Gurus : Mohanish Pabrai (Forbes Interview)

Forbes: You are one of the noted value investors, one of those who is an admirer of Warren Buffett. What did you take from Warren Buffett? And what do you do differently from Warren Buffett? You're not a clone.

Pabrai: Well, you know, we will never have another Warren. I think Warren is a very unique person. And also, I think that his investing prowess is so strong that many of his other attributes and, I would say, his other qualities get ignored. I believe thebest things about Warren have nothing to do with investing. But they have everything to do with leading a great life. So many ofthe things, I think, most of the great things I've taken from Warren have more to do with life than investing.

Forbes: Such as?

Pabrai: Well, such as, you know, how to raise a family, interaction with friends, the importance of keeping your ego in check.You know, humility. Just a whole bunch of different attributes. The importance of candor, the importance of integrity. Just all these, the soft skills that are very important in life.

Forbes: They do interconnect. Now, in terms of how you approach an investment, you, I think, probably pay more attention to intangibles than perhaps Warren Buffett or Ben Graham might have done.

Pabrai: Well, Warren pays attention to intangibles, but Ben Graham was very much a tangible guy. And yeah, so we're looking at the qualitative as well as the quantitative. And yeah, so I would say that one way to look at that is to consider what CharlieMunger would call his latticework of mental models. So when you look at a business, look at it in a broader context of how itfits into the world. And sometimes, if you can see it in a light that the world is not seeing it in, that can give you an edge.

Forbes: Munger also said, "You have three choices: yes, no, or too difficult." You subscribe to that too.
Pabrai: That's right. And 98% is too difficult.
Find Deep Moats
Forbes:So that gets to knowing your areas of competency. You share Warren Buffett's antipathy to technology. Not that you

dislike it, but you just don't feel you're going to bring value added there.

Pabrai:Yeah, you know, my degrees are in computer engineering. I spent a lot of time in the tech industry. And I like to say that I don't invest in tech because I spent time in it. And I saw firsthand that the durability of technology moats is many times an oxymoron.

Forbes:Now quickly define moats, in terms of a business that keeps the competition away.

Pabrai:Well, you know, if you talk to Michael Porter, he would give you five books on what is meant by, you know, strategy and competitive advantage and durable competitive advantage. And if you talk to Warren and Charlie, they would just say it's a moat. And they'd break it down to one word. But basically it's the ability of a business to have some type of an enduring competitive advantage that allows it to earn a better-than-average rate of return over an extended period of time. And so some businesses have narrow moats. Some have broad moats. Some have moats that are deep but get filled up pretty quickly. So what you want is a business that has a deep moat with lots of piranha in it and that's getting deeper by the day. That's a great

business.

orbes: So summing up in terms of what do you think do you bring to value investing that others perhaps don't, that give you a unique edge?

Pabrai: I think the biggest edge would be attitude. So you know, Charlie Munger likes to say that you don't make money when you buy stocks. And you don't make money when you sell stocks. You make money by waiting. And so the biggest, the single biggest advantage a value investor has is not IQ; it's patience and waiting. Waiting for the right pitch and waiting for many years for the right pitch.

Forbes: So what's that saying of Pascal that you like about just sitting in a room?

Pabrai: Yeah. "All man's miseries stem from his inability to sit in a room alone and do nothing." And all I'd like to do to adapt Pascal is, "All investment managers' miseries stem from the inability to sit alone in a room and do nothing."

Forbes: So you don't feel the need to pick 10 stocks a quarter or one stock a quarter, just what turns up?

Pabrai: You know, actually, I think that the way the investment business is set up, it's actually set up the wrong way. The correct way to set it up is to have gentlemen of leisure, who go about their leisurely tasks, and when the world is severely fearful is when they put their leisurely task aside and go to work. That would be the ideal way to set up the investment business.

Forbes: Does this tie into your ideas and other value investors' ideas of low risk, high uncertainty?

Pabrai: That's right. I mean, I think the low risk, high uncertainty is really something I borrowed from entrepreneurs, and you know, the Patels in India or the Richard Bransons of the world. Basically if you study entrepreneurs, there is a misnomer: People think that entrepreneurs take risk, and they get rewarded because they take risk. In reality entrepreneurs do everything they can to minimize risk. They are not interested in taking risk. They want free lunches and they go after free lunches. And so if you study any number of entrepreneurs, from Ray Kroc to, you know, Herb Schultz at Starbucks and to even Buffett and

Munger and so on, what you'll find is that they have repeatedly made bets which are low-risk bets, which have high-return possibilities. So they're not going high risk, high return. They're going low risk, high return.

