MOI Global | The Membership Community of Intelligent Investors

Asset-Based Investing in an Earnings-Focused World

December 21, 2017 in Best Ideas 2018 Featured, Best Ideas Conference, Curated, Letters

This article is authored by MOI Global instructor Amit Wadhwaney, portfolio manager and co-founding partner of Moerus Capital Management, and founding manager of the Moerus Worldwide Value Fund. Amit is an instructor at Best Ideas 2018, the online conference featuring more than one hundred expert instructors from the MOI Global membership community. The following discussion is drawn primarily from excerpts of a previously published Moerus Capital Investor Memo, which can be found in its entirety here.

Moerus Capital employs a fundamental, bottom-up investment process, with the goal of investing in assets and businesses at prices representing significant discounts to our estimates of intrinsic value, all the while placing heavy emphasis upon risk avoidance and mitigation. Importantly, the risk that we seek to mitigate is not short-term share price volatility, but rather the risk of a permanent loss of capital. In fact, we embrace short-term share price volatility as a provider of periodic opportunities to invest in what we believe are high-quality assets or businesses at bargain prices. We believe that buying as cheaply as possible is critical both to risk mitigation as well as to the potential generation of attractive long-term returns.

In striving to buy as cheaply as possible, we estimate intrinsic value using very conservative estimates that weigh a company’s balance sheet and what is known today much more heavily than projections of future earnings and cash flow, which may (or may not) materialize. In other words, as a general rule of thumb, we try to buy shares of businesses at sizeable discounts to what we think that they would be worth if they sold their assets today, using conservative assumptions. The asset-based investment approach that we follow at Moerus stands in contrast to the approach of many in the investment community who tend to focus more heavily on earnings and cash flows.

Our estimates of a company’s intrinsic value generally do not heavily weigh forecasts of cash flows years into the future, simply because we believe the future is notoriously, inherently difficult to predict. We are not willing to “pay up” for businesses at prices that would only be attractive under optimistic assumptions of continued prosperity years into the future. By contrast, we believe that a conservative, asset-based valuation methodology often yields a “bedrock” (lower-bound) valuation, and that buying at a steep discount to such a bedrock valuation provides a cushion that not only provides downside protection, but also offers meaningful upside potential in the event of favorable future outcomes, which typically aren’t “priced in” to the stock at such beaten down levels.

Implications of the Asset-Based Approach

Our approach to investing has several noteworthy implications regarding which type of situations tend to find their way into the portfolio, and why.

What’s the catch?

At Moerus, we search for high-quality, long-term investment opportunities which are available at attractive prices relative to what we believe their net assets are worth today – attributing very little value to forecasts of earnings or cash flows, visions of the future which are far too often seen through rose-colored glasses. One implication of our approach is that, at the risk of stating the obvious, such opportunities do not come easily or often – alas, there is usually “a catch,” or something “wrong” which drives pricing down to the unusually attractive levels which pique our interest. Common examples of what might be “wrong” include, among others, a challenging short-term outlook facing a company’s relevant industry or geography, or a company-specific misstep or hiccup that results in share price declines.

For traders and investors with very short time horizons, near-term uncertainty and turmoil might rule out any such investment. But our long- term focus allows us to look past temporary rough patches that render a company, industry or geographic market out of favor in the broader market as they often prove to be interesting sources of longer-term investment opportunity, provided that the turmoil is indeed temporary, and the potential investment has the staying power and wherewithal to survive tumultuous times and thrive if, as and when the situation normalizes.

Unappreciated, Misunderstood, or Event-Driven

In addition to situations involving short-term (but temporary) turmoil, asset-based investing has also often led us in the direction of two other scenarios that sometimes lead to atypically attractive investment opportunities. First, companies that are underappreciated, underfollowed, complex and/or misunderstood occasionally provide interesting opportunities, in part because fewer eyes are examining and recognizing the value that may (or may not) be present within the business in question. Second, opportunity periodically can be found in situations in which there is hidden value that could potentially be unlocked through event -driven scenarios ; examples of these include liquidations, corporate reorganizations, mergers and acquisitions, and changes in industry or shareholder structure, among others.

Patience

We think that it’s worth noting that given the nature of these sources of opportunity, patience is indeed a virtue when it comes to implementing an asset-based investment approach. Patience is needed to hold cash in the absence of attractive pricing and wait for quality investments to become available at truly modest prices. Once a promising long- term investment becomes available at a price that is cheap enough, patience is often required to hold (or add to) the investment, as the poor near-term conditions that contributed to the deep discount continue to run their course. Of course, patience must go along with and be backed by conviction – developed through research, analysis, and considerable reflection – that such a prospective investment has the staying power (financial, operational and otherwise) to navigate its way through temporary difficulties until its underlying value is ultimately realized.

Not for the Fashionable

The asset-based investment approach requires patience because investment opportunities available at the type of valuations we seek do not make themselves available frequently, and when they do, it is usually at a point in time in which the assets in question are underappreciated and/or out of favor. Attractive value investments, particularly those at the deep discounts to conservative intrinsic value estimates that we require, are not available whenever they are “in fashion.” In that sense, we often find ourselves looking for bargains in some of the most far-flung or “out-of-fashion” places, to which many others in the investment community for various reasons are biased against venturing. This is one of the reasons why we have periodically found emerging and frontier market securities to offer attractive opportunities, specifically of the kind that by and large fall under the radar of more earnings-based analysts and investors.

Deep Value and Emerging/Frontier Markets: Compatible…at Times

Another implication of our asset-based investment approach is that while opportunities to implement it in emerging and frontier markets are apt to be sporadic and infrequent, occasionally compelling balance sheet-based investments can and do become available at attractive prices in even these markets, which traditionally have not been considered a welcoming destination for deep value investors. Notwithstanding the bloodletting that occasionally takes place from time to time in many emerging and frontier markets, in general these markets have historically appealed to growth investors due to their attractive growth potential relative to that offered by more mature markets.

Simply put, many investors have historically been willing to pay up for the future – in the form of expected future growth – in emerging and frontier markets, whereas at Moerus we look for bargains here and now, based on our estimates of the net assets on the balance sheet today. Partly as a result of this dichotomy, the predominance of investors who are willing to pay for projected future earnings growth in emerging markets has, in our view, generally translated into less frequent opportunities for the asset-based value investor such as Moerus.

However, the very fact that these markets are heavily populated by short-term growth investors provides us, from time to time, with intriguing investments that fit our approach. This is because many such opportunities often bring “baggage” that shorter-term or growth oriented investors tend to avoid:

For example, emerging markets can sometimes bring extreme uncertainties – such as coups, political turmoil, wild swings in economic (mis)fortunes, et al. – that are difficult if not impossible to swallow for those who invest with a short-term time horizon and/or depend upon robust projections of future earnings and cash flow growth. Many times the “catch,” or whatever makes the investment compelling on a long-term basis in our eyes, is the very same thing that makes it off-limits for those who are unwilling (or unable due to their investment mandate) to be patient and take a long-term view.

As noted above, asset-based investing is not for the fashionable simply because such bargain pricing does not typically become available when things are going well, particularly in emerging and frontier markets which often command premium valuations during better times because of their greater observable growth prospects. On the contrary, these opportunities often become available in times of crisis and angst – take Brazil in recent years, with its historic recession, political turmoil and corruption scandals – just when many short-term investors who buy what’s popular have already fled.

