Stephen D. Cutler Center for Investments and Finance,
 Babson College
 Managing Director: Patrick Gregory
    (00:00:00) - Introduction
 
 (00:02:03) - Value vs Growth Investing
 
  (00:05:45) - Microsoft
 
  (00:09:12) - Volatility in auction driven markets
 
  (00:14:36) - Portfolio management
 
  (00:18:32) - Change in Investment philosophy
 
  (00:22:45) - Walmart vs Nifty 50
 
  (00:25:26) - Reysas
 
  (00:29:43) - Micro vs. Macro
 
  (00:32:05) - Investment in Turkey
 
  (00:35:19) - John Arrillaga’s Tiny Circle of Competence
 
  (00:41:49) - Structural changes due to pandemic
 
  (00:46:47) - Three variables that drive long-term wealth
 
  (00:47:39) - My daughter's introduction to investing
 
  

I'm the Managing Director of the Cutler Center for Investments in Finance and the Director of

It's my pleasure to introduce tonight's speaker.

Monish Pabrai is the Managing Partner of Pabrai Investment Funds, which has more than 500 million in assets under management and invests in public equities using a focused value approach.

With this approach, his fund has delivered annualized returns of 12% since inception in 1999 versus 8% for the Nasdaq index.

Monish has been profiled on Forbes and Barron's, appeared frequently on CNN, CNBC, and Bloomberg TV, and is the author of 2 books on value investing.

Those are the Dundoe Investor and Mosaic Perspectives on Investing.

We expect tonight's discussion to last approximately 60 minutes.

He's going to be interviewed by Anay Gawande, who is an undergraduate student and 1 of the sector managers in the Babson College Fund.

Anay will spend the first 20 to 30 minutes on prepared questions, and then open it up to the audience for Q&A.

I should note that recently, a 30 minute Zoom call with Monish raised

on eBay for the Dakshana Foundation, which he founded for gifted but underprivileged children.

Put differently, the next hour is valued at just over

We're certainly in for a treat and grateful to Mr.

Pabrai for taking the time to speak with us this evening.

So just to kick things off, Monish, value as a style class has been underperforming growth for several years.

How has this changed your investment philosophy?

And can you expand on the idea of compounders that you started to talk about and how you go about looking for those.

So, Anay, anyway, it's a pleasure and honor to be here.

And just before I answer your questions, I just want to state that Babson is a very unique place in the universe, and its focus on entrepreneurship is 1 of the reasons why it's so unique.

So generally speaking in business schools, entrepreneurship is a neglected area.

And it's a neglected area because generally business school professors will generally find it hard to get consulting assignments if they specialize in entrepreneurship.

If you're a business school professor, you specialize in branding or leadership or organizational development or marketing, you will have a lush consulting career on the side.

But if you specialize in entrepreneurship, us entrepreneurs are too cheap and scruffy to engage B-school professors to tell us what to do because we also think we know what to do.

So basically it ends up that most and also the other the other thing is that to teach the subject well you would have needed to be a practitioner.

And generally speaking, the entrepreneurs usually don't have the PhDs and the credentials.

So, you know, they would have a harder time with tenure, you know, getting appointments and so on.

So for a multitude of reasons, basically entrepreneurship gets ignored.

And I think that it is the engine that drives it drives everything.

It's the engine that created these United States made us 1 of the.

Richest large countries in the world and the most powerful nation in the world.

So at the core of all of that is an entrepreneur with an impossible dream that he's chasing, he or she is chasing.

So anyway, after more than 2 decades, Babson finally called.

I think that your first question, if I can still remember it, you know value and growth are 2 sides of the same coin.

You cannot really separate them and you cannot say for example value has underperformed and growth has done well.

Any business is worth the sum of all the future cash it's going to produce from now till judgment day discounted to a present value.

And so if a business is growing 10% a year, growing 15% a year, growing 50% a year, or declining 5% a year, all of them have future cash flows coming out, which drive the result in terms of what that business is worth.

And if we are paying less than those discounted cash flows, meaningfully less than those discounted cash flows, then we are engaging in value investing.

If we are willing to pay anything for those future cash flows, then usually that has led to not such good results in the long term.

And so some of the things that we are seeing currently in the markets are frothy and some of the things, you know, eventually we will find out who's been swimming naked when the tide goes out.

