Mohnish Pabrai

One technique to play with during times of duress

Published on:
April 25, 2020
Reading time: 4 Minutes.
Last Update:

COVID-19 impact on the first quarter of 2020 capital markets results was felt by all of us. And every profession slowly finds ways to respond and to adapt.  

In this essay, I write that treating your portfolio of stocks as a portfolio of businesses - and not a collection of ticker prices - may help you see things differently. 

A random walk on the Indices

Imagine an investor placed a $10,000 bet on a S&P 500 mutual fund on January 1. By the end of January, the value of bet would $9,984. The value would further drop to $9,144 by the end of February. The portfolio would drop to $8,000 by the end of the quarter [1]. In short, the investor's bet would be down 20% for the quarter.

The fall in market prices was felt across the indices. Nasdaq started 2020 at 9,151 points and ended the month of January at 9,190 points. By February, the index dropped to 8,667 points and ended the quarter at 7,459 points. A drop of 1,692 points or an 18% drop. One more example is the Dow Jones Industrial Average. The Dow started 2020 at 28,638 and ended the quarter at 21,227, down 7,411 points, about a 25% drop. 

Global markets were down, too. The MSCI World index dropped by 21% during the first quarter of 2020. And the MSCI Emerging Market dropped by 23.6%. (Try not to laugh next time you hear about the benefits of global diversification.) 

So it took just three months to bring back the five indices two to market levels seen over two years ago. Can we assume that's likely the time frame for the indices to return to the early 2020 levels? 

"No,"  nervous investors would say. They would further note that if we annualize the market loss over the past three months, the initial $10,000 bet in the SP&500 will be worth $4,096 by the end of 2021. 

Bearish investors would remind us that it can take a long time - much longer than two years - for indices to recover. They would recite that on December 31, 1964, the Dow was at 874 points. And that if we fast forward 17 years later, The Dow stood at 875 in exact on December 31 [2].   

COVID-19 effect on my portfolio

My portfolio of stocks was not immune to the vicissitudes of the market. Out of sheer luck, before the market fell, I didn't own any restaurants, cruise lines, hotels, retail, or restaurant businesses. I also didn't have any material positions in the gas and oil industry and airlines.

I did own three companies in the Gas and oil business (Gulfport Energy, Noble Energy, and CNX Energy). I also owned one Airline company (Hawaiian Airlines, which I wrote about in June 2019).  While the market value of the four positions more than halved, the overall effect was small. The four companies represent less than 7% of the portfolio. 


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But the portfolio's value took a hit nonetheless. It dropped by 38% over the past quarter. So I opened Excel and fooled around with a few "what if" scenarios, hoping this exercise may alleviate my mood. 

The 'What If's

My highly-concentrated portfolio of common stocks consists of 19 companies. The first ten names are three-quarters of  the value. 

Let's imagine one conglomerate had owned the 19 companies. Let's name the conglomerate G.H. Here is what G.H. would report to shareholders for yearend 2019: 

G.H. 2019 revenue [3] was $5,847 million, with an operating income of $1,184, a reasonable 20% operating margin [4]. The pre-tax earnings were $416 million, and the after-tax earnings were $330 million, a 5% profit margin.

With a market valuation of $6,867 million as of yearend 2019, the market valued the 2019 earnings at 21 times. 

Ganel Holdings 2019 Income Statement
G.H 2019 Income Statement

If G.H profit margin stays at 5% over the next five years, then the annual return between 2019 and 2023 will be a loss of one percent. This gloomy result assumed a 10 times earnings valuation in 2023 [5].

Ganel Holdings 2019 Balance Sheet
G.H. 2019 Balance Sheet

If G.H net profit is 10% sometime over the next five years, then the 5-year annual return will be 10%. Again, the earnings multiple assumption is 10 times the earnings.

Let's increase the earnings multiple valuation assumption from 10 times to 15 times the earnings. At a gutsy 15 times, the 5-year annual return will be 8%, assuming a 5% profit margin and 24% assuming a profit margin of 10% [6].


"While we see ourselves as rationale machines, constantly weighing the cost and benefits of our decisions, current research says otherwise," I wrote in January 2019 in The Ten Commandments of Value Investing. "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." 

Indeed, these are times that try men's souls.

[1] The S&P 500 lost 0.16%, 8.41%, and 12.51% during those months, respectively. [2] Read more in Tap Dancing to Work written by Carol Loomis. [3] Figures are weighted average to reflect the proportional positions in each company. [4] Driven upwards because of GrafTech's operating margin of 53%. [5] For reference, the S&P500 earnings multiple was 18 times at the end of 2019 and 13 times at the end of the first quarter of 2020. [6] According to Factset, the S&P 500 profit margin is about 10%.

Life in equity research

Published on:
December 21, 2019
Reading Time: 4 Minutes.
Last Update:

Life in equity research is about asking questions. It is about wondering what exactly did Fiserv, a financial services company, do over the past decade that drove the stock price tenfold [1]. It is thinking about how, after 105 years, General Electric was part Down Jones Industrial Average, it lost its place.

"If he [Charlie Munger] were teaching finance, he would use the histories of 100 or so companies that did something right or something," writes Jennifer Lowe in Damn Right! Behind the Scenes with Berkshire Hathaway Billionaire Charlie Munger. 
"Finance properly taught should be studied from cases where the investment decisions are easy."

Life in equity research is about understanding businesses. Not academic theories.  