Examples of situations that could create such opportunities for us include the following:

Quarterly earnings disappointments, or revenue growth figures that fall short of what had heretofore been lofty expectations – the kind that are typical of many emerging market securities during the good times – might result in growth investors heading for the exits, leading to a plunging stock price. For example, Company ABC might produce earnings per share growth of 5% – not spectacular, but certainly respectable – yet still see its share price punished, if shares had previously been priced based on expectations of, say, 15% annual EPS growth. In that sense, temporary slowdowns, setbacks, and disappointments occasionally offer opportunities to invest at reduced prices in companies that are usually well-loved, and consequently rarely marked down except when inflated hopes are dashed.

Broader macroeconomic slowdowns and turmoil could be particularly punishing to investors in emerging markets given the growth bent of many who typically invest there. Heavenly expectations – the kind that are typically heaped upon market darlings and “the next big growth stories” – leave investors vulnerable to adverse shocks which could yank sentiment back to Earth in a steep, rapid descent. Amid the ensuing rubble, even previously well-loved gems can sometimes become available at compelling prices.

A final important point to make on this subject is that share price declines in emerging and frontier markets could be and often are exacerbated by the relative illiquidity of many of these markets. When investors flee illiquid markets, dramatic share price declines could result, potentially turning a stock that used to trade at a sky-high valuation a year or two ago into a bargain today. In sum, the main point which we’d like to make clear is that although emerging and frontier markets have traditionally been considered the preserve of the more adventurous, growth-oriented investor, we believe that compelling asset-based, deep value investment opportunities periodically can and do become available there, albeit perhaps more sporadically than in developed markets.

Summary Conclusions

The deep value, asset-based investment approach that we apply stands in stark contrast to those of many/most investors, notably many emerging and frontier market investors who tend to be heavily earnings-focused.

We believe that buying at a substantial discount to a bedrock valuation, one which is estimated using a highly conservative, asset-based methodology, provides downside risk mitigation while also offering attractive upside potential, since favorable scenarios typically are not priced in at such depressed levels.

Attractive investment opportunities that become available at sizeable discounts to conservatively estimated, balance sheet-based intrinsic values are unusual. Typically, there must be “a catch,” or something “wrong” that has created bargain pricing.

Common “catches” include short-term turmoil affecting a company, industry or geography, a situation that is complex or underappreciated, neglected, or misunderstood by the broader market, or event-driven scenarios which cause a business to become “unfashionable” in the minds of most market players.

Although sporadic, compelling asset-based value investments can and do become available even in emerging and frontier markets, which have traditionally been considered the stomping grounds of growth investors who often have shorter-term investment time horizons than what an asset-based investment opportunity might require.

Unusual bargains can sometimes be found in corners where, in our opinion, many market participants are biased against looking. Asset-based investment opportunities may additionally present themselves in the form of companies that create value by means other than recurring earnings from continuing operations, yet which at times are neglected in an earnings-focused world.

Many thanks – as always, your interest and curiosity are very much appreciated! For those interested in learning more about us, we invite you to visit our website at www.moeruscap.com and contact us with any questions or feedback at ir@moeruscap.com.

download printable version

DISCLAIMER: This document shall not constitute an offer to sell or the solicitation of any offer to buy interests in the Moerus Global Value Fund or any other entity managed by Moerus Capital Management LLC (“Moerus”), a registered investment adviser, in the future (such entities are collectively referred to the as the “Fund”), which may only be made at the time a qualified offeree receives the Confidential Private Offering Memorandum (the “Offering Memorandum”) relating to the Fund, which contains important information (including Investment Objectives, Policies, Risk Factors, Fees, Tax Implications, and Relevant Qualifications), and only in those jurisdictions where permitted by law. In the case of any inconsistency between the descriptions or terms in this document and the Offering Memorandum, the Offering Memorandum shall control. These securities shall not be offered or sold in any jurisdiction in which such offer, solicitation or sale would be unlawful until the requirements of the laws of such jurisdiction have been satisfied. This document is not intended for public use or distribution. While all the information prepared in this document is believed to be accurate, Moerus makes no express warranty as to its completeness or accuracy, nor can it accept responsibility for errors appearing in the document. Only those representations and warranties that may be made by Moerus in an Executed Written Agreement shall have any legal effect. Moerus shall not have any liability to you or any other party resulting from the use of, or reliance on, the material contained herein. The information provided herein, including, without limitation, Investment Strategies, Investment Restrictions and Risk Management Parameters, and Investment Personnel, may be modified, terminated, or supplemented at any time without further notice in a manner which Moerus believes is consistent with its overall Investment Objective. The preceding information is not being provided in a fiduciary capacity, and is not intended to be, and should not be considered as, impartial investment advice.

An Authentic Dilemma: What to Do When Bargains Are Scarce

December 20, 2017 in Best Ideas Conference

This article is authored by MOI Global instructor Juan F. Matienzo, managing director of Mercor Investment Group, based in Mexico. Juan is an instructor at Best Ideas 2018, the fully online conference featuring more than one hundred expert instructors from the MOI Global membership community.

As stock prices have risen and bargains have become scarcer, we have been expanding our hunting grounds to countries where we had never invested before. The broadened search has yielded some fine catches, but not enough to keep us from being confronted with a question many other value investors currently face: Should we keep an ever-larger percentage of our portfolio in cash (which at present produces next to nothing) until the bargains return, or should we lower the standards by which we decide what constitutes a bargain?

In favor of hoarding cash, we might reason that having investment standards is what gives us an edge, and that the edge is lost to the extent that the standards are relaxed. Also, there is the argument that, while cash is a drag on performance, it might eventually prove very useful. In Charlie Munger’s terse rendering: “It takes character to sit there with all that cash and do nothing. I didn’t get to where I am by going after mediocre opportunities.”

In favor of lowering our standards is the argument that it can be done to a certain extent while still remaining true to deep value investment principles. Many studies have shown, for instance, that a portfolio invested in the cheapest decile of the market works well over time, which implies, of course, that the average stock in the portfolio is, on an absolute basis, more expensive at some points in time than at others. And many investors have done very well by adjusting to rising markets – my hero Walter Schloss, for instance, seems to have always been at least 90% invested during four and a half decades that included all sorts of market conditions.

Which of the two approaches ends up working better for today’s value investors depends of course on how long the bull market has to go. If it still has a long run ahead of it, we’d be better off relaxing our absolute standards and remaining fully invested in the relatively cheapest stocks we can find. If the bull market will soon end, we’d be better off hoarding cash. But, of course, if we were confident in our abilities to predict the ups and downs of the market, why be value investors at all?

At Mercor, we have relaxed our standards a little bit. For example, today we might hold on to a stock whose price has climbed up to the liquidation value of its assets, hoping to “buy on assets and sell on earnings”, whereas before we typically would have sold it by that point and used the proceeds to buy another set of cheap assets.

We have chosen, however, to keep most of our standards intact, and so our cash balance has grown significantly. We don’t find it too hard to “sit there with all that cash”, perhaps because we have the character traits Mr. Munger was referring to, or perhaps because doing so allows us to think of ourselves in flattering terms (bastions of prudence patiently waiting for the next financial bust while the investing masses mindlessly extrapolate recent trends into the future, etc.).

In any case, our choice of hoarding cash over relaxing our standards is not based on our anticipating the imminent end of the bull market. It simply is what we’re most comfortable with.