So that will become apparent, But I'll just give you an example.

In early 2000 I visited Microsoft headquarters in Redmond and 1 of my in early investors.

The funds were just about a few months old.

Then he had said to me, hey listen, he was.

He was very early employee at Microsoft and well at prison and done.

But he said look if you ever find yourself in Seattle, I could probably introduce you to some current and former Microsoft employees who might have an interest in your fund.

I'm going to be there day after tomorrow.

So I spent a day where he took me to different offices in Microsoft and I met with a bunch of current and former employees.

And, you know, when I was, you know, suggesting that PubRai funds, maybe a place they could put some money, most of them had almost all of their assets in Microsoft, in stock and options.

And of course their Paychecks came from the company.

And Microsoft in 2000, when I looked at it, it was a very successful company, but it was very overvalued.

So I told them, look, I don't think it's a good idea to have this much exposure to Microsoft, because I think quite frankly, the future results aren't going to be that great.

So their perspective and their response to me was, well, what if you really don't understand technology well and you don't understand our company well?

We have done nothing but go straight up for 24 years.

The stock always does well, and it will continue to do well.

So I said, well, you know, the math is against you because you're producing less than 10 billion a year in cash flow and your stock is valued at 600 billion, you know, probably the second most valuable company on the planet or something at the time.

And I just said that unless those cash flows go up quite dramatically, It's just not going to be worth that money.

And it turned out that right from 2000 till about

or 2016 or so, Microsoft was a terrible company to own, Even though the business did really well.

So the company did well, the business did well, but the stock was just too overvalued.

And so even though cash flows were higher in years after 2000, it just wasn't enough to keep that.

So in fact, at 1 point you had a 70, 80% drop in market cap.

So it was a rough ride and Cisco had the same issue.

And so these are not fly by night, patch.com type businesses, which had no business model.

And we see some of that today where there are companies where the valuations look quite extreme.

I haven't studied them in detail, but if you were to do these future cashflow calculations, So if you take a company like, let's say Snowflake, I mean, I would love to see the future cash flow calculations on Snowflake for the next 20 years.

And that would just give you the answer whether it's overvalued or not.

So value and growth are the same, 1 and the same, joined at the hip.

And it's all about buying those future cash flows and well below what they're worth.

And I guess moving on to the second question, You spoke about how Microsoft's market cap at

there was a similar story where your fund lost 65 to 70% in the great financial crisis.

I think as a young investor, what I want to know is, you know, how do you maintain your conviction?

Your so-called intestinal fortitude and continue to remain to hold when things aren't working out for you?

So I think that in general, if you are going to be a participant in auction-driven markets, you have to understand that these markets overshoot and undershoot all the time.

And so there are times that markets get euphoric and there are times the market gets pessimistic.

I think like Charlie Munger says that 3 times in his life so far, Berkshire has dropped 50% or more from the previous high.

And he just considers that like kind of par for the course.

So At the time in 08, 09, when we lost 2 thirds of value, the intrinsic value was a lot higher.

And so 1 has to have the right framework in those times.

So if you look at any stock on the New York Stock Exchange or NASDAQ and just look at the 52-week range on that stock, you will find that something is traded from $50 to $100 in the last 12 months and currently valued at $80 or something or $40 to $90 and currently valued at $85 or something.

So the thing is that you'll almost always across all these stocks see like a 100% delta between the high and low price in a 12 month period.

And these are not 12 month periods with a stretch.

You could go back and look at any 12 month period.

You could look at 2008 or you could look at

or 2006 or 2015, you would find the same phenomena.

So auction driven markets causes this attenuation because prices are set in the near term by people voting with their, by buying and selling the shares.

And in the long run, they get weighed appropriately.

They get weighed based on what they're worth.

So in 2008 and 09, when we were down 2 thirds, our funds were very undervalued.

In 9 months, I think in the year, in 2009, we were up, I think the funds were up over 110%, for example.

So it's not like those businesses did a lot better.

It's that we were sitting very undervalued at that point.

And I think for the next few years, the funds did very well.

So I think that if you're going to participate in auction driven markets, you have to understand volatility is part and parcel of that.