That studying business is at the heart of equity research was not clear to me when I started this journey. When I studied for Chartered Financial Analyst (CFA) exam[2]. During that period, I read investment topics such as the risk management application of option strategies and reviewed foreign exchange concepts such as forward markets and sport markets. While these topics, perhaps, are of interest to the student of finance, they serve little in the hunt for the next Amazon.      

Cultivating relationships

Another subject absent of finance programs is the value of relationships. I believe that none of the legendary investors would achieve success if they didn't have a supporting spouse, a loving family, a community to belong to, and outside interest beyond the passive ownership of equity interests. In other words, developing soft skills is as vital as understanding GAAP accounting.  

One example of a life skill is creating goodwill. It is so much easier to ask someone for help when already you have assisted them in the past. In our time of just-because-what-can-I-lose Linkedin requests, you will gain an advantage over your peers if you carefully develop an ecosystem of friends that genuinely care for one another.

And developing and maintaining relationships requires work. It is about spending time each week thinking about how to bring value to others. It is about small acts of kindness and putting the focus on others. It is about remembering what Viktor Frankl used to say in the name of Kierkegaard. That the 'The door to happiness opens outward.'

The door to happiness opens outward.

Understand: Whether the stock portfolio increases in price over 12 months is mostly dependent on factors beyond your control. But whether you build genuine life-long relationships is entirely up to you.  


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Bringing business development efforts to nil

There is tension between investment research and the business of investment management. I estimate money managers use between half to three-quarters of their time in the latter. They travel to meet prospects, they speak at conferences, they interview at any opportunity.

From conversations I had with money managers, I learned that many of them would much prefer to replace the ratio of business development to investment research.

I don't have an answer on how to do that. My personal story is that I saw this inherent tension between the research and business side of things. And I decided to avoid managing other people's money so that I won't have to spend time explaining to them my investment decisions.

Business development becomes crucial when fund managers hire a team of professionals. As I wrote in January of this year,

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 sift through the analyst's cliffs notes.

Read more in Mohnish Pabrai's Ten Commandments of Value Investing.

In short, I keep business development efforts to nil and decided to be a team of one. Read Paul Jarvis' Company of One, to learn about this model of work.

The lifestyle of an equity analyst

There is no single formula for life in equity research analysts. Your lifestyle is different when you have young children compared to your lifestyle when they are in college. Not unlike life, the investment life is much different when markets are fully priced compared to market everybody is selling.

While there is no fixed, daily time structure, I find it useful to have a few key performance indicators (KPIs). These KPIs allow us to keep track of progress.

For example, in a particular one month, I will write in my Bujo calendar: "This [Month] I will read [Number] 10-k reports. I will read about the business model of [Number] companies from [Number] investment newsletters; and track the stock activities, via 13-F filings, of [Number] fund managers."

Your lifestyle should drive investing decisions. These decisions should not drive your lifestyle.

Some investment ideas take months to understand. For example, I bought GrafTech (read the GrafTech article) after researching the industry and the competitive landscape for weeks. Others are much faster. I recently bought Micron in less of six hours of research (Write to me if you would like to know why.)

How to measure success

In The Big Book of Endurance Training and Racing, Doctor Philip Maffetone ridicules the 'no pain no gain' fitness concept. He explains that "this is an emotional reaction - one that is based on current trends, often started by advertisements and other marketing - and one that can be irrational."

The 'no pain no gain' attitude is irrational because you should listen to your body's intuition. And the same can be said about the myth of "no risk no reward." (Read more about this myth and other investing myths in The five myths of stock investing.)

Success in the stock market should be about processes. Not about a percentage point more or less compared to the performance benchmark. In the long run, your financial success is the knowledge and wisdom you accumulate about business, the relationships you cultivate, the investing principals you follow, and how you chose to live your life.

You will never hear investors in their later years regret making that they didn't earn a extra percentage points to their investors. More likely that they will lament that they didn't spend enough time with the people they loved and didn't make an effort to make the world a better place.

When asked by William Green, about the key to a fulfilling life, the legendary Irving Kahn remarked:

"For me, the family has been very important. Having a family, healthy children, seeing what we've achieve at the firm. These have all given me great pleasures."

We know that we should explore and travel the world. We should inspire others to lead. And we should remember and recite what former President Theodore Roosevelt said, "I have never in my life envied a human being who led an easy life. I have envied a great many people who led difficult lives and led them well."

And that is life in equity research.

[1] Fiserv stock went up from $12 in 2010 to $117 in 2019
[2] I passed the CFA exam in five years of work.

Why I bought GrafTech shares

Published on:
December 7, 2019
Reading Time: 13 Minutes
Last Update:

The first part of this essay is a description of GrafTech (EAF on Nyse), a manufacturer of graphite electrodes and petroleum coke. As much as possible, I keep this part objective, stating facts and not my opinions.  But the second part is subjective. Here I give reasons why I bought GrafTech's common stock.

GrafTech's business

You can tell that GrafTech is manufacturing something (more on that 'something' below) just by glancing at the property, plant, and equipment account (PP&E).

PP&E of $689 million represents about a third of the balance sheet. It is $67 million in the value of buildings, $46 million in land, and $532 million in machinery. The PP&E hints at us that GrafTech makes stuff.

Specifically the company makes graphite electrodes which are a small-but-integral part of the steel manufacturing process. In GrafTech's words:

"Graphite electrodes are an industrial consumable product used primarily in EAF steel production, one of the two primary methods of steel production"

Here is how Brookfield (an asset manager that acquired GrafTech in 2015) describes graphite electrodes:

"Graphite electrodes are 10 to 12 inches in diameter and can be up to nine feet long. They can take up to six months to manufacture, in a multistage process that requires significant technical skill and raw material known as petroleum needle coke. GrafTech is the only graphite electrode produce able to produce its needle coke, a significant competitive advantage."