I’m not one of those who think that investors should do what they’re comfortable with over what’s rational, so as to be able to “stay in the game”. In my view, if one is not comfortable doing what’s rational (i.e. what the evidence suggest is likely to work best, given the state of one’s knowledge and ability), then it is one’s job to become comfortable doing it.

However, when choosing between hoarding cash and relaxing our standards we don’t have much to go by, as both strategies have worked well in the past, and a decent case can be made for either. So, in this case, why not go with what’s more comfortable?

download printable version

Value investing: Insights From the Modern Field of Neuroeconomics

December 20, 2017 in Best Ideas Conference, Featured

This article is authored by MOI Global instructor Luis García Alvarez, equity portfolio manager of MAPFRE AM. Luis is an instructor at Best Ideas 2018, the fully online conference featuring more than one hundred expert instructors from the MOI Global membership community.

The human brain is one of the most complex and highly evolved structures across the universe. But evolution hardwired the brain with instincts that aided ancient humans in escaping extinction, not in making decisions that have to do with managing their money. In this regard, Neuroeconomics represents a recent field of research with a huge potential in the coming years to help us to better understand how the psychology of individuals impacts the financial markets. The development of modern techniques, such as the functional magnetic resonance imaging (fMRI), are paving the way for new discoveries regarding how human beings approach investment decisions. These new findings are reinforcing the idea that, when we face situations that have to do with our money, we are much more emotional and much less rational than what we would like to be. Today, thanks to the new technologies, we know that these decisions are influenced by a large number of factors that are completely unconscious and at times beyond our control.

The explosion of research in Behavioral Economics, as well as recent Nobel prizes being awarded to Daniel Kahneman (for his work with the late Amos Tversky), Robert Shiller and Richard Thaler can be interpreted as a paradigm shift in economic science. Economics had traditionally been based on complex mathematical models inherited from the field of physics and on the assumption of the existence of rational economic agents (homo economicus or Econs). These rational economic agents were supposed to be highly intelligent and cold beings, totally lacking in emotions but capable of making the most complex of calculations in a record time, much like Mr. Spock, the character from the television series Star Trek that was extremely popular in the 60s and 70s.

The research in Behavioral Finance, which integrates concepts from psychology, deviates from this unrealistic view of the human being. It focuses instead on the way people really make financial decisions, which is under the influence of a large number of cognitive biases that affect their behavior. This approach to explaining how financial markets work offers a significant contribution to the development and understanding of the value investing philosophy. Basic value investment strategies consist of buying stocks with a significant discount to their fair value during periods of pessimism (about a company or the economy as a whole) and selling them when they trade above their intrinsic value as a result of collective euphoria. As Warren Buffett phrased it, value investors have to “be fearful when others are greedy and be greedy when others are fearful”. They must also be patient and long-term oriented, as it can take time for the market to prove them right.

In their investment process, value investors usually take an entrepreneurial approach, thinking as if they were the sole owners of the firm that they are analyzing. Most of them look for companies with businesses that are easy to understand, have solid and predictable cash flow generation, little or no leverage, good management teams whose interests are aligned with those of investors, high returns on capital employed and sustainable competitive advantages (or economic moats, as Buffett called them). But the trigger that finally defines their decision to invest in a given stock is the possibility to pay a price that is sufficiently below their estimated fair value for the business, offering a margin of safety that serves as a protection against the potential mistakes that can arise in the analysis.

However, buying high-quality businesses, showing most of the characteristics mentioned above, at significantly low prices is an extremely difficult task. In fact, it is almost impossible to perform under normal circumstances. When a stock trades at low valuation multiples this is usually the result of a general perception within the investment community that something is going bad with the business. When there is uncertainty regarding a company, most people prefer just to avoid its stock, as their brains have evolved to trigger a flight response from a potential danger, just as our predecessors used to do when they went hunting and suspected that a fierce animal could be nearby.

At this point, an in-depth fundamental analysis is needed to find value where others just see problems. When faced with negative news, investors need to differentiate between companies in which the fundamentals have deteriorated forever from those where the damage is just temporary or the impact is much lower than the one discounted by the market (which tends to overreact). Value investors concentrate their efforts in this second group, trying to find companies that have a strong competitive position in their industries and a solid balance sheet that guarantees they will survive after the storm (this is why most value investors prefer to avoid highly leveraged firms). These resilient companies represent extremely attractive opportunities for the patient investor that has the ability to wait until things revert to the mean (or even improve further, if one manages to find antifragile companies as defined by Nassim Taleb). However, for this process to be successful an in-depth fundamental analysis is usually not sufficient and the temperament of the investor will play a central role. He or she will need to remain committed to his ideas against the general view of the other players in market, while being open to reviewing the initial thesis with humility if new confronting information appears. Given the limitations of our brains in dealing with fear and stressful situations, a solid and easy-to-repeat investment process is crucial for those portfolio managers who decide to follow a contrarian approach.

Faced with uncertainty, our mind reacts with fear or rejection, predisposing us to run away from problematic stocks.

The brain of the investor is not hardwired to buy stocks from companies that are facing difficulties, although those may be temporary. Faced with uncertainty, our mind reacts with fear or rejection, predisposing us to run away from problematic stocks. This is due to a psychological reaction in our brain that activates the amygdala. The amygdala is the region responsible for multiple emotional responses, such as fear or anger. When we consider financial decisions, the amygdala creates an aversion to risk and can make investors become paralyzed by fear, being unable to take a rational decision and hence missing attractive opportunities. This is why people will feel more comfortable buying stocks from companies that are commonly perceived as “high-quality”. Popular stocks will not have an influence the amygdala. Just on the contrary, they will activate the reward system of the brain, releasing endorphins and creating a sense of well-being to the investors holding them.

For the long-term investor, buying high-quality companies can undoubtedly be a very profitable strategy, given that they can compound very attractive returns for their shareholders over time. For this kind of stocks, even paying a fair price may be enough to protect your capital, as the margin of safety can come from the quality of the business itself. This is the reason why the investment universe of many value investors ranges from decent companies selling at large discounts, to high-quality businesses trading at what they think is their fair price. They avoid businesses with poor fundamentals even if the stock looks temptingly cheap, but also brilliant companies if everybody else is buying them. The problem with the latter is that, as a result of the common perception about the company, very positive expectations get incorporated in the consensus and the stock becomes significantly overpriced. This can completely eliminate their margin of safety (wherever it comes from), increasing the probability of making an investment mistake.

A clear example of the risk from overly optimistic expectations about a stock is the reaction of investors to earnings releases. In his book Contrarian Investment Strategies: The Psychological Edge, David Dreman talks about a series of studies he did over time in collaboration with Drs. Eric Lufkin, Vladimira Llieva, Nelson Woodard, Mitchell Stern, and Michael Berry. Their results showed that earnings surprises often helped the performance of out-of-favor stocks (those trading at low valuation multiples), while negatively affecting the returns of favorite stocks (trading at elevated valuation multiples). This suggests that investors should take advantage of the high rate of analyst forecast error by selecting out-of-favor stocks to enhance portfolio performance. In a second step, they separated positive surprises from negative ones. The study showed that when a negative surprise arrives for a favorite stock, the results are devastating. After all, investors expect only glowing results from their favorites, as they overconfidently believe that only good things will happen to them in the future. These stocks are not supposed to disappoint, and this is the reason why investors are willing to pay top dollar for them. However, for unloved stocks, where expectations are already low, the occurrence of a negative surprise was found to be not much of an event in the surprise quarter and definitely a nonevent in the nine months following.