So leverage becomes lethal when you are going to have large drawdowns because then your broker is going to tap you on the shoulder and ask you to send more cash just as the moment you happen to be short of cash.

And that's not a good situation to be in.

And the second is that, You know, I always remember this old saying.

If wealth is lost, nothing is lost, and if health is lost, something is lost.

And if character is lost, everything is lost.

So we are only talking about temporary loss of wealth.

So it has never bothered me when my portfolio has dropped a lot or the funds are down a lot, because in general, those very times when that is happening generally tend to be very orgasmic periods in terms of opportunities to invest in.

So I'm more interested in, hey, this is a good time to improve my portfolio.

Can I get rid of a lesser quality business and maybe a better quality business?

Because when everything's being thrown out, they're getting thrown out in different ways.

And so some things get more deeply undervalued than others.

commodity prices and commodity stocks got crushed.

I mean they just went to numbers that made no sense And it was happening at such a furious place that I created a basket of commodity bets.

I mean, companies in the commodities area.

And I just kept putting 2% into each bet because I didn't have that much time to really drill down on the businesses.

And so we had like 7 or 8 different commodity bets.

I mean, every single 1 of them was at least a double in a relatively short period of time.

So I think that's just par for the course with option driven markets.

You're gonna have a volatility and you should just be comfortable with that.

And I think to expand on your point, you're very famously known to run a very concentrated portfolio.

I'm wondering if you can lend some insight into how you think about structuring your portfolio and some of the other portfolio management related issues that a portfolio manager may face?

Yeah, so I think you should think of yourself not as a investor, but more as a partner in a business.

I think that's a better way of looking at the business.

So you might say, you might own like, you know, 0.1% or

of the company, but you should think of yourself as a co-owner of the business.

And so once you kind of take an approach where you think of yourself as the owner of a company, when you look at entrepreneurs and you look at great entrepreneurs like Sam Walton or Steve Jobs or Bill Gates, any of them.

1 thing you'll notice is that in general, they are extremely non-diversified.

So when they are building their businesses, sometimes 99% of their wealth is in a single business.

Many times that single business is privately held, illiquid, cannot be sold, etc.

Some couple that owns a Chinese restaurant, for example, they may have everything in that business and they're not diversified.

So we as investors have a better set of hands to play than the typical entrepreneur.

So the entrepreneur is almost naturally driven towards extreme concentration, right?

90 plus percent of assets in 1 particular business.

Charlie Munger and Warren Buffett both believe, you know, Buffett says that if you understand a few businesses well, it is madness to put any money in your 25th best or your 30th best idea.

And Charlie Munger would be more direct and he would say that there's no need to have a portfolio of even more than 5 stocks.

So his perspective is a 3 stock portfolio is more than enough.

So in my personal accounts or my IRAs and things like that, I rarely have more than 2 or 3 stocks.

Sometimes I just have 1 stock, my highest conviction idea.

In Pabrai funds, because it's OPM, other people's money, I have told my investors that I won't put more than 10% at cost into a single idea.

But it has happened in the past that we've had a single position or 2 positions become 60, 70% of the portfolio.

And because they've gone up so much and such.

And at those times I've been reluctant to cut them back.

So I don't think you need to have too many positions.

I definitely think that it is very hard to outperform the index.

If you have a 20 stock portfolio with 5% going in at the max and any company and that sort of thing.

I think if you understand a bunch of businesses, there are clearly a set of businesses that you understand extremely well.

And there's a difference between the ones you can understand extremely well and not so well.

And then also kind of there's a convergence between a business that you understand really well and that particular business being very undervalued, then you need to step up to the plate.

Or like Buffett says that when it's raining gold, don't put out a thimble, put out a bucket.

And I'll ask my last question before we open it up for Q&A.

Manish, when you build a checklist just for new companies, and now as you start looking for long-term compounders, what are you looking for?

In other words, in the story of Arjuna, when he aims for the fish's eye, what is that center of eye?

What is that 1 piece that every company you look at has to have?

Yeah, so actually, that's a great question, because I went through a significant change on my thinking last year on that.

So for most of my career as a professional investor, I took the approach of trying to buy a dollar bill for 40 or 50 cents or less, and sell it for 90 cents or a dollar, kind of capture that arbitrage.

And hopefully if the intrinsic value went up in that period, then it could be more than a 2x.