And even with Bill Gates, for example. The total amount of capital that ever went into Microsoft was less than $50,000, between the time it started and today. That's the total amount of capital that went into the company. So Microsoft you cannot say was a high-risk venture because there was no capital deployed. But it had high uncertainty. Bill Gates could have gone bankrupt. Or Bill Gates could have ended up the wealthiest person on the Forbes 400. And he ended up at the extreme end of the bell curve, and that's fine. But he did not take risk to get there. He was comfortable with uncertainty. So entrepreneurs are great at dealing with uncertainty and also very good at minimizing risk. That's the classic great entrepreneur.

Low Risk, Low Capital

Forbes: This is your almost third career. And this idea you have on uncertainty and risk. You started a company. It worked. You sold it. You started another company. It did not work. What did you learn from that that gave you insights on investing that, those that had not been in the trenches, don't bring?

Pabrai: Well the first company took no capital and generated an enormous amount of capital for me. Then I got fat, dumb and happy and my second company, I put in a lot of capital.

Forbes: You thought you knew what you were doing.

Pabrai: And I violated the low risk, high uncertainty principle. I got my head handed to me. And I got that seared heavily in my

psyche. And now the third business, if you call Pabrai Funds a business--I call it a "gentleman of leisure" activity--but Pabrai Funds is, again, low risk, high uncertainty in the sense that there is no downside. It never took capital. So it's a great business.

Forbes: So as a gentleman of leisure, is that why you take a nap each day at 4 p.m.?
Pabrai: There's nothing better. Do you have a nap room?
Forbes: I wish.
Pabrai: You know, when I went to Warren's Berkshire headquarters last year, my friend Guy asked Warren, he said, "Warren, Mohnish has a nap room in his office. Do you have a nap room?" And Warren's answer was, "Yes." OK, so I was surprised. So I said, "Warren, you're telling me in Kiewit Plaza, there's a nap room for you." He says, "Yes." He says, "Not every day, but every once in a while, I need to go to sleep in the afternoon."

Forbes: Well there's something to that. My father called it having a conference.

Pabrai: That's right. No, it does wonders. I have a hard time getting past the day without the nap, so the nap is a must.

Forbes: So having those two experiences--no capital, then as you say, fat and happy and then you got your head handed to you--when you look at an equity, when you look at a possibility, what are those experiences, give what insight do you get from those experiences.

Pabrai: Well, the insight is the same, in the sense that I think that, you know, Warren says that I'm a better investor because I'm a businessman, and I'm a better businessman because I'm an investor. So the thing is that my experiences as a businessman have very direct, long-term positive impacts on me as an investor, because when I'm looking at an investment, I now look at it like the way I looked at my first business, which is, the first thing I'm looking at is, how can I lose money on this? And can I absolutely minimize my downside?

The upsides will take care of themselves. It's the downsides that one needs to worry about, which is why even the checklist becomes important. But so the important thing that value investors focus on is downside protection. And that's exactly what entrepreneurs focus on--what is my downside? So that is the, I would say, the crossover between entrepreneurship in investing, and value investing especially, is protecting your downside.

Pabrai's Fees
Forbes: Now you're a hedge fund manager, but you're unusual. First, your fee structure. Explain that.
Pabrai: Well you know, my fee structure, one of my attributes about a great investor is be a copycat. Do not be an innovator.
Forbes: What's it, pioneers take the arrows?
Pabrai: Yeah. When I started Pabrai Funds, I actually didn't know anything about the investing business. And the only, if you can call it a hedge fund, that I was familiar with was the Buffett partnerships. And when I looked at the Buffett partnerships, Ifound that Warren Buffett charged no management fees. He took 25% of the profits, after a 6% hurdle. And all of that made allthe sense in the world to me, because I felt it aligned my interests completely with my investors. So I said, "Why mess withperfection? Let's just mirror it." And that's what I did. And what I didn't realize at the time--it took me a few years to realizeit--is that that mirroring created an enormous moat for Pabrai Funds. Because the investors who joined me will never leave,because it's the first question they ask any other money manager they go to work for or they want to put money with is, "Whatis your fee structure?" When they hear the fee structure, they say, "I'm just going to stay where I am." And so first of all, it creates a moat where the existing investors do not want to leave. And the new ones who join the church are happy to join.