Dreman et al. defined two categories of earnings surprises for favored and out-of-favor stocks. They called the first category an “event trigger” and the second a “reinforcing event”.

Dreman et al. defined two categories of earnings surprises for favored and out-of-favor stocks. They called the first category an “event trigger” and the second a “reinforcing event”. They defined an “event trigger” as unexpected negative news about a stock believed to have brilliant prospect, or unexpected positive news about a stock believed to have a mediocre outlook. An “event trigger” changes the perception of investors about a stock, from positive to negative or vice versa. The second category of earnings surprises was called “reinforcing event” and was defined as positive surprises for favored stocks or negative surprises on out-of-favor stocks. Rather than changing the investors’ perception about a stock, this kind of earnings surprises reinforced their current beliefs. The results of the study showed that the response of the market to unanticipated good and bad news is remarkably different for favored and out-of-favor stocks. “Event triggers” result in a perceptual change for investors and have a major impact on stock prices through the end of the year. “Reinforcing events”, on the other hand, have a minor effect on stock prices by the end of the twelve months following the surprise.

These results strengthen the case for investing in unloved or unpopular companies and seem to have a physiological explanation coming from the field of Neuroeconomics. Let us take a look first at how the release of dopamine affects our feelings. Dopamine is a chemical released by the body that is associated with the pleasure system of the brain. It provides feeling of enjoyment and reinforcement, motivating a person to perform certain activities. The neurons that are able to release dopamine are activated by rewarding events that are better than predicted, they remain uninfluenced by events that are as good as predicted and they are negatively influenced by events that are worse than expected. Note that the structure of these outcomes corresponds to the four types of earning surprises that Dreman et al. defined in their analysis.

According to a research study by Pammi Chandrasekhar, C. Monica Capra, Sara Moore, Charles Noussair, and Gregory Berns published in NeuroImage (2008), higher-than-expected rewards, such as a positive surprise for an unloved stock (the first type of “event trigger”), result in a release of dopamine in the brain. Additionally, another study by Schultz, Montague and Dayan published in Science (1997) found that dopamine neurons activate when people believe that a reward is coming but, if the reward finally does not arrive, they will stop firing. This situation is equivalent to a negative surprise for a favored stock (the second type of “event trigger”) for which investors believed that only positive news would come. This will make the brain feel disappointed as it is deprived from its expected shot of dopamine. Finally, the two other types of earnings surprises, defined as “reinforcing events”, do not seem to have much impact in our neuroprocessing. In these cases, the outcome was seen as highly probable and, hence, was already anticipated. These series of findings are consistent with the results obtained by Dreman et al. for the financial market, where the impact of an “event trigger” on the stock price was shown to be about four times larger in absolute terms than the one of a “reinforcing event” in the quarter of the surprise, and almost twenty-four times as much after one year. From the investor’s point of view, the advances in the field of Neuroeconomics seem to support the case for contrarian strategies.

…value investing requires portfolio managers to take a contrarian approach and to deviate from the crowd. This is something that the large majority of individuals are not prepared to do…

As we have already mentioned, our brain is a survival machine and it feels safer when we act as part of a group. However, value investing requires portfolio managers to take a contrarian approach and to deviate from the crowd. This is something that the large majority of individuals are not prepared to do, either because they are not able to overcome their own cognitive biases or just because they prefer not to put their professional careers at risk if they happen to underperform the market in the short-term. This is the reason why, despite its recent growth, value investing will never be the part of the mainstream as, by definition, it implies doing things differently and buying undervalued stocks that other investors do not want to hear about. Portfolio managers cannot expect to get extraordinary results by just betting with the consensus, because the information will already be incorporated in the market price. To obtain superior results, it is necessary to deviate from the herding behavior and to follow our own analysis. But we know by now that this will make our brain feel uncomfortable most of the time.

Indeed, even when the contrarian investor is right, there are usually not many people willing to celebrate the good news with him or her given that, by definition, most of the other investors were holding the opposite side of the trade. Take as an example the film The Big Short (based on the book by Michael Lewis with the same title) and think about the words by the character of Ben Rickert, the retired hedge fund manager played by Brad Pitt and based on Ben Hockett in real life. When his two young friends were celebrating the idea to short mortgage bonds and get extraordinary profits if the housing market collapsed, Ben cautioned them to temper their joy as they ultimately were “betting against the American economy”. If they were proven to be right, “millions of people will lose their jobs” and suffer massive hardship of all kinds. This idea about the intrinsic loneliness of the contrarian investor was also brilliantly summarized by Seth Klarman in the 2015 Baupost Group letter to clients: “You don’t become a value investor for the group hugs”. However, the field of Neuroeconomics has shown that our brain likes the group hugs and is not designed to drive us comfortably through the road that can lead us to superior investment results. This gives a huge importance to digging deeper into the understanding of our minds and to the design of strategies that allow us to benefit from the systematic mistakes of other investors while protecting our decisions from our own cognitive biases.

download printable version

Bias from Over-Influence by Extra-Vivid Evidence

December 20, 2017 in Human Misjudgment Revisited

“It’s very easy to misweigh the vivid evidence, and Gutfreund did that when he looked into the man’s eyes and forgave the colleague.” –Charlie Munger

This article is part of a multi-part series on human misjudgment by Phil Ordway, managing principal of Anabatic Investment Partners.

download printable version

Munger cites the example of Belridge Oil where turned down a large block of shares because he “just mis-weighed it” based on his assessment of an extraordinarily peculiar CEO. That decision cost him a short-run profit of more than $5 million that mushroomed into the hundreds of millions of dollars on an opportunity-cost basis over the ensuing decades.

Belridge was the first of the oil company megadeals that began as a little-known California producer. It was forced onto the auction block in July 1979 when the descendants of its three land-speculator founders, owning a collective 55%, got an attempted squeeze-out offer from the Mobil/Texaco JV that owned 34%. “The two majors attempted to buy out the other shareholders, negotiations with each shareholder individually so as to gain the company on the cheap. However, the members of the founding families, mostly in their sixties and seventies, would not be pushed around, and instead decided to run an auction.”[52] The market price at the time was around or slightly above $110 million, and the company rarely if ever traded on the Pink Sheets. In 1978 had posted $43.9 million in profit on a book value of roughly $177 million. Profits in the first half of 1979 were up 50%.[53]

The auction resulted in Belridge’s acquisition by Shell for $3.6 billion in late 1979. At the time it was thought to be the biggest cash takeover in American history.[54] Shell reportedly topped the next highest bid by $500 million, shocking all observers.[55] The per share takeout price of more than $3,600 compared with the Munger’s price of $115. The auction result even got an eventual mention in a Buffett shareholder letter, noting that Belridge was sold for $3.6 billion against its book value of $177 million, while LTV and Baldwin-United showed audited book values of $652 million and $397 million, respectively, just before they went bankrupt.[56]

As noted above, I often think about this in the context of the many investors/allocators still fighting the War of 2008.

