To a class of graduate students at Boston College, Mohnish Pabrai facetiously said that he had spoken to the Great Spirit of the Universe. And in that conversation the Great Spirit confessed to him that the Ten Commandments, originally handed off to Moses, were slightly off.
And for the next two hours, Pabrai presented to the class of MBAs the Ten Commandants as given to him.
I thought it was a wonderful talk. It introduces some of the fundamental principles of value investing which I decided to summarize in this meditation.
While management fees have been dropping, over 98% of asset managers still charge a management fee between 0.25% and 2.00% of assets under management. So managers continue to pay their utility bills, whether they win or lose money for you.
Pabrai argued against this practice for two reasons. First, with such a misaligned incentive structure, the asset manager typically spends his or her time growing assets under management while their sole focus should be to earn a higher-than-market rate of return for you.
Second, as Charles Ellis wrote in Investment Management Fees Are (Much) Higher Than You Think, a one percent management fee may seem trivial and harmless at a first glance. But when viewed as a percentage of the actual income generated by the asset manager, management fees in the financial industry are high, ranging between 10% and 20% of the actual investment revenue. As a point of reference, your local property manager would charge 3% to 8% to manage your home while you are away on vacation.
The investment management profession was intended for the individual. "If you like to sit in a room alone, intrigued by how the world works, you will do just fine," Pabrai said.
To him, hiring a team of analysts will distract the asset manager with tiresome managerial duties. And instead of carefully reading about investments, the manager will eventually read the analyst’s cliffs notes.
By explicitly investing in stocks, you implicitly take unforeseen risk. For example, buy Coca Cola stock today and you will immediately be exposed to changes in consumer preferences (just try to pitch to consumers a coconut or Kombucha drink a century ago) and to geopolitical changes (for decades after World War II, consumers did not purchase AEG products because they were associated the Germany).
In short, expect a bumpy road and be humble.
Because of commandment number three, investors must look for stocks that will multiply by at least two-fold within three years. Grab your HP12C and you will see that this is an implied expected return greater than 25% per year.
In his talk, Pabrai described his investment in Fiat Chrysler, a car company, that was at the time he had bought its stock, the valuation was a price to earnings of one. Another example was a company in the funeral business. "Good things happen when you buy companies at a p/e of 1,” he proclaimed.
If you cannot mentally understand why you are buying the stock of a company, you should not invest in the stock in the first place. Surely, Quants that trade in stock market using math algorithms, would be disappointed.
I think Pabrai argued for us to get rid of Excel program because by adjusting input assumptions, we may turn a mediocre investment into an excellent one. This is known in the investment industry as “garbage in, garbage out”.
In this commandment, Pabrai brings a wonderful example of the implicit, unrealistic, growth expectations of a current investor in Apple, as the stock is trading at over 20 times the trailing earnings.
While we see ourselves as rationale machines, constantly weighting the cost and benefits of our decisions, current research says otherwise. And so, this commandment addresses our emotional side.
It is only a matter of time before something drastically bad will happen to us. And it is important to prepare for times when we will recite that these are times that try men's souls.
To some, Vipassana yoga is the answer. To others it may be family or a community to belong to. For yours truly, it is reading about history as a means to appreciate the present and to prepare for the future.
The Pareto principle, also known as the 80/20 rule, states that roughly 80% of the effects comes from 20% of the causes. What had become a business axiom (80% of the sales come from 20% of the clients) applies to stock research.
For example, reading a company’s annual filings, such as 10-k report, which often takes less than an hour, provides the reader with a general understanding of the business, its industry and its risks. It quickly provides answers to questions such as how much deb does the company carry? What is the return on invested capital over the past five years?
Yet if you get distracted and read about possible changes in government policies where the company domiciles, or if you look at the history of the stock price and try to infer where the stock is heading based on the historical movements, you will get overwhelmed.
No need to bring much details or to further expand on this concept. In shorting stocks the math operates against you (your upside is limited while your downside goes to infinity). View Pabrai's talk at Google for an expanded discussion on the topic of shorting.
And not only that you bet on a future outcome, which is by definition unknown in the present, you are betting on its timing. And if the Oracle of Omaha does not short, why should you?
In Buffett’s owns words:
“Charlie and I have agreed on around 100 stocks over the years that we thought were shorts. Had we acted on them, we might have lost all our money, every though we were right just about every time. A bubble plays on human nature. Nobody knows when it’s going to pop, or how high it will go before it pops.”
Charlie Munger said that, “You can’t get ahead in life if you owe someone 20% on the money they gave you.”
Pabrai, who reveres Munger, takes the principal to heart. You will rarely see leveraged institutions - such as banks - in his portfolio of stocks. Without borrowing money, you can't go bankrupt.
Pabrai did not invent the 0/6/25 investment model (zero percent management fees, six percent hurdle rate and a quarter of the profits to the asset manager). But he thought it was crazy that no asset manager had copied this business model.
Pabrai shared with MBAs that most of his investing ideas are the result of reading annual reports by other fund managers and copying ideas that are sensible to him.
With that, I am certain he would be proud of me for copying - and for sharing with you – his ten commandments.