Forbes: You're also unusual in another way. You don't seem to go out of your way to woo institutional investors.

Pabrai: Yeah, I mean, I think I'm looking for people who want to invest their family assets for a long period of time. I really don't want investors who are looking at putting things into style buckets or going to look at allocations every quarter or might need to redeem in a year and those sorts of things. So their frameworks are very different. So in general--
Forbes: So someone who comes with you is a minimum of, what, two years, three years, what, before you allow them an exit?

Pabrai: Our exits are annual. So people can get out once a year. But what we suggest to them is to not invest if they don't have at least a five-year horizon. But we don't impose any, because people can have hardships. They can have all kinds of things happen.

Forbes: Now, low cost, one of the things that apparently institutional investors are flummoxed by is, it's you.

Pabrai: Our total expenses for running the funds, which the investors get charged for, is between 10 and 15 basis points a year. That's what they pay for, for all the accounting, audit, tax, administration and everything. They don't pay for my salary or my staff's salary. We take that out of the performance fees. And they only pay the performance fees after 6%. So what a deal.

Forbes: Now, you're not big on schmoozing investors.

Pabrai: You know, I think the thing is that every business ought to figure out who their ideal customer is.

And at Pabrai Funds, what I've found is that investors who do their own homework find me and do the research on me on their own, without any middlemen involved, and then invest in Pabrai Funds like Amazon--which is wire the money and send the forms--tend to be the best investors. In fact the investor base we have is mostly entrepreneurs who created their wealth  hemselves. And they're very smart. And they're in a wide range of industries. In fact, my analyst pool is my investor base. So Ihave investors in all kinds of industries. And when I'm looking at investment ideas in particular industries, I can call them. And Iget the best analysts at the best price with no conflict of interest. So it works out great.

Forbes: Free. That sounds really good. They pay you.

Pabrai: Yeah, exactly. It's great

Forbes: You're not even registered with the SEC?

Pabrai: I think the hedge funds so far have not had to. I don't know if the rules will change. If the rules change, of course, we'll follow the rules. But you know, we have audits by Pricewaterhouse. We have to report 13fs to the SEC. So I think there's plenty of disclosure and transparency.

Forbes: You also don't engage in things like short-selling.

Pabrai: You know, why would you want to take a bet, Steve, where your maximum upside is a double and your maximum downside is bankruptcy? It never made any sense to me, so why go there?

Forbes: You focus on a handful of individual investors, maybe institutional investors, but people who know you, are with you.

Pabrai:Right.

Forbes: You're not part of a formula, not spit out of a computer.
Pabrai: That's right.
Use Index Funds
Forbes: What's an individual investor to do? You have some unique advice for individual investors.
Pabrai: Well the best thing for an individual investor to do is to invest in index funds. But even before we go there, you know, Charlie Munger was asked at one of the Berkshire annual meetings by a young man, "How can I get rich?" And Munger's response was very simple. He said, "If you consistently spend less than you earn and invest it in index funds, dollar-cost average," because you're putting in money every paycheck, he said, "that in, what, 20, 30, or 40 years, you can't help but be rich. It's just bound to happen."

And so any individual investor, if they just put away 5%, 10%, 15% of their income every month, and they just bought into thelow-cost index funds, and just two or three of them, to split it amongst them--you're done. There's nothing else to be done.Now if you go to active managers, the stats are pretty clear: 80% to 90% of active managers underperform the indexes. Buteven the 10% or 20% who do, only one in 200 managers outperforms the index consistently by more than 3% a year. So thechances that an individual investor will find someone who beat the index by more than 3% a year is less than 1%. It's half apercent. So it's not worth playing that game.

Forbes: And in terms of index funds, S&P 500 or--

Pabrai: I'd say Vanguard is a great way to go. I think you could do S&P 500 index. You could do the Russell 2000. And if you wanted to, you could do an emerging-market index. But you know, I think if you just blend those three, one-third each, you'redone. And if you're in your 20s and you start doing this, you don't need to even go into bonds and other things. You can just dothis for a long time and you'll be fine.

Don't Go in the Roach Motel

Forbes: On TV when these folks make recommendations--you compare it to if you buy something that you heard somebody recommend on TV as going into the roach motel. Can you please explain?

