand, refuses to invest in companies without a sustainable competitive advantage.

There's a good chance that McElvaine will return to form in the future.  His success in the past was not an accident, and he has wisely remained loyal to the key ideas that have served him, and many other excellent investors, so well.  To be sure, he has tweaked a few things, such as investing less money in small caps to provide more liquidity, and diversifying into a somewhat larger number of holdings.  To his credit, however, he hasn't abandoned a formula that is likely to work over time.  And a greater commitment to buying only companies with a wide and formidable "moat" would further increase the odds that Tim McElvaine returns to his past glory.

Sources: Thompson, Bob.  Stock Market Superstars: Secrets of Canada'sTop Stock Pickers. Toronto: Insomniac Press, 2008.

Publications that can be found on Tim McElvaine's website. 

Other Profiles include investor Tom Stanley, and New Yorker writer James Surowieki.

Disclaimer: The host of this blog shall not be held responsible or liable for, and indeed expressly disclaims any responsibility or liability for any losses, financial or otherwise, or damages of any nature whatsoever, that may result from or relate to the use of this blog. This disclaimer applies to all material that is posted or published anywhere on this blog.

Profile - Tom Stanley

From 1993 to 2006 Tom Stanley's Resolute Growth Fund returned a staggering 29.63% per annum.  The lucky and grateful investors who were carried along for the entire ride enjoyed a total return of better than 25-to-1.  Over the same span, the TSX returned a touch above 10% per year, or about 3.5-to-1.  Importantly, only about half that timeframe straddled the long bull run that lasted from the early 1980s to the late 1990s.  Between the Dot Com bubble and the current crisis, stock market performance overall was distinctly mediocre, while Stanley's performance was outstanding.  Indeed, over the eight-year period from 1999 through 2006, he returned 46.25% per year (1).  To be sure, his performance since has been more pedestrian, but whose hasn't?  Such impressive returns put Stanley among North America's finest investors. 

Despite such impressive performance, few students of investing are likely to have heard of him, particularly if they reside outside of Canada.  Stanley doesn't do much media, and will not be found revealing his top picks on BNN Market Call or similar forums, so his ideas, alas, aren't readily available to copycat investors.  Even investors situated within the corridors of Canada's financial power might not know him.  Instead of operating out of a glitzy Bay Street high-rise, Stanley's shop is in a nondescript office far from the heart of Toronto's financial district.  However, there's much to learn from his experience and philosophy.  Though Stanley is justifiably tight-lipped about the specific stocks that he's invested in, he openly shares his principles of investing, and has posted them on his website.

It's not just his performance that distinguishes Stanley from most other investors.  He has conviction.  Everyone talks a big game about their undying commitment to clients; Stanley backs up his words with honorable actions.  He charges a paltry 2% management fee (which includes all expenses), an anachronism in the era of 2-and-20 hedge fund managers, most of whom charge fees of 2% of assets per year, regardless of performance, plus 20% of any gains.  He launched a fund that catered not to rich investors, but to ordinary ones, and held Town Hall-style meetings once per year to engage with them face-to-face, not all that different from one of his major influences, Warren Buffett (Stanley cites Charlie Munger, Peter Lynch and John Templeton as his other role models).  Most notably, when interest in his fund soared, he made the self-uninterested decision to close it to new investors.  The bigger a fund is, the harder it is to grow at above average rates, after all.  Stanley preferred to give clients the chance to gain outsized returns, even if it meant earning less himself. 

Buffett's influence is apparent elsewhere, too.  Stanley has a knack for catching trends before most other market actors know there's a pattern at all.  For example, he understood more than a decade ago that oil was likely to rise significantly, and outlined his reasoning in a letter to clients dated October 11, 2000.  His case was straightforward: inflation-adjusted oil prices were low, which depressed industry profits, and spare capacity was limited, meaning that new supply was unlikely to both replace depleting wells and meet growing demand unless prices rose (2).  He was able to find small-cap energy producers that were trading for just two or three times cash flows (3).  During the same period, many investors were wild about high-tech stocks, and some of Stanley's own clients encouraged him to add Dot Coms to his portfolio.  He refused.  However, contrarianism sometimes masquerades as independence, and Stanley understands the difference.  Indeed, one of his principles is: "You don't have to win by being original, you win by being right" (4).
Stanley concentrated heavily in a few ideas - sometimes his entire fund is invested in less than 10 stocks - and ignores the conventional advice to rebalance his portfolio constantly, so that positions are evenly weighted.  In fact, in 1996 one name - and not a household name, either - accounted for 36% of his fund's assets.  Predictably enough given such concentration, his fund has dropped by 25% or more on several occasions.  However, he credits much of his success to just a few ideas.  On the other hand, he's one of the rare money managers who's admitted that he would liquidate his entire portfolio and sit on 100% cash if market conditions warranted it (5).

Citing Buffett's notion of staying within one's "circle of competence," Stanley rarely strays outside of Canada when making investments.  Though he doesn't have a firm rule against investing elsewhere, he believes that he has access to better information about local businesses, and a more in-depth understanding of political and economic issues, in Canada.  His sterling record is all the more impressive, given Canada's more limited pool of public companies than there are in, say, the US.
One surprising area where Stanley appears to differ from Buffett is in the quality of the businesses he invests in.  Many of the names that Stanley has invested do not appear to be of the highest caliber.  The Oracle of Omaha insists on buying only the best businesses, ones that enjoy a durable competitive advantage; Stanley has little to say on the matter, but many of the names that he's invested in that are public knowledge would be unlikely candidates for Morningstar's "Wide Moat" index.  At least, the last time I checked, UTX, International Uranium and Cangene weren't on that rarified list.  Most of them were bought on the cheap, however, rather like the companies Ben Graham - and the pre-Munger Buffett - preferred to buy, though they don't seem to be as dismal as the "cigar butts" that Graham scavenged for.  Stanley finds undervalued stocks largely by searching for ignored small cap stocks that have fallen under the institutional radar.

Like many formidable investors, Stanley doesn't fit in any conventional mold.  For example, he proves (again) that it's a myth that investors must have an accounting background, or a formal education in business, to have success.  Charlie Munger studied Law (he didn't receive an undergraduate degree at all, but was admitted into Harvard's law school thanks to the intervention of a family friend); Bill Miller studied Philosophy at the graduate level; and the late Barton Biggs majored in English Literature.  Stanley, for his part, focused on Psychology as an undergraduate, though he later supplemented his studies with an MBA.  He's of the view that most people's brains are not wired to invest well, and he pays close attention to the research that explores the psychology of investing (6).  The insights from behavioral finance, combined with what he has gleaned from investors both prominent and private, with a lot of independent thinking, too, have produced a rare and special investor in Tom Stanley.


Sources: (1) (2) (4): http://www.resolutefunds.com/
(3) Thompson, Bob. Stock Market Superstars: Secrets of Canada's Top Stock Pickers. Toronto: Insomniac Press, 2008, p305

(5) Thompson, p319-20

(6) Thompson, p293

Disclaimer: The host of this blog shall not be held responsible or liable for, and indeed expressly disclaims any responsibility or liability for any losses, financial or otherwise, or damages of any nature whatsoever, that may result from or relate to the use of this blog. This disclaimer applies to all material that is posted or published anywhere on this blog.