A more recent example is a “quiz” on violence I often give to friends. Chicago has had a lot of attention in this regard, and some of it is deserved; every shooting is one too many. But the vivid evidence cited in some prominent tweets – and the contrast phenomenon that ignores Chicago’s absolute size – can play tricks. The facts are that Chicago’s murders per 100,000 residents spiked from 15-17 in 2005-2013 to more than 25 in 2016…but in the early/mid-1990s it was over 30.[57] And its murder rate ranked 8th among big U.S. cities in 2016. St. Louis was at nearly 60, and Baltimore was over 51.[58]

The same is true for America generally. The annual murder rate per 100,000 people bounced between eight and 10 from 1970 to ~1995 before declining sharply through ~2014 near 4.5. It has since ticked up above 5.5.[59] To keep the size in perspective, that is an extra 3,000+ Americans killed per year at the higher rate of 2016 vs. 2014’s but almost 15,000 fewer Americans killed at the lower rate of 2016 vs. 1994’s. Nonetheless, concern about violent crimes was at or near all-time highs in many surveys/polls of Americans.[60]

Even more broadly, from 1945-2011 the global violent death rate fell from 22 people per 100,000 to 0.3, but by 2014 it had ticked back up to 1.4.[61]

Mental confusion caused by “why” – Also, mis-influence from information that apparently but not really answers the question “Why?” Also, failure to obtain deserved influence caused by not properly explaining why.

Munger: “Well we all know people who’ve flunked…they try and memorize and they try and spout back and they just…it doesn’t work. The brain doesn’t work that way. You’ve got to array facts on the theory structures answering the question “Why?” If you don’t do that, you just cannot handle the world.” “You want to persuade somebody, you really tell them why.”

  • Fuerstein at Salomon
  • Karl Braun’s communication practices

Update

  • Real knowledge requires the ability to explain why to a novice
  • History’s greatest leaders all explained why
  • Unraveling short ideas usually requires asking “Why?” ad infinitum. Chanos has said that many of his best analysts were
  • journalism students and practicing investigative journalists, not MBAs.
  • Everyone knows what they do; most know how; but few know why. Concentric circles with “Why?” at the core.[62]
  • Success ≠ straight A’s in school

nextseries start series overview

[52] https://goo.gl/Qzdz8k
[53] http://www.nytimes.com/1979/09/29/archives/shell-appears-to-win-belridge-bidding-contest-just-550-shareholders.html
[54] https://www.washingtonpost.com/archive/politics/1979/09/30/shell-to-purchase-calif-oil-land-for-365-billion/2dda0dcd-78b7-4288-92a8-81b183837cda/?utm_term=.e685015f3115
[55] https://goo.gl/Qzdz8k
[56] http://www.berkshirehathaway.com/letters/1987.html
[57] https://fivethirtyeight.com/features/chicagos-murder-rate-is-rising-but-it-isnt-unprecedented/
[58] https://fivethirtyeight.com/features/u-s-cities-experienced-another-big-rise-in-murder-in-2016/
[59] https://fivethirtyeight.com/features/u-s-cities-experienced-another-big-rise-in-murder-in-2016/
[60] https://www.brennancenter.org/publication/crime-2016-preliminary-analysis#Executive%20Summary
[61] Joshua Goldstein and Steven Pinker: https://www.bostonglobe.com/opinion/2016/04/15/the-decline-war-and-violence/lxhtEplvppt0Bz9kPphzkL/story.html
[62]

Mohnish Pabrai on Philanthropy

December 19, 2017 in Audio, Best Ideas 2018 Featured, Best Ideas Conference, Featured, Interviews, Transcripts

We recently had the distinct pleasure of recording a special kind of Best Ideas 2018 session with noted value investor and philanthropist Mohnish Pabrai, managing partner of Pabrai Funds, CEO of Dhandho Funds, and author of The Dhandho Investor and Mosaic​. We are grateful to have Mohnish as an active member of — and mentor to — the MOI Global membership community.

Shai Dardashti, managing director of MOI Global, spoke with Mohnish about philanthropy, Dakshana Foundation, having lunch with Buffett, and more.

Here is how Mohnish describes his philanthropic focus (source: Forbes):

“I spend most of my energy running a medium-sized investment fund based in Irvine, Calif. My wife, Harina Kapoor, and I believe in recycling most of our estate back to society. The problems we wish we could solve have defied solutions for decades on end—billions of humans still do not have the fundamentals of adequate food, shelter, education, healthcare and a sustainable livelihood. So we’re trying to make a meaningful dent by applying something we too rarely see elsewhere in the sprawling world of philanthropy: a laser-like focus and a business mindset. We’ve openly shared all the learning (and our mistakes) in running our foundation to hopefully be of some value to others who want to make a difference.”

download printable version
download audio recording

The following is an edited transcript of an interview and may contain errors. The transcript has been condensed for space, clarity, and readability.

Shai Dardashti, MOI Global: While our next instructor here at Best Ideas 2018 needs no introduction, I’d like to share a few words of background:

Mohnish Pabrai is the founder and managing partner of Pabrai Investment Funds, modeled after the original Buffett Partnership of the 1950s. Since inception in 1999 with $1 million in assets under management, the Pabrai Funds has grown to over a half billion dollars of assets, largely based on market-beating performance.

Mohnish is also the founder and chairman of the Dakshana Foundation. The Dakshana Foundation is a philanthropic foundation focused on alleviating poverty. I’d like to briefly read an excerpt from Dakshana’s website:

“Dakshana’s founders and management have a few core aspects to their vision for Dakshana. These are: to be intensely and singularly focused on one or two causes; to focus on causes that do not have a natural funding constituency; to focus on causes that deliver the highest possible return on invested capital measured in terms of the improvement in quality of life; to be scalable; to be self-sustaining where the beneficiary of aid today is the donor of tomorrow.”

In the coming decades, Warren Buffett’s extraordinary success at Berkshire Hathaway will become a rounding error relative to the societal impact of his charitable giving, both financial and intellectual. So too, I think, will be the case with our next instructor that we have joining us in a moment.

Mohnish Pabrai is a generous teacher and role model. Additionally, his work with the Dakshana Foundation is off the charts. A decade ago, when Mohnish started Dakshana, he estimated that by spending $4,000 per student, his organization could boost each student’s lifetime income by an average of $158,000. What has transpired in the years since is remarkable and it’s an honor to welcome Mohnish Pabrai to Best Ideas 2018.

Mohnish Pabrai, Dakshana Foundation: Thank you, Shai, for that generous introduction and a pleasure to be at Best Ideas 2018. I’ve always been a big fan of the work you and John do – it’s wonderful.

It’s always fun for me to talk about Dakshana. I’d just like to start by going back to the genesis of why there even is a Dakshana. It really goes back to the influence by Warren Buffett.

In reading and studying him, Buffett has highlighted that large inheritances given to our gene pool actually does them a disservice. It actually has a higher probability of negative impact than any positive impact. That resonated with me. Warren also said that if you’re Jesse Owen’s son you shouldn’t be allowed to run 100-meter dashes starting at the 60-meter line when everyone else is at the starting blocks. He said it’s okay to start at the 10-meter line, but not the 60-meter line. These were strong influences for me.

I realized that Warren also talked about how giving money away is far more difficult, especially giving it away effectively, than making it. So, what my wife had decided is that once our net worth went to north of $50 million, we started giving away 2% a year of our net worth, and 2% of $50 million would give us about a million dollars to give away, which is a decent sum to do some meaningful experimentation.

The idea was as the net worth grew – maybe to $100 million, we’d make it 3%, and at $150 million, we’d make it 4%– as the years went by and hopefully the net worth keeps rising, we keep bumping up the percentages. The idea was that by the time we got towards the end of our lives, we’d have compounded money at a good rate, which is fun, but also have built up a kind of an institution that could do some meaningful work and impact lives.