Pabrai: Well you know, you remember those ads that ran where the roaches check in.
Forbes:Yup.
Pabrai: But they never check out. So the thing is, you watch some talking head on TV. And he tells you, "Go buy whatever company, Citigroup." When its price gets cut in half, he's nowhere to be found. And now you're like that roach in the roach motel and you don't know what to do. You don't know whether you should hang on or sell or stay. So the only reason--

Forbes: Or if it goes up, do I get out? Do I wait?

Pabrai: Yeah, yeah. If it goes up 10% or 50% or 100%, what are you supposed to do? Do you want to go for long-term gain, short-term gains? Basically you have no road map. So the only way one should buy stocks is if you understand the underlying business. You stay within the circle of competence. You buy businesses you understand. And if you understand the business, you understand what they're worth. And that's the only reason you are to buy a stock.

The Chinese Books

Forbes: And looking around the world, you made mention I think in the past, if you want an index fund with the emerging markets, OK. But you have us take a skeptical eye to investing in other countries around the world. You don't preclude it, but you see some risks.

Pabrai: Well, you know, Steve, there's plenty of great opportunities in many countries. But I would say it's probably a no-brainer to avoid Russia, Zimbabwe. And even if you look at a place like China, which I think will create incredible amount of wealth for humanity in this century, the average Chinese company has three sets of books. You know, one for the government, and one for the owner's wife and one for the owner's mistress. And so the problem you have is you don't know which set of books you're looking at. And so I think in Chinese companies, or even in Indian companies, there you have to add another layer, which is you have to handicap the ethos of management. And that can get very hard, especially when someone like me is sitting in Irvine with naps in the afternoon, trying to figure that out. Forbes: You also say you don't think you get much talking to CEOs, because they're in the business of sales. Pabrai: Yeah, you know, the average CEO, first of all, the average public CEO is a person you'd be happy to have your daughter marry, any five of them. But they got to those positions because they have charisma and they are great salespeople.

Now you cannot lead, you cannot be a leader, without being an optimist. So CEOs are not deceitful. I think they are high-integrity people. But if you sit down with a high-charisma CEO of an oil company, and he knows everything about oil and you know nothing about oil, by the time you finish that meeting, you just want to run out and buy all the stock of his company that you can. And it's just not the right way to go about it. So you're better off not taking the meeting, but looking at what he's done over the last 10 or 15 or 20 years. So not being mesmerized by charisma will probably help you.

Forbes: And what areas are you looking at right now? You remember back in 1968, '69, we did a story on Buffett when he was fairly unknown. And he was getting out of the market, height of the bull market of the '60s. Five years later after the crash of '73, '74, we went out to see him again, to see what he was saying after the market had gone down 50%, 60%. And he politically incorrectly said that he felt like a sex maniac in a harem because of all the bargains around.

Pabrai:Right.

Forbes: You've probably had the same feeling a year ago. What do you see? How does the harem look now?

Pabrai: That's right. In 1969 Warren told you "I feel like a sex-starved man on a deserted island." And in '74, that deserted island had become a harem. Well nowadays, we're twiddling our thumbs. It's good that I enjoy playing racquetball and bridge and so on. So there's a lot of bridge. There's a lot of racquetball. And you know, I have an eye out on the markets, but there's just not a whole lot of value presently. But value can show up tomorrow, for example. So we're not in a hurry. Happy to have a leisurely lifestyle and wait for the game to come to us. Make Checklists

Forbes: So in the first quarter of 2010, did you add any positions?

Pabrai: Yeah, actually, we did. We did find. In fact, there's one I'm buying right now. But I found two businesses, but they're anomalies. They were just, you know, businesses that had distress in them because of specific factors. And I think we'll do very well on both of them. They'll go nameless here. But no, I think, for example, in the fourth quarter of 2008 or the first quarter of 2009, you could have just thrown darts and done well. And that is definitely not the case today.

Forbes: And finally, telling you about mistakes, one of the things I guess an investor has to realize, they cannot control the universe. Delta Financial: You had done the homework, you fell and then events took it away from you.

