|Buffett Disciple Shares Market Tips|
By JOHN KIMELMAN
HEDGE FUND MANAGER Mohnish Pabrai is a lot like his hero and investment mentor, Warren Buffett.
Like Buffett, Pabrai, who runs the $218 million-asset Pabrai Investment Funds, holds a small basket of stocks and manages that basket very closely.
And like his mentor, Buffett, whom Pabrai calls "the greatest capital allocator in the history of mankind," Pabrai hews to a strict value discipline.
But unlike Buffett, who has eagerly bought up shares of big companies such as Coca-Cola, Gillette, and American Express through the years, Pabrai, 40, usually avoids large-cap stocks because they rarely are as mispriced by the market as smaller companies.
As of the end of last year, his portfolio included names such as Sunrise Senior Living, Fairfax Financial Holdings, and Stamps.com.
Though hardly a luminary in the world of investment, Pabrai, a native of India who works alone out of his Orange County, California office, has generated a 31.9% annualized return (net of fees) from the time he launched his hedge fund operation in July 1999 through the end of last month.
Pabrai doesn't talk about individual companies he invests in -- with the exception of Berkshire Hathaway. But he was willing to discuss his clever and highly contrarian approach to stock-market investing.
Barron's Online: What are you looking for in an investment?
Pabrai: If I can find hated, distressed, thrown away businesses that are mispriced, that' I'm all set.
Stocks I buy fall in two categories they are either unloved or they are misunderstood (See accompanying chart of Pabrai's holdings as of Dec. 31, 2004.)
Q: What's the average market cap of a stock in your portfolio?
A: About $500 million to $600 million.
Q: Given that you can buy companies of any size, why do you prefer small-cap stocks to larger issues?
A: You know, the lower you go on the capitalization scale the higher the inefficiency. When you look at a GE or a Microsoft there are 30 analysts following that company.
Markets are significantly less inefficient at the higher end in terms of capitalization than the lower end.
Q: I've read that you-- like the great value investor Benjamin Graham -- don't like to meet with company CEOs because you view them as salesmen who can cloud rational thinking about a company.
A: That's correct.
Q: Does that mean that you don't value management as a factor in determining future share price?
A: No, the nature of management is very important. However trying to get to the nature of management by meeting executives is very stupid. What you want to do is look at a long history of how that management has operated. For example, look at the annual report five years ago and see what they are saying and then see how the next five years unfolded. You want to look for executives who have underpromised and overdelivered.
Q: Though you're clearly a bottom-up stock picker, do you try to diversify your portfolio by industry groups as well?
A: Yeah. I usually make only one bet per industry. Ideally, I want there to be minimal correlations between the holdings. So I'm happy to hold the stock of a oil shipping company and the junk bonds of a telecommunications company.
Q: But you also avoid certain industries altogether. For example, you have written that retail stocks are generally not worth the risk because these businesses are easy to replicate by new competitors.
A: Yeah, with retail, there is really no such thing as trade secrets. I can walk into a store and figure it all out. If you look at say the top 15 or 20 retailers in the sector today and you look at the same category 13 years ago, you will find that a number of the players have changed. Sometimes you get a Wal-Mart or Target which do well over time. [But that's more often not the case.]
Q: What's an industry where the opposite is true – where the top companies maintain their competitive advantages over time?
A: Pharmaceuticals. If you look at the top 10 or top 15 drug companies 15 or 20 years ago and you look at them today, the only thing that might have happen is some shuffling in the rankings.
The key for the major drug companies is what I would call the limited toll bridges that can get a drug through the FDA approval process.
So there are just a few companies that are competent enough to take a drug through the FDA approval process -- maybe 15 or 20 in the world.
Even if they were not doing so well on their internal innovation of drugs -- because innovation sometimes is a crap shoot -- they can partner with other companies or they can do acquisitions of promising bio-tech companies.
But the toll bridge is really the ability to take that drug from concept to market and there are a limited number of toll bridges and that is unlikely to change.
Q: That's sounds like an endorsement for a fund that invests in leading pharma names. Let's get back to industries you stay away from – why no technology in your fund? Is it just because of the high valuations that most tech companies carry?
A: There is no tech in the portfolio because my background is in tech. I spent 15 years working in technology and it is because of that understanding that there are no investments in this area.
Q: Now that's a twist. You're saying that you avoid tech stocks because you know the industry too well?
A: Yes. If you look at Cisco, Intel, Microsoft. Oracle or even a Google, there are so many forces working on hammering at their core business. And many of these upstarts have a much lower cost structure.