 GrafTech's five plants are in Mexico,Pennsylvania [1], Texas, Brazil, France, and Spain. The company's headquarters are in Brooklyn Heights, Ohio. It also leases five locations, mainly for sales.

GrafTech's income statement

While GrafTech does not itemize the depreciation expense in the income statement, it is worthwhile data to go over. In total, depreciation expense was $131 million over the past three years.

Between 2018 and 2015, the total capital expenditures were $131 million, too. So if you belong to the group of investors that follows the magic formula investing [2], you would be pleased to see in GrafTech a business that requires little capital improvements.

GrafTech Key Operating Metrics 2018-2017
GrafTech's key operating metrics 2018-2017. Source: public filings.

The table above shows that GrafTech had a dramatic revenue increase in 2018, largely the result of the graphite electrodes price hikes. (Also, bottom line benefited from some operational efficiencies.)

The weighted realized price for graphite electrodes was $9,937 in 2018 compared to $2,945 in 2017. The company produced 185 million tons of it in 2018 compared to 172 million in 2017.

The price of electrode graphite is up threefold. The price was $9,937 in 2018 compared to $2,945 in 2017.

Over the past three quarters of 2019, GrafTech showed high operating margins. The average realized price for electrode graphite was $9,976; the average operating margin was 56%, with an average net income margin of 41%.

I estimate the company will report in 2019 an annual revenue of $1,800 million in revenue and earnings of $767 million, roughly $2.5 to $3.0 per share.

GrafTech's future earnings

"Change is the law of life," former U.S. President John F. Kennedy once said. "And those look only to the past or present are certain to miss the future." Returning to GrafTech, let's focus on future earnings.

GrafTech cumulative profits until 2022
GrafTech cumulative profits until 2022. Source: public filings.

On page 45 of GrafTech's annual report which you can download here, GrafTech shows future contracts  of 674,000 million ton of graphite electodes at about $10,000 per MT. These contracts represent about 65% of the planned capacity. GrafTech writes:

"We have executed three- to five- year take-or-pay contract, representing approximately 674,000 MT, or approximately 60% to 65% of our cumulative expected production capacity from 2018 through 2022. Approximately 90% of the contracted volumes have terms extending to 2022.

These expected earnings will determine GrafTech's future value. And these expected earnings are dependent on (1) the growth in the graphite electrodes industry, (2) the price of graphite electrodes, (3) the production capacity, (4) competition from BOF manufacturing (more on that below), and (5) the cost to produce the product.


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Electric arc furnace (EAF) v. basic oxygen furance (BOF)

There are two ways to make steel, the electric arc furance (EAF) method and basic oxygen furnace (BOF) method.

Visually, this is how EAF looks like: 

And this is how BOF looks like this: 

GrafTech writes:

"In the EAF method, steel scrap is melted and recycled to produce liquid steel, while in the BOF method, virgin iron ore is smelted with metallurgical coke, a carbon product derived from metallurgical coal."

GrafTech's competitive advantage

GrafTech is a low-cost producer. In my view, it costs the company about one-fourth to produce the graphite electrodes compared to its peers. To be a low cost producer is good, it is even better in a tight marketplace, where the top five electrode graphite companies [3] of the world hold over 80% of total production.

GrafTech is a low-cost producer.

GrafTech is the only vertically integrated electrode manufacturer. Vertically integrated means that they control the price of needle coke, the main ingredient behind graphite electrodes.  GrafTech writes on page 10 of the 2018 annual report: 

"Seadrift [the needle coke manufacturer] provides a substantial portion of our petroleum needle coke supply needs internally and at a competitive cost and allows us to maximize capacity utilization more efficiently than
competitors, who may be more constrained by petroleum needle coke supply."

GrafTech's peers

There are direct and indirect competitors. The direct competition [3] are four companies that compete with GrafTech . With these  companies, GrafTech competes in production capacity, the price of the product, and the cost to produce the product.

The indirect competition to GrafTech is BOF steelmaking. While the difference between the steel manufacturing method is only exciting to students of mechanical engineering, for this essay suffice to note that if BOF manufacturing decreases, then EAF manufacturing increases. And if EAF manufacturing increases, GrafTech benefits.

If BOF manufacturing decreases, then EAF manufacturing increases. And if EAF manufacturing increases, GrafTech benefits.

That, at least, has been the historical case. According to the steel statistical yearbook, produced by the World Steel Association, Between 1984 and 2011, EAF steelmaking was growing at 3.5% per year.

But this trend was reversed between 2011 and 2015 because of an increase in blast furnace (BOF) steel production that for the most part came from China.

(Write to me if you would like a detailed description of the dynamics in the steel industry.)

The steel industry's gloomy outlook

Value Line ranks the steel industry in 91 of 97 possible ranks. ( Why I read Value Line reports.) According to Value Line, you can't find any worse businesses to invest in over the next few years.

 Here is how much you would have lost if you bought five years ago any of the following steel companies:

AK Steel Holdings loss was 69%; Posco loss was 42%; Timmenksteel loss 83%; and U.S. Steel loss was 53%. In short, if you want to spot a liar, ask someone at a party if they made money on steel stocks over the past few years.

"The main question is the long-term outlook for the company," writes Sven Carlin. "As the main product is steel, electrode prices will depend on steel prices and demand for it, especially for EAF steelmaking." 