Pabrai: Well Delta Financial was a full loss for the firm, for the fund. We lost 100% of our investment. It was a company that went bankrupt. And we've learned a lot of lessons from Delta. And one of the lessons was that Delta was, in many ways, a very highly levered company and they were very dependent on a functioning securitization market. And when that market shut down, they were pretty much out of business. And they were caught flat-footed. And so there's a number of lessons I've obviously learned from Delta. It's easier to learn the lessons when you don't take the hits in your own portfolio. But when you take the hits in your own portfolio, those lessons stay with you for a long time.
Forbes: So that gets to, you're a great fan of The Checklist Manifesto. And you now have checklists. You said one of the key things is mistakes, in terms of a checklist, so you don't let your emotions get in the way of analyzing. What are some of the mistakes on your checklist now that you go through systematically, even if your gut says, "This is great. I want to do it."

Pabrai: Yeah, so the checklist I have currently has about 80 items on it. And even though 80 sounds like a lot, it doesn't take a long time. It takes about 30 minutes to go through the checklist. What I do is when I'm starting a business, I go through my normal process of analyzing the business. When I'm fully done and I'm ready to pull the trigger, that's when I take the business to the checklist. And I run it against the 80 items. And what happens the first time when I run it, there might be seven or eight questions that I don't know the answer to, which is great, which what that means is, "Listen dummy, go find out the answer to these eight questions first." Which means I have more work to do. So I go off again to find those answers. When I have those answers, I come back and run the checklist again. And any business that I look at is going to have some items on which the checklist raises red flags. But the good news is that you're looking in front of you with all your facilities at the range of things that could possibly cause a problem. And when you look at that list, you can also compare it to how those factors correlate with the rest of your portfolio. And at that point, kind of, you have a go, no-go point, where you can say, "I'm comfortable with these risk factors here. I'm comfortable with probabilities. And I'll go ahead with it." Or you can say, "I'm just going to take a pass." And one of the things that came out of running the checklist was I used to run a 10x10 portfolio, which is when I'd make a bet, it was typically 10% of assets. And after I incorporated the checklist and I started to see all the red flags, I changed my allocation. So the typical allocation now at Pabrai Funds is 5%. And we'll go as low as 2%, if we are doing a basket bet. And once in a blue moon, we'll go up to 10%. In fact I haven't done a 10% investment in a long time. And so the portfolio has become more names than it used to have. But since we started running the checklists, which is about 18 months ago, so far it's a zero error rate. And in the last 18 months, it's probably been the most prolific period of making investments for Pabrai Funds.We made a huge number of investments, more than any other period, any other 18-month period in our history. So with more

activity so far, and it's a very short period, we have a much lower error rate. I know in the future we will make errors. But I know those errors, the rate of errors will be much lower. And this is key. The thing is that Warren says, "Rule No. 1: Don't lose money. Rule No. 2: Don't forget rule No. 1." OK, so the key to investing is downside protection. The upsides will take care of themselves. But you have to make sure that your losers are few and far between. And the checklist is very central to that. Forbes: Can you give a couple of the things that are on your 80 [item] checklist?

Pabrai: Oh yeah, sure. The checklist was created, looking at my mistakes and other investors' mistakes. So for example, there's questions like, you know, "Can this business be decimated by low-cost competition from China or other low-cost countries?" That's a checklist question. Another question is, "Is this a win-win business for the entire ecosystem?" So for example, if there's some company doing, you know, high-interest credit cards and they make a lot of money, that's not exactly, you know, helping society. So you might pass on that. Also, a liquor company or tobacco company, those can be great businesses, but in my book, I would just pass on those. Or a gambling business, and so on.So the checklist will kind of focus you more toward playing center court rather than going to the edge of the court. And there's a whole set of questions on leverage. For example, you know, how much leverage? What are the covenants? Is it recourse or non-recourse? There's a whole bunch of questions on management, on management comp, on the interests of management. You know, just a whole--on their historical track records and so on. So there's questions on unions, on collective bargaining. So you know, and all of these questions are not questions I created out of the blue. What I did is I looked at businesses where people had lost money. I looked at Dexter Shoes, where Warren Buffett lost money. And he lost it to low-cost Chinese competition. So that led to the question. And I looked at CORT Furniture, which was a Charlie Munger investment. And that was an investment made at the peak of the dot-com boom, where they were doing a lot of office furniture rentals. And the question was, "Are you looking at normalized earnings or are you looking at boom earnings?" And so that question came from there. So the checklist questions, I think, are very robust, because they're based on real-world arrows people have taken in the back.

Forbes: Terrific. Mohnish, thank you.