Or if I bought it at like, for example, 20 cents on a dollar, it could be a 4 or 5x.

Like in the, during the financial crisis, you know, those commodity plays were pennies on the dollar.

The change in thinking I went through last year was to switch from looking at these undervalued businesses to looking at great compounders.

And the 1 difference is that I've made many investments in the past in great compounders, but the problem was that they would get to full price or maybe even get to a little bit overpriced.

And I would see it as risky to keep holding.

And I'd want to go put it into some of the investment.

Of course, the negative with that is that in taxable accounts, it's tax inefficient.

And in great states like Massachusetts and California, we have even more extreme results because of all the high state income taxes.

So it's very tax inefficient if you are in taxable accounts.

And the second is that if you could identify businesses with very long runways that you can buy even at small discounts for intrinsic value, it may not be 50% off, and then you are right on the runways and the long-term value creation, then those can turn into 10 baggers or 100 baggers.

And in those scenarios, just a couple of positions can make a big difference.

You know, in the late 60s, early 70s, there was this notion of the nifty

which was that you identify these 50 great businesses, which were quite richly valued at the time, but they had great future prospects.

And the thinking was just buy this basket of these 50 businesses, don't worry about the price, and everything will take care of itself.

And so this basket included things like McDonald's, Coca-Cola, it had, you know, Polaroid, Xerox, Kodak.

So these were some, you know, I mean, If you look at a company like McDonald's in

I mean, you could not see the end of that runway.

I mean, just such a huge, massive runway.

And even now it's growing, you know, it's been 50 years since then and it's growing, Coke is still growing and so on.

But the end result of that nifty 50 wasn't great because some of these companies were trading at

which really, I mean, 70 years ago combined, the market lost like 2 thirds of value.

So first of all, if you had strong intestinal fortitude, and you saw your portfolio go down

and you decided, well, it's not a big deal, I'll keep holding.

Even after that, the pain wasn't over because they were just so overvalued.

But there's a kind of a small ignored footnote in the Nifty 50.

There's a controversy whether Walmart was in the Nifty 50 or not.

If you put Walmart in the Nifty 50 and you put 2% into Walmart and you run the numbers, the nifty 50 beats all the indices by a mile.

If you take out Walmart, it performs terribly.

Okay, and Walmart is in there at just 2% weightage at the beginning.

So 1 business, 1 business at 2% weightage causes this.

Because Walmart in 1970, when they had come public, I mean, the market cap was less than 30, 40 million.

It was a very small business at the time.

And look at the runway, you know, it's a 50-year runway and still going.

And So 1 of the things that took me a long time to figure out, I should have learned this a long time ago, is if you are, like if I have a portfolio of 10 stocks carefully picked and they are all compounders with long runways and they aren't bought at ridiculous valuations, etc.

You may not need more than 1 or 2 of those to have a good run as long as the rest of them don't cause you too much heartburn.

So it is a given that when you make 10 bets, at least 4 of them are not going to work the way you think they are.

So predicting the future of businesses is not a easy thing to do.

But even if you have a 40% error rate, in the case of the Nifty 50, you had a

error rate and you still did well if you were right on the 2%, right?

And the other thing is that when you think of yourself as an owner of a business, because that's the mindset you have to be, because the only way you'll be able to keep, no 1 other than the Walton family has kept Walmart stock from 1970 to now.

Is it not obvious that it has, you know, very strong ethics and moat and all of that?

You know, there's a lot of things that are obvious about Sam Walton and Walmart.

So just to give you a little bit of example there is I made an investment before my enlightenment of 2020.

And When I made the investment, the market cap of this company was $19 million.

And the best that I could tell the liquidation value of the business, because they were 12 million square feet of warehouses.

They have got the largest freight operations network, the largest truck fleet in Turkey, and so on.

Liquidation value was at least around $500 million or so.

The people who ran the business were exceptional capital allocators, so I was buying a business.

You know, probably less than 5 cents on the dollar.

You know the kind of opposite of the nifty-fifty, you can say.

So I said, okay, this is great, you know, we'll hold this for a while.

See all Chai with Pabrai transcripts on Applepodcasts

Mohnish Pabrai’s Q&A with members of The Babson College Fund (Babson College Students)– Feb 9, 2021