I was 42 years of age, or so, when Dakshana was originally conceived. It was pretty clear we were going to focus on education and we were also initially going to focus on India. It goes back to a quote, “Give a man a fish and you feed him for a day. Teach a man to fish and you feed him for a lifetime.” I didn’t have much interest in giving away fish, both of us, my wife Harina and I, had a deep interest in teaching fishing because clearly the returns on investment are much better.

Given that we were going to be teaching fishing in India – while we were based here and given all the difficulties, corruption, and distance – I just assumed that we might spin our wheels for maybe at least ten years, which means we would have kept giving a million dollars or more a year and we wouldn’t have seen any output. I viewed that as part of the tuition bill to learn how to do this properly.

When I started in my early 40s, the idea was that by the time I got to my early 50s, we would have sort of figured out how to actually make it work, and on a number of fronts we got extremely lucky. I remember in the fall of 2006 in Irvine, I was reading an article in Businessweek about a guy in Bihar in India, which is one of the most under-developed, backward states in India – very high population, very low quality of life. This guy in Bihar, Anand Kumar, was identifying thirty 18-year-olds per year who are really smart but very poor, then he took them under his wing for about eight or nine months. After eight or nine months, they took the IIT entrance exam. He had between 80% to 100% success rates in getting these kids into IIT.

The Indian Institutes of Technology, where there’s about a dozen or more campuses now, is the toughest set of engineering schools to get into in the world. The admission criteria are very objective. It is simply based on a couple of tests. These are pretty intense tests on Physics, Chemistry, Mathematics and Logical Reasoning. About a million kids take this test every year with about 12,000 or so seats across all the different campuses, so the acceptance rate is just 1.2%, which is a fraction of the acceptance rate of place like Stanford or Harvard.

It’s a very difficult exam. It requires a lot of prep. What Anand Kumar was doing is he was taking these kids in, providing free room and board, his mother would cook for them, and then he and a few other teachers would train these kids. Once you enter the IITs, it’s difficult to get in, but once you enter the IITs, it’s a very heavily subsidized set of institutes – so the cost of a four-year IIT engineering degree would be about $7,000 or so, maybe around $1,500 or $1,700 a year. Even with that $7,000, it’s very easy to get either grants or bank loans especially if you have needs, so once you get in it’s almost a 100% that you will be able to go through the degree program regardless of whether you even have a penny to your name.

Of course, once you go through the IITs, then you’d pretty much get connected to the global economy. Microsoft is recruiting from there, and Cisco, and Google, and IT grads are sought out the world over. Pretty much once you enter the IITs you become a great credit risk, first of all, and then, secondly, you have a wide range of employment choices in India and around the world. It’s pretty much a very simple ‘zero to hero’ – if you can get in.

Now, of course, getting in is really hard. What was really surprising to me, when I read about Anand Kumar, was that he was – he’s a teacher, he provides private tutoring to kids in the slums. Then, he was taking a small portion, or maybe a large portion, of what was left over from his paid teaching activities and he used that to fund this thirty-student program. He was spending about $800 per kid over the eight or nine-month period.

When I read the article, and I saw the success rate, and I saw the $800, I said, “Wow, if you if you spend $800 and get a really poor kid into IIT, the ROI on that investment is off the charts,” because the first thing that happens is that by spending the $800, it unlocks something close to $30,000 or $40,000 subsidies by the Indian government to pay for the education. Then, subsequent to that, it opens up a wide range of career opportunity.

So, I contacted Anand. I was able to get his email address and I said, “I’m really excited about the work you’re doing and we’d be very excited to fund you and to see if we could scale your program.” Anand was somewhat curt on the email, he said, “Thanks for the appreciation, but we don’t take any donations or anything. All the best.” I, again, nudged him after a few weeks and I got a similar response. Then, I said, “Let’s go meet the guy in person.” I told him, “I’m coming to Patna in Bihar in February of 2007. Would you be willing to meet with me and could I meet the kids?” Of course, he was very gracious and he said, “You’re most welcome.”

When I met him, I thought maybe I’d use my persona to convince him that scaling was in the best interest of humanity, but it was very clear he wasn’t interested in changing anything about the way he was running things, or expanding things, or taking money from others. Then, I asked him if he would have any objections if I cloned his model. Obviously, in investing and, even before that, in my entrepreneur pursuits, I realized that cloning was a very powerful mental model. Of course, Anand said, “Oh, I would be very supportive if you want to scale this model and I’ll try to provide you with all the help you want. I’m all for it, if you want to take this model and run with it.”

So, that’s what we decided to do. I said, “Okay, since I can’t get him to do anything, why don’t we just try to see if we can do it on our own?” But, of course, I’m a guy who goes to work in shorts in California and have absolutely no presence, or contacts, or anything in India, so I was trying to figure out how I’m going to make this happen.

One of the things that I was lucky about is that I’ve had a lot of experience in early stage businesses and start-ups. Starting a for-profit or non-profit, there isn’t that much difference. What I did was that I contacted some of my friends in the US who were IIT grads. I said, “I’m looking for someone in India who could maybe be a consultant to me, and who can help me crystalize this model and get this thing going.”

One of the one of my friends was from IIT Madras, he said, “There’s an alumni message board. I can put a posting on the message board. Why don’t you write up something?” and I did just that.

What ended up happening is that I got a number of responses and one of the responses was from an older, retired gentleman who was an IIT Madras grad in his 60s. He said, “Listen. Your project sounds interesting. I’m retired and I’ve got time available –” he lived in Bangalore – “Tell me what you’d like me to do and I’m willing to give this a try.” I brought him on as a consultant where he would be paid something like $100 for every day that he put in this effort. If it was a partial day, I worked out an hourly rate. And he didn’t really care so much about that. He just said, “Sounds fair,” and, “let’s get going.”

So, once we had a general understanding, I basically told him, “The one piece of the equation that we don’t know, which is kind of a black box that I haven’t yet cracked, is how do I find poor kids who are very bright and find them in some significant quantities?” Of course what Anand Kumar had been doing for so many years is he had built a brand and reputation, so every year when he announced his selection test for this batch of thirty, a few thousand kids would show up to take the test and then from that he’d pick his thirty. In our case, with Dakshana, we were unknown. We couldn’t quite clone that and I was trying to figure out how we’d go about doing that.

Ramesh started meeting people. I asked him to go meet the coaching institutes who provide IIT coaching for a fee and one thing led to another. There’s a school system called Jawahar Navodaya Vidyalaya (JNV), which is a school system I never heard of and most Indians I would talk to had never heard of. It’s quite a remarkable school system that was set up by Indian government. There are 600 of these schools. They’re boarding schools. They’re magnet schools. They’re in every district, which is like a county, in every district in India. These schools are from 6th grade to 12th grade. The admission process is based on an IQ test, language-independent, in 5th grade. About 2 million kids annually take this IQ test and about 40,000 of them get admitted into the school, so it has about a 2% admit rate.

I saw the nature of these schools and that they were a magnet program, and that they were pooling kids from the absolute bottom of society, and that the Indian government was pretty much paying for everything, so it was a fully paid system. We went and spoke to the folk who ran the school system in Delhi and explained to them what we were trying to do, and they were receptive. One thing led to another.

We got a Memorandum of Understanding done and we said that from the 40,000 students in every grade, we would pick the top 4,000 based on test results and invite them to take the Dakshana selection test. From the Dakshana selection test, we would pick about 400 kids and we’d put them into maybe eight or nine schools around the country. Then, those 400 kids – we would prep for the IIT entrance exam for a couple of years. Of course, we were taking 400 kids out of an original pool of 2 million. With that level of filtering, obviously, we were going to have some really smart kids.