Because of the reported declines in both revenue and earnings by practically all publicly traded steel companies, the outlook for the steel industry is gloomy. Paraphrasing Howard Marks [4], there is too much steel chasing too few manufacturers.

There is too much steel chasing too few manufacturers.

Why I bought GrafTech

At a market capitalization of about $3,500 million, GrafTech is trading a multiple of one. As I wrote in the first section of this essay, I estimate GrafTech will report to shareholders of $1,800 in revenue and of $767 million in earnings for 2019.

And since GrafTech sold 674,000 million tons at $9,937 per MT, we can estimate total revenue of $6,700 million and earnings of $2,814 million by 2022.  Adding $767 million and $2,814 million, we find $3,851 million in profits by 2022.

A p/e of one for a company whose 2018 operating margin was 49% and net profit margin was 45%  seemed nonsensical to me.

Careful readers of GrafTech's annual report will see that between 2008 and 2017, the price for electrodes graphite was $4,500, and during the worse year (2016), the price was $2,500 per MT.

At about $10,000 per million ton, GrafTech's operating margins are high. But the operating margins are reasonable at $5,000 per MT, too.

At about $10,000 per million ton, GrafTech's margins are high. But the  margins are reasonable at $5,000, too.

There are also reasons to believe of growth. The first reason is that China will export less steel in upcoming years. In 2019, for example, it exported between 4 to 6 million tons of steel per month. But in 2015, in comparison, China exported about twice as much, between 6 to 10 million tons of steel per month.  

There are two other factors, which I cannot estimate their effect numerically. The first factor is the price of needle coke may jump in the near term as a result of the growth in electric vehicles (EV) sales [5].

And the growth in the EV industry is clear. Five years ago lithium-ion batteries production was 1,00 million tons. And last time I checked it was 60 times as much, about 60,000 million ton.  

The growth in the EV industry is clear. For example, lithium-ion batteries production was 1,00 million tons in 2014. In 2017, it was 60 times as much, 60,000 million ton.  


A reminder for readers: my goal in writing is to share thoughts. None that was said above should be construed as investment advice.

Also, this essay is incomplete; there are many important topics I left out. Among them: GrafTech's management and compensation structure, why Brookfield purchased GrafTech, a detailed analysis of the risks ahead, a peer-company review, and a valuation analysis.

More on that in future essays.

FOOTNOTES: [1] The facility in St. Mary's is warm-idles according to GrafTech. [2] Magic formula investing an investment technique outlined by Joel Greenblatt which puts emphasis on companies with high return on capital. [3]  These five companies are Showa Denko K.K., GrafTech, Graphite India Limited, Tokai Carbon Co., Ltd., and HEG Ltd. [4] For more information, read his 2018 memo titled The Seven Worst Words in the World. [5]  The EV industry uses needle coke for the production of lithium-ion batteries.

Why both active and passive investors should expect market swings

Published on:
November 13, 2019
Reading Time: 3 Minutes
Last Update:

Timing the markets is hard; perhaps, impossible. But it is easy to see that market prices widely swing.

In this essay, I describe the investing performance of past and current value investors. As you will shortly read, all legendary investors reported poor results at times. The active investor should know that even great investors failed to correctly time markets. 

For the passive investor, I bring the historical record of indices such as the S&P 500 and the Dow Jones. Here, my goal is to show you that if history is any evidence of the future, then markets swing in price. 

So if you invest in an active mutual fund or an exchange-traded fund (ETF), unless you can calmly withstand market swings,  you are best to buy assets that do not have a daily market quotes.

The active record

Even great investors reported paper losses [1]. The legendary Walter Scholls wrote to investors of a 5% loss in 1957, followed by a 9% loss in 1969 and an 8% loss in 1970. 

During 1973 and 1974, Scholls reported a loss of 15% during each of those two years; Sequoia fund, another legendary fund,  reported a loss of 38% during those years. Even Charlie Munger lost over 53% [2].

Let's fast forward to current examples. Between July 2007 and June 2008, Mohnish Pabri lost 32%, and in the following year, he suffered an additional 25% paper loss. In other words, in two years, the market value of a $100,000 investment was halved. 

Pabrai, whom I admire and who much influences my thinking, also reported a loss of 22% in June 2012. So let the record show that even great minds experience bad years.

Another investor whom I consider to be one of the greatest is Guy Spier.  In 2008, he reported on a 47% loss and a 16% loss in 2015. He writes in The Education of Value Investor 

"2008 was something else. I'd never experienced an avalanche like this within my portfolio. The serious damage began in June when the fund fell by 11.8%. The following month, I was down another 3.5%. And then things started to get ugly. In September, it tumbled by another 12.5%. For the year as a whole, I was down 46.7%. On paper, almost half of my shareholders' money and my family's money had gone up in smoke."

(To clarify: by no means is this an attempt to embarrass Pabrai or Spier. The goal here is to show you that it is a certainty that you will see paper loss if you invest in the stock market. Whether you invest on your own or let others manage your money.) 

The next section is for readers who are disinterested in neither investing on their own nor in a fund. This section is for those who choose to invest in the stock market using ETFs. 

The passive record

If you were bullish [3] on the United Stated economy and, say, a decade ago placed a $100,000 bet in an ETF that tracks the performance of the S&P 500 index, the value of your position would now be $271,000.

And compounded growth of about 12% over ten years may now affect your expectation levels. Yet it is unlikely you will get double digits return from a single-digit growth economy. 