In 10 years, what will the end result be in the battle between Microsoft and Google? Right now, Microsoft is going head to head for Google's core search-engine business. Maybe Google is able to survive and maybe they are not.
But, you know trying to handicap those odds is difficult. Plus, you are paying some ridiculous price-to-earnings multiples and there is no margin of safety for these companies.
It's very hard to get tech businesses which have value prices – 5 to 10 times cash flow. Instead, they are going for valuations that seem to indicate that for decades on end, they are going to continue to dominate. And that is just not the way things work in tech.
Looking far out in the future with a tech company, things get very murky. It's very hard to handicap.
You know there was a time when DEC or Wang were invincible. But they were wiped out and smaller tech businesses often have even less staying power. So I stay away from tech.
Holdings of Pabrai Fund
(as of Dec. 31, 2004)
Berkshire Hathaway BRKA
Dr. Reddys Labs RDY (ADR)
Embraer-Empresera Brasileira ERJ (ADR)
Fairfax Financial Holdings FFH
Harvest Natural Resources HNR
Star Gas Partners SGU
Sunrise Senior Living SRZ
Universal Stainless & Alloy USAP
Q: Do you currently own any large cap stocks in your portfolio?
A: From time to time, for example, I have owned Berkshire Hathaway, I think it's undervalued right now. In fact because [New York Attorney General Eliot]. Spitzer is going head to head with Mr. Buffett and Berkshire, there has been selling of the stock.
(Editor's Note: Though Berkshire Hathaway has come under scrutiny because of its General Re unit's link to a questionable reinsurance deal with insurer American International Group, a spokesperson for Spitzer has said that "there is no indication that Berkshire Hathaway was doing anything at all like AIG." Buffett, moreover, has denied any wrongdoing.)
Q: Is this an interesting time to buy Berkshire Hathaway?
A: I think so. At the end of the day, Berkshire will get a slap on the wrist at most. (See Barron's, "Buying Opportunity?," April 4, 2005)
Q: What's the investment case for Berkshire?
A: Based on the current share price of $88,000 for Berkshire's Class A shares (ticker: BRK-A), the company has a market cap of $135 billion.
Now let's look at what the company is really worth. If you look at income the operating businesses are generating, that's about $5 to $7 billion a year. You would be willing to pay $70 to $80 billion for it at least. But on top of that, they've got a portfolio of publicly-traded companies, which is not part of the income stream but that's another $30 billion or so of value.
So now you have a $110 billion of value, but then you've got about $45 billion in cash so that takes you up to about $150 billion. But that cash gets deployed at some point, right now it is generating 1%. But historically when Mr. Buffett deployed the cash he generates anywhere from 12 to 20% on that.
So your earnings is going to go from $5 billion to $7 billion in a few years to maybe $10 billion to $12 billion plus the cash it is producing. Using a multiple of 15x and you've looking at a value of at least $150 billion.
Based on shares outstanding of 1.5 million, you are probably going to get to a price sort of north of $120,000 or something per share of the Class A stock.
Q: How long will it take for such a price target to be reached?
A: I don't know. With any stock I buy, I have no idea under what circumstances or exactly when it hits a price target. But I would just say that if you look at that economics versus buying the S&P 500, it is a no-brainer that you would buy Berkshire. You get much great margin of safety and you get the greatest capital allocator in the history of mankind.
Q: I know you never short stocks, arguing that the best return you can get is 100 percent but the downside is unlimited. But aren't there times when you are just awfully tempted to short -- when you see a stock that just seems ridiculously overvalued?
A: Yeah, but you still have to consider that management has the incentive to keep the stock price up. So they could do a deal or buy-back shares [or engage in some other financial engineering.]
You know AOL was ridiculously overvalued and Steve Case just went out and bought Time Warner and took care of the problem.
Q: Finally, you have written that investors should stay away from companies that manage their earnings so that they grow consistently over time. Your thinking is that such companies may be engaged in questionable accounting to pull off that feat. But doesn't that keep you out of some great companies such as General Electric?
A: First off, GE is an anomaly in the sense that there are very few large companies of that size that you could have made that sort of investment and done well.
It is the nature of businesses that earnings are going to gyrate. But Wall Street forces companies to be consistent. They want consistency and they are willing to reward consistently. But the reality of the business world is it is very non-linear and there is a number of factors that affect cash flow and profitability. In fact even Microsoft themselves admitted a couple of years back that they had smoothed earnings all the way through.
So if a business like Microsoft doesn't naturally have smooth predictable earnings, then no business does. And so when you are see that in a statement you are looking at a fairy tale.
Q: Thanks for all the insights.