The negative in all of this is that these government schools do take in really smart kids, but, after that, the execution at the school level and at the teacher level can be hit or miss. We’ve sometimes noticed that the height of the kids is really short, which means there’s not proper nutrition. We also noticed sometimes that the teachers, etc., aren’t the best. The schools do take in great talent, but in the five or six years before we get to them, I think, large swaths of the talent does not get up to full potential. Even then, we are doing such heavy filtering once we took these 400 kids.

The first time we did this, we had a success rate of approximately 15% or 20% of these kids going to IIT. We had a lot of issues and problems with our coaching, but I always felt in businesses and in start-ups that you just want to make tomorrow better than today. Once we could identify the results, because the results are very precise and metric-driven, then we would also look at why we were getting the results that we were getting. Then, from that point on, all I cared about was blocking and tackling and improving the result.

Now, Dakshana, if you fast-forward ten years – we are taking in somewhere around about 1,100 kids per year and our success rates have gone up quite a bit. Last year, we were at 80%-85% of the kids going to IIT, and we’ve also expanded to training doctors as well as engineers, and even there the success rate is pretty similar.

What we also did a few years back is we bought a 109-acre campus of our own, so we ran our program in the government school systems and we also ran the program on our own campus. We found the government, many times, were slow to task and slow to scale; now, with our own campus, we are able to scale up quite quickly.

One of the things about the non-profit world is that – in the for-profit world, when you’re running a business, if you do not deliver value to your customers, what’s going to happen is that the business is not going to produce a profit and eventually it’s going to cease to exist. There’s a feedback loop. There’s a very tight feedback loop in the for-profit world which makes sure that the only businesses that have an enduring quality are ones that truly deliver for the customers, and have all the pieces set up so that they have great employees, and great customers, and great financials, and are able to make it all work.

In the non-profit world, we don’t have this feedback loop. I’ve mentioned that once we cross $50 million, we’d give away 2% – so as long as my net worth stays over $50 million, I could keep giving the 2% regardless of outcomes, which is not the case in the for-profit world. In the non-profit world, the lack of a feedback loop is very problematic because it means that you cannot course correct. Every business does well because they listen to the feedback and they continuously course correct.

…using one of Charlie Munger’s mental models of inversion, we made a decision that we would only focus on causes where there was a feedback loop.

So, what I did is, using one of Charlie Munger’s mental models of inversion, we made a decision that we would only focus on causes where there was a feedback loop. There are many, many causes in the non-profit world that are very worthwhile, but measurements are either difficult or impossible and there is just a sliver of causes where measurements are actually possible. The first thing we did is we said, “Well, if something cannot be measured, we’re not going into that endeavor.” Even though, on the surface, it might sound good or it sounds like we might be doing good, but because we can’t get tangible measurements, we wouldn’t be able to know whether we were doing a good job or what we need to do to improve.

What I liked about the Anand Kumar Super 30 model Dakshana we adopted is there were two metrics available every year. The first metric is how much money was spent on every scholar to get him or her trained for the IIT exam – that’s a very precise number. The second metric is: what were the results? How many scholars took the test and how many were admitted to the IITs?

The thing about the second number, the acceptance rate, is that we have no control over that; we have control over how much we spend per scholar, but we have no control over outcomes, someone else does a scorecard on that. Therefore, it’s not subject to corruption or management fudging things or any of that because it’s not like my management team can tell me, “Oh, we did a great job this year” and kind of wave their hands. I only just look at the test results and the acceptance rates, and that tells me pretty much all I need to know.

The thing with Dakshana is that when we first started, we had a certain amount we were spending per scholar and the second metric was the conversion rate. Like I mentioned, in the first few years, we were spending around $3,000-$4,000 per scholar and the conversions were 15%-20%. It was very low. Now, we are spending around $2,000 per scholar and the conversion rates are north of 80% and we’ll see if we can reduce that $2,000 further. Even if that doesn’t go down, if the acceptance rate stays up there, then the ROIs are really high.

The second thing that’s happened is that, of course, in the last ten years, thankfully with the power of compounding, the net worth has gone up. Now, for my family, the annual giving is north of $6 million a year when it used to be about $1 million a year. We’ve also had some folks like Prem Watsa and Fairfax, who have committed to $1 million dollars a year, and we’ve got a number of other donors, and also some of our kids who have graduated have also started contributing.

So, Dakshana is on a very robust financial footing at this point, which is great. We spent $10 million on our campus and we’ve paid that off. Just last week I’ve made the last payment on that asset, which is great. One of the things about the model we have with training these kids for IIT and spending, let’s say $2,000 or $2,500 per kid is that once we are doing something like 2,000 or 3,000 kids a year being trained – we’re not there yet, but we’ll get there – and once we are spending in the $4 million or $5 million a year range, the system may not be able to absorb more than that. We are now getting to the point where our resources, for the first time in 2017 and beyond, are thankfully exceeding what this program can absorb.

The first thing we’re doing is we’re taking about 1,100 kids a year and we’re going to be working in the next three or four years to increase that to about 3,000 so that we max out the program. Then, we’ll have to, again, go back to the drawing board and figure out what’s the next program. Of course, we lucked out big time because the Dakshana program right now has very high ROIs and it’s perfectly fine if we have to drop our bar, if you will, a little bit. I think the pieces that have worked well for Dakshana have been the measurements and metrics – they have been really important.

We have never, ever, hired a single person from the non-profit world. We have a fairly large team in India now. None of them have come from the non-profit world and that is by design. I think the non-profit world has a lot of bad habits because they’re used to this continuous drip coming from some donor, whereas, most donors aren’t so focused on the measurements, so that leads to a lot of inefficiencies. They almost run like government departments, if you will.

I never wanted that for Dakshana. We’ve always taken people who, basically, have no experience with that sort of a culture, so we never had to teach them to unlearn stuff. The team is really good. I’ve been very lucky we have a fantastic CEO, Colonel Ram Sharma, and he’s brought a great team under him, so it has worked out vastly better than I would have thought in terms of when I started and where we are today.

Also, my life and my family’s life would be far less interesting and far less exciting if there weren’t the Dakshana Foundation. Some of the best days of the year for me are when I’m either visiting the scholar homes in the middle of nowhere in India or I’m meeting with the kids in the classrooms. Those experiences have just been priceless. They’ve just been amazing.

I think that I’ve been very lucky that all of these pieces came together. There was an Anand Kumar, there was a Super 30, we found a great CEO, we found the government of India is willing to cooperate, and we focused on the metrics and worked on the improvement, so all the pieces came together really well. We’ll see what lies in store in the decades ahead, but it’s a fun journey. With that, go ahead, Shai, with how you’d like to take this conversation further.

Shai Dardashti: I understand that, together with Guy Spier, you enjoyed a private lunch, and conversation, with Warren Buffett. I’d love to learn how the experience impacted your thoughts on charity.

Mohnish Pabrai: The objective I had in bidding for the Buffett lunch was simply to thank him. I didn’t really have any other expectation. At the time, in 2007, when we were bidding for the lunch, most of my net worth had been generated because of Warren Buffett’s intellectual property, if you will, which he’s freely shared with the planet. I just felt that I owed him a huge debt. He was willing to take a bribe and sit down for a meal. He was living when I was living, so I said, “You know, why don’t we pay the bribe, which was going to a good place, and see if we can win the lunch?” I just wanted to be able to look him in the eye and just thank him from the bottom of my heart. That was the primary driver for the lunch.