In Bull!, Maggie Bahahr shows why. She provides three examples of market cycles. First, between 1882 and 1897, 15 years, the S&P 500 total return was 3.4%. Between 1903 and 1921, 18 years, the total return was 0.6%. More recently, the S&P 500 annual return between 1967 and 1982, 15 years, was 0.2%. And between 2000 and 2004, the annual total return was negative 5%.

Can you imagine the frustration of parting with cash for 15 to 18 years only to realize that you are no better off than when you started?

Not only do market cycles affect return, but the annual return also affects the investor's psyche. For example, between 2000 and 2003, the S&P 500 lost value. If you had $100,000 in the stock market, the value of your portfolio would be $60,000 three years after. In 2008, the market lost that same amount of value in a single year - the S&P 500 lost 38% in 2008.

Both the Dow Jones Industrial Average and the Russell 2000 show similar results. Between 2000 and 2003, the Dow lost 28% in total, and in 2008 it lost 34%. The Russell 2000 dropped 21% in 2012 alone and 35% in 2008.


There is little we can do to stop, delay, or change the natural swings of markets. But two things are in our control. First is an awareness. Knowing that you will have a significant paper loss at some point should leave you less troubled when the day arrives. You will know that this too shall pass [ 4] .

Secondly, keep cash handy. It is one thing to see the market price of your portfolio drop - yet it is terrific when price declines allow you to buy great businesses at excellent prices.

[1] Paper loss is the unrecognized loss in a stock's market value. 
[2] Performance results taken from The Superinvestors of Graham and Doddsville as written by Warren Buffett in 1984.
[3] Bullish in a sense you believed the economy would become stronger.
[4] This adage was notably employed in a speech by Abraham Lincoln before he became the sixteenth President of the United States.

A Guide to Zero Management Fees

Published on:
October 25, 2019
Reading time: 7 Minutes.
Last Update:

This article gives a reason for the zero-fee structure. I discuss the lure of the structure and some of the potential pitfalls. I conclude the essay with a practical review of how fees, both explicit and implicit costs, affect returns over the long-term. My main point is that there is no way to invest without paying fees.

Zero fee structure in a mutual fund and a fund partnership

Mutual fund

When mutual fund managers declare zero management fees, they are waiving three costs. The initial cost is an asset fee, which typically ranges from 0.50% to 2.0%. The other expenses are load fees. "A load is a type of commission," explains Wikipedia.

The third costs are distribution and service costs, also known under the technical term of 12b-1 fees. These costs compensate mutual fund managers for marketing and for providing shareholder services. Visit distribution and service fee on Wikipedia to learn more.  

Two examples: Third Avenue Management, a mutual fund I admire, charges its shareholders a 0.90% management fee, distribution fees of 0.25% and other expenses of 0.30%. The total annual fund operating expenses are 1.45%. So if you invest $10,000 with Third Avenue, you will be charged $145 per year. Download the Third Avenue Value Fund to read more.

Fidelity funds have no fees. Consider Fidelity ZERO Total Market Index Fund (FZROX) as example. It opened in August 2018, the fund today manages $3.9 billion in assets. It aims to track the performance of large-capitalization U.S. stocks using automatic trading algorithms. Household, large-capitalization companies such as Microsoft, Apple, Amazon, Facebook represent about one-fifth of the fund. Visit ZFROX to learn more.

Hedge funds

Yet when fund managers [1] speak of zero fees, they refer to something entirely else. Fund managers will require at least 1- or 3-year hold time, which means you will not withdraw funds from the partnership during that "lock-up" period.

Another change in the partnership structure as a result of the zero-fee structure is that the manager's fee, known as carried interest [2] is higher. For example, under a one percent fee, the managers' interest in the profits may be 10%. Under zero-fee structure, the manager's compensation may jumpt to 20% of the profits.

What lures about zero-fee structure

The right performance evaluation

How you evaluate performance is essential. And the manager's performance evaluation should be judged using the change in the after-tax market value of your investment.

Payment for value

Under the zero-fee structure, only if the fund performs, the fund manager is paid. That is, you pay the manager only if the fund's fund returns are above a hurdle rate.

But the practice today is that you pay fees irrespective of the fund's performance. With a management fee, a fund may have lost market value during the year, but you still pay the fund manger.  

The zero-fee structure is a value-for-value trade. You only the managers only if you got value.  

The Buffett-Pabrai effect

Zero-fee structure appeals to investors because of great investors. Warren Buffett started the Buffett Partnerships in the 1960s with a similar structure. And Mohnish Pabrai, inspired by Buffett's biography written by Roger Lowenstein, had copied the zero-fee model in the late 90s.

And since both investors performed well for their investors, logic prescribes that a zero-fee structure results in success.

Yet, as the science community knows, there is a difference between causation and association. It is more likely that both Buffett and Pabrai would have achieved high returns regardless of the fee structure.

At least, when a fund manager offers you zero fee structure, you know the manager commits to performance. And that they probably read and studied Buffett and Pabrai - a blessing in itself.


In Pen&Paper, I only write about companies I am personally invested in, and on finance topics, I find it important to share.

Buying a stock is easy. But it requires a lot of effort and discipline to keep track of the company's performance. And no matter how much a stock appreciates, you're not capturing those returns until you sell. Join the waitlist to get real-time updates.


The downside of zero-fee structure

The impracticality of the structure

But after two- to five-years of lousy performance, can we expect of managers to open their doors? Most funds have a hurdle rate. So when capital markets drop, payments to funds managers may not be for a while, six- to eight years of wait time.

Very few managers can wait that long. It remind me of the story of how Benajmin Graham dissolved his fund only after his investors recouped their capital. Or the story of Pabrai, patiently waited for a decade before pulling any money from his fund. But these are out of the ordinary stories, not the rule. I believe that for every one Pabrai, there are over a hundred managers who would walk away from the fund.

For every one Pabrai that stuck around, there are hundred managers that would walk away.

An appetite for risk

Another cause of concern is the fund manager's increased appetite for risk. Knowing the only way to get paid is by stellar performance, managers may take additional risk because of the zero-fee structure.

Marty Whitman once wrote that "an adjective must precede the word 'risk.'" Here I use the word 'risk' in two contexts. One, when fund managers lack time to research and two, when they look for stocks outside of their circle of competence.


Founded in 2004, by Charlie Tian PHD, GuruFocus provides institutional-quality financial stock research for the individual investor.

GuruFocus hosts many value screeners and research tools and regularly publishes articles about value investing strategies and ideas. One of the features I use most is the 30-year financial information on businesses. For example, see how easy it is to review AT&T balance sheet.


Lack of empirical data

Intuition aside, there is little to show that zero management fee structure is superior to any other form of fund arrangement. There are too few zero-fee funds to track. And the fund fee structure is outside of the student of finance scope of interest. Outside of common sense, the argument for zero management fees is unbacked by any data.

I am not sure there ever will be enough data to back the zero-fee structure. A fund performance depends on factors that work at the same time, and that cannot be isolated.

Research does not always support decisions. Among those: the partner we decide to marry and the business venture we choose to take and also the outcome from the principles in life we want to have. Perhaps - and not unlike in real-life -  investment decisions require a leap of faith.

Investing requires a leap of faith.

The cost of fees over the long term

Explicit costs

Page 4 of The Manual of Ideas shows a table the SEC should require fund managers to show their fee-paying customers. The table shows that a 2% management fee will cut the value of your portfolio by 22.2% after ten years; by 39.4% in 20 years; and 52.9% over 30 years. The assumption is of a 5% gross return.

Implicit costs

In a talk [3] given in 1994 to students of the University of Southern California, Charlie Munger retells the story of Federal Express's early days. Employees left packages in the warehouses. Which penalized the company's profits. So management decided to change the worker's compensation from an hourly basis to a shift basis. You got paid when the work you completed the work, not when the clock said it was five o'clock. Unsurprisingly, perhaps, the new structure dramatically changes the number of package deliveries.

In Munger's words:

"As usual in human affairs, what determines the behavior are an incentive for the decision-maker, and 'getting the incentives right' is a very, very important lesson."

Not unlike Federal Express workers, salary structure changes the fund manager's behavior. When the portfolio size determines wages, managers naturally focus on increasing the size of the portfolio. They will talk to CNBC reporters; Work with advertising agencies on brand awareness. It would be better if managers focused their attention to the portfolio needs and no to what the market thinks about the portfolio.  

The fund industry somehow managed to market their services differently. Mutual funds charge you not as a percentage of the actual revenue, but as a percentage of the assets under management. This incentive structure results in much higher management fees.

For example, with a 1% management fee, mutual fund managers will charge you $100 annual management fee for every $10,000 you invest with them. In today's capital markets environment, on average, managers will earn  6% on average on your investment. We find $600 in management fee. But we would expect that they would charge 5% to 7% of that, which is $30 to $40. Yet, since using the investment management's calculation of fees, you will be charged $100, more than three times what a real estate relationship would require.

The investment management industry charges more than three times what a property manager would charge.

Read about this phenomenon in Investment Management Fees are (Much) Higher Than You Think.


You should now be able to assess the benefits and drawbacks of the zero asset management fee. If you would like to add to the article or you still have questions about zero asset management fee, write to me. I always respond.  

For additional information, I suggest that you also read Guy Spier's white paper on zero management fees. Also The New York Times recently published an article this trend. Visit this page to read more.  

FOOTNOTES: [1] Fund managers are managers of either a hedge fund or a private equity fund. [2] Carried interest is the share of profits paid to fund managers. [3] The talk's name is a lesson on elementary, worldly wisdom as it relates to investment management business.

On trading costs, diverse portfolio and passion.

Published on:
August 24, 2019
Last Update:

Hiller the Elder, who lived in the first century before the common era, said that we should first take care of ourselves so that we can take care of others. Not unlike his comment, I research companies for my own benefit but hope that others may benefit from the research too.

The topic of this meditation is what attracted me to stock research in the first place. I will then mention three reasons why I decided to not let others manage money and three reasons why I decided to buy stocks on my own.

Why I don't let others manage my financial destiny

The first reason is cost. Gabelli Funds, a mutual fund, charges 1.35% management fee. That means that if I was to give them $100,000 to manage, they would charge $1,350 a year.

To put in perspective what the fee of $1,350 is, excluding transaction costs, it is more than what I pay for all research and trading software. Guru focus annual fee is $450. Seeking Alpha annual fee is $200. The annual subscription fee for Barron's, WSJ, The Economist and Forbes is less than $300 in total.

And the high fee didn't meet higher return. Open to investors since 1986, the fund's average annual return is 9.98% after fees. The S&P 500 return, which you can buy for a management fee of less than 0.10% was 10.07% during this time.

The second reason is that I don't believe in neither the Noah Approach[1] to investing.  Consider the Gabelli fund again. The fund has an equity interest in over 40 sectors of the economy, from airlines and computer hardware to telecommunications and machinery. And the fund owns over 700 stocks.

To me, successful investing is not about consistently beating a performance index. And since every mutual fund’s manager knows their performance will be judged quarterly - even monthly - they focus on the flawed metrics, such as Sharp Ratio, Alpha and Beta. This is also known as the Greek approach to investing.

Why I decided to manage my money

As a business hobbyist I enjoy reading about companies; researching their profit margins, risks and business plans. My friends remind me that when I was eight or nine, I bragged to everybody that I bought a bargain: a pen on which I didn't have to pay taxes since it was bought in the city of Eilat. (In contrast to Tel Aviv where you would pay VAT. )

I am also contrarian. I ride my bike to the office and hardly drive. I much prefer to exercise alone than in a groups and you will not see me on social media. So, if the common convention is to let someone else - be it a financial advisor or a mutual fund manager - manage money, perhaps I chose the opposite just to prove a point.

There is a wealth of information that is widely available. This is a key point I believe many do not fully appreciate. It was only two decades ago that if you wanted to read the financial statements of a company, you would call the United States Securities and Exchange Commission (SEC), pay for the shipping of the statements to be delivered to your home and wait for a few weeks. Today, you can get the information in less than five clicks.

Another boon to investors was the SEC's requirement of Form 13F filing. Today the SEC requires anyone who manages above $100 million and more to publicly disclose which stocks they bought and sold. Using websites such as Guru Focus or WhaleWisdom , you can read what legendary funds and investors, such as Third Street Avenue or Mohnish Pabrai, are doing. In the last quarter of 2018, Third Avenue bought the stock of PNC Financial, Hawaiian Holding. Pabrai bought shares of Micron Technology.    

Trading costs are minimal too. If you decide to sell your home, the real estate commission and other fees can eat up about 10 percent of the sale price, according to Bankrate.com. Yet if you would like to sell your stock in, you could easily do so and it would cost you $4.95.

Your parents paid a much higher transaction fee. According to a Columbia University study, in December 1968, to trade 100 shares with a value of $400 (about $3,000 in today's currency) would cost you $3 of 1968 currency (which is about $22 today) plus 2% of the amount traded. So, it would cost a total of $82 to sell a position, about 16-fold higher than the cost of today' markets.

I believe in taking responsibility. If I lose money, I would much rather blame myself for an omission of thought than to blame another person. Jerry Seinfeld, perhaps, said it best:

"People always tell me, you should have money working for you. I've decided I'll do the work. I'm gonna let the money relax."  
[1] The Noah approach to investing is when a fund manager has an equity interest in hundreds of companies.

The 8th wonder of the world

Published on:
March 9, 2019
Reading time: 3 minutes.
Last Update:

Page 3 of Sequoia Fund's annual report to shareholders demonstrates the power of compounding interest. Say it's now July 1970, you are 25 years of age and you place $10,000 in Sequoia. Fast forward to today, and your investment would now be worth $4.3 million at the end of last year.

Since its inception, Sequoia Fund achieved an annual rate of return of 13.65% compared to 11.00% for the SP 500 index - and this 13.65% yearly return compounded for almost 50 years would have turned a moderate amount of savings into a comfortable retirement.

The effects of compound interest

Can you imagine what a 26% compound rate of return could do? To illustrate the point, I will use $50,000 as a starting amount, which is what $10,000 was worth in the 1970s[1]. And using the 72-rule, we calculate that every three years, the initial amount will double.

So in 2022 it will be worth $100,000; in 2025 it will be $200,000; in 2028 it will be $400,000; in 2031 in will be $800,000; in 2034 it will be $1.26 million; in 2037 it will be $3.2 million; and in 2040 it will be $6.4 million. 

A compound rate of return of 26% over 21 years, multiplied the initial amount of by 128x.

And that is the miracle of compound interest.

How to achieve a high compounded interest 

To look for investments with a 26% rate of return means that you expect that the stock you buy today will be worth at least twice as much in three years. And to inspire for that level of return, you must be an active investor. 

I define an active investor as one who spends a large portion of the time reading and valuing companies, analyzing financial statements and corporate statements, and is not afraid to act completely different than the market. Active investing requires a lot of effort with an unknown expected outcome.  

Active investing requires a lot of effort in the present with an unknown expected outcome in the future.  

In pursuit of such high standards, the active investor will make a lot of errors. Both Mohnish Pabrai and Guy Spier bought Horsehead Holdings, a company that declared bankruptcy and wiped equity shareholders

Warren Buffett and Charlie Munger bought Dexter Shoes Company and Cort furniture, which Munger referred to as "macroeconomic error." And Sequoia Fund had a significant position in Valeant, a stock that dropped in price by 70% in 30 days two years ago.

By focusing on such a high, abnormal rate of return, we also avoid the stock of companies that cannot possibly demonstrate such a performance. For example, Nike Inc. earned $1.93 billion or $1.17 per share in 2018. For $69 per share, the implied earnings multiple is about 60 times. For the investor with a 26% required rate of return, the company would have to earn $3.86 billion or $2.34 earnings per share in three years, an unrealistic expectation [2]. 

Passive investing, defined as the purchase of ETFs, cannot return 26% either. The S&P 500 total return, which includes dividends reinvested, has returned an 11.66% over the past 40 years; the Dow Jones Industrial Average's with dividends reinvested annual return was 12.4% during that time. The Wilshire 5000 with dividend reinvested earned 8.7% during that time. 

And since the return of the stock market is dependent, in the long run, on corporate earnings, which have never shown to grow in the double digits, at 26% compounded return is unrealistic. 

Mohnish Pabrai

I learned about the rule of compound-at-26% from Mohnish Pabrai. In his talk at Boston College, he illustrates this point. The purpose of this meditation is by no means to convince you that a 26% rate of return is reasonable. The first point of this essay is to encourage you to think about an adequate rate of return for you and the second point is to reflect how you plan to achieve it.

[1] To be exact: $10,000 in 1970 is $63,175 in 2019. [2] Nike never grew earnings by that rate since it became a public company over 35 years ago.

Mohnish Pabrai's Ten Commandments of Value Investing

Published on:
January 11, 2019
Last Update:

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.

Click here to view to the full Youtube vide or visit Pabrai's website.

#1 Do not skim off the top

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.

#2 Do not have an investment team

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.  

#3 You will be wrong at least 1/3 of the time

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.

#4 Search for a price to earnings multiple

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.

#5 No Excel

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.  

#6 Find a rope to climb

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.

#7 Have a single focus, like Arjuna

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.

#8 Never short

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.”  

#9 Do not borrow

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.  

#10 Become a cloner

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.

What I learned about stock investing in 2018

Published on:
December 8, 2018
Reading Time: 4 Minutes
Last Update:
December 19, 2019

"Learning is the oldest excuse in the book for the failure of execution. It's what managers fall back on when they fail to achieve the results promised," writes Eric Ries in The Lean Startup. "Entrepreneurs, under pressure to succeed, are wildly creative when it comes to demonstrating what they learned. They can tell a good story when the job, career, or reputation depends on it."

Yet, what else are we to do as investors but reflect on what we learned this year [1] ? Since January 1 of this year, index fund investors witnessed a drop of 2% in value. And if you look back at the stocks I bought this year, you can now buy them at an average price that is 8% less than what I paid for them.

Find processes

Over the past 11 months, I sifted through the financials of 170 publicly traded companies [2]. Only when the price to earnings ratio was low enough, I downloaded the 10-k report and began to read about the business.

Reading public filings was a new process for me. In 2017 as a comparison, if I had seen a stock listed in the 52-week low list, I would have then carefully read about the company and determined whether it was an opportunity or not. 

Spending a lot of research time on a company was a mistake. It was flawed because by the time I read about the firm, I felt compelled to invest in the company just because I already spent hours of my time.  

Focusing on the right side of the balance    

Learning the hard way, I finally understood this year how important it is to understand the right side of the balance sheet. Buying the stock of Orchid Paper Company, for example, was an unforced error on my part.

It was not difficult to see that in a rising interest rate environment, Orchid's ability to cover its debt service would tarnish.

Buying shares in Orchid Paper Company was an unforced error on my part.

Another unfortunate example was forgetting to adjust for the market value of preferred stock. The company was Rait Financial Trust, and in What Buying Rait Financial Trust Taught Me, I explained what eventually happened because of my omission of thought.

A checklist for stock investing

Even with a dormant stock market in 2018, I now realize how emotional stock investing is. When I saw the price of stocks climb in price, I immediately sensed a call to action. And because of this urge, I overlooked important issues before buying these shares.

Reading for the second time, Guy Spier's The Education of Value Investor reminded me that checklists are crucial. So, throughout 2018 I developed a checklist as part of the investment process. It has standards that I now must follow before buying, while holding, and before selling a stock [3].

Reading newsletters and annual reports

It is easy to see what other great investors are buying. Websites such as WhaleWisdom.com dig in the portfolio of some of the great investors of our time. 

For example, Mohnish Pabrai owns Fiat Chrysler (FCAU); Bruce Berkowitz owns Vista Outdoor Inc. and St. Joe Corporation. Guy Spier holds MasterCard (MA). 

And even better, they often write and explain why they bought the position. In Berkowitz' words why he bought St. Joe purchase: 

"The St. Joe Company recently announced that it received final approval from state and local agencies for its 110,000-acre Bay-Walton Sector Plan, with 170,000 residential units and more than 22 million square feet of retail, commercial and industrial development."

 There is a wealth of information out there, and most asset managers are not shy to share it.

 There is a wealth of information out there, and most asset managers are not shy to share it.

Developing a watch list

Building a watch list is one of my goals for 2019. During the past year, I came across beautiful businesses that generated plenty of cash flow while showing little to no debt. But the valuation of these businesses was too rich for me. With earnings multiples higher than 20 times the trailing earnings per share, I paid a dollar and thirty cents for a company that is worth one dollar.

Building a watch list is one of my 2019 goals.

But market values change. And my mistake this year was that given the rich valuation, I dismissed and never wrote down the names of the businesses that, at a price, could be great buys. In short, next year, I plan to list all the companies that I would like to purchase.

Plans for next year

I intend to buy more stocks next year than I plan to sell. At the time of this writing, 60% of my investment portfolio is still in cash. Not because I am fearful of the stock market, but because I have not found any companies of interest.

Over the past two months, I added to positions I took earlier this year. I bought more shares in Leeway (LWAY) and Frontier Communications (FTR). I wrote about my purchase of LWAY in Why I Am Long Probiotics. And I described my acquisition of Frontier Communications in March of this year. 

Finally, I continue to be passionate about sharing my journey with you. If you learned a thing or two about the stock market, then my efforts, and the efforts of Lisa, who edits these meditations, were not in vain.

[1] Especially as the stock market dropped to its lowest level in 2018. 
[2] I use the word "sifted" deliberately as I did not read 170 annual reports, but merely reviewed and compared the average 10-year earnings per share to the price of the stock. 
[3] For example, I now force myself to ask: "What is the value of the business if the publicly traded company was to become private?" Or "What would a liquidator pay for this company?"