Of course, what I learned at the lunch, and subsequently, is that Warren is very focused on making sure that the folks who win these lunch auctions – he realizes that it’s a big deal for the people who win these auctions and for many of them the amounts are large as well – he wants to make sure that at the end of the lunch, they feel like they got a bargain. He tries really hard to deliver an incredible amount of value. For example, when he showed up at our lunch – I went with my wife and kids, and Guy Spier came with his wife Lory – the first thing Warren said to us was, “I’ve got nothing going on all afternoon. When you guys get sick and tired of me, just let me know and I’ll leave, but I don’t have specific schedule or particular time.” Basically, what Warren was saying was there was no time limit on the lunch.

The second thing that would happen is that whenever I, or someone else, would ask a question, he always tried to convert these questions, even though sometimes they were innocuous questions, into learning opportunities. The thing about Warren and Charlie is that they have been very open and almost everything about them is in the public domain. If you want to learn what Warren Buffett has to teach or what Charlie Munger has to teach, you don’t need to meet them, or have lunches with them, or any of that. Read the biographies, the Berkshire letters, Poor Charlie’s Almanack, and the transcripts of the annual meetings, and you will learn an incredible amount.

But, what the lunch did for me is it helped me calibrate some of the things that were really important to Warren. We know he cares about a whole bunch of different things, but it helped me calibrate what aspects were more important than others. Before he came to the lunch, I had sent him the first Dakshana annual report. We just published our first report, in 2007. He had read every word of that report and he was, from memory, quoting things from certain pages. He’d say, “Oh, yeah. You had this and that, and all of that,” which was very surprising for me because I had no idea what was on page 7, but he did. Subsequent to that, I sent Warren the annual report for Dakshana every year and he – I think, most years – finds the time to read it and sometimes writes notes back.

One of the most important mental models for Warren Buffett is the mental model of an inner scorecard.

Again, what the lunch did is it helped me calibrate what were the things that were really important to Warren. One of the most important mental models for Warren Buffett is the mental model of an inner scorecard. This is covered in Alice Schroeder’s biography. You can live your life with an outer scorecard, which is the way the world sees you, or the inner scorecard, which is how you measure yourself based on internal yardsticks, not external yardsticks. That is very fundamental to who Warren Buffett is – he uses internal yardsticks. He also does not care about whether a particular action he’s taking is acceptable to society or not. He makes a decision on acceptability based on an inner scorecard. These are things I could read about in Alice’s book, but I think in the interaction, it became very clear that that was important.

We spent quite a bit of time talking about philanthropy, and giving back, and all of that. A lot of great talks that he shared on that front, but I would again stress that for a careful study of Warren and Charlie, you’re not going to be missing much whether you get to sit down for a meal or not.

Shai Dardashti: What would you suggest are appropriate next steps for someone curious to learn more about Dakshana, or perhaps inspired to get involved?

Mohnish Pabrai: We have a website. Please feel free to browse the website. There is a lot of data on it. We have profiles on a lot of our scholars on it. The other thing is we have all our annual reports on the website. Warren has told me that the Dakshana annual reports are the best annual report he’s ever seen from a non-profit, which made me feel really good when he mentioned that. Of course, one of the reasons he probably feels that way is because I took a lot of cues from the Berkshire annual reports. We don’t have pictures in our annual report, it’s a black and white report, and it’s a letter from me to the constituents of Dakshana, and we spent a lot of time on the metrics. I think he probably appreciates that.

The other thing that, which is also something I learned from Warren, is that if you’ve got bad news and good news, put the bad news upfront. One of the things, which is a part of the Berkshire culture, is that Warren always brings out the bad news first because if you bring out the bad news first, you have a good chance to learn from it and improve yourself. If you sweep stuff under the rug, you yourself never learn from it. What I always try to do at Dakshana is that we’ve made a zillion mistakes, and we’ll continue making mistakes. We’ve spent a lot of time highlighting those mistakes in the annual reports just to show you how dumb we are. I think if people are interested, I think the annual reports are a good place to go.

There are a few different ways to get involved. It’s easier if you’re in India, if you want to give time. We’ve got a number of things we can do. We’ve had people serve as mentors and different things, and now our alumni do a lot of that. Certainly, you could become a supporter with financial contributions – it’s another way to get involved. But, I think that, like I said, to me the best thing would be if people just studied the Dakshana model, and then, whether or not they support us, but if it has some impact on their thinking on the subject, then I think that’s all I can hope for. I think that would be a wonderful outcome.

Shai Dardashti: On the question of “trust, but verify” – trying to get a firsthand due diligence perspective, where should one begin and how should one proceed?

Mohnish Pabrai: I think at Dakshana, it’s an open book. It’s easy to meet the kids, it’s easy to talk to them, it’s easy to meet the alumni, because they’re now on their own, and get perspectives from them. I think, clearly, you can get a lot of data from us on our website, but I think you could also kick the tires by meeting the alumni. I think we have a number of alumni now who are in the U.S. They’re working for places like Microsoft and Google and some of them are going to grad school, they’re doing PhDs.

Now, our alumni are all over the world, so it’s relatively easy, no matter what your geography is, to actually even have phone conversations with some of these folk and we encourage that. In fact, I always try to get data from the alumni on how we can do better or what was the problem when you went to the program and that sort of thing.

Shai Dardashti: Are on-location site visits welcome, and if so, how should visits be coordinated?

Mohnish Pabrai: We welcome that. Obviously, they need to coordinated because the kids are on an intense program for two years, but they like the diversion from taking a few hours off from their intense studies. Prem Watsa has visited a couple of times with his family and we’ve had a number of other kind of luminaries interact with the scholars.

There are a number of ways to interact with the scholars. One is to visit one of the eight locations where we run our program – that’s one way to do it. The other way is to visit the IITs where we have our alumni or the NITs (the National Institute of Technology). Our alumni are in all these institutes and these are in places like Mumbai, Delhi, and Chennai. Another way to interact is to interact with them when they enter the workforce. We’ve got folk in Michigan, California, and New York, and, of course, all over the place in India, and Singapore. There are a number of different ways the interactions can take place.

One of my favorite ways to interact is to visit the scholars’ homes. Those are more complicated because these are in very remote geographies and it takes a lot of coordination to make it happen, but I’ve done a number of trips. Usually, I try to do one trip a year where I focus on meeting scholars in their homes. I’ve been a little busy in the last two, three years – so that hasn’t been as much of a priority, but I’m hoping to get back into it. Those have been some of the best trips and the best days that I’ve spent. I think that’s when we truly can see the impact of the program, when we go deep into some of these villages in India and we are actually able to see how the families are living – in many circumstances it’s very desolate conditions – and how quickly that gets reset.

Shai Dardashti: As a final question, what you would suggest are the right ten-year goals, both from your side and for anyone who is a contributor?

Mohnish Pabrai: Our end, one of the things we want to do is to make sure that we have a high input-output ratio. If we are spending $2,000 or $3,000 per scholar and we are getting these 70%, 80% type outcomes – because even the other 20%, 30% go to very good schools, that engine is working. Obviously, another piece is to make sure that we’re picking up the right demographic where they wouldn’t have an option if we weren’t in the picture. Those are things that matter, that we are focused on.

But, if I look ten years out, it’s a bit scary because – we’ll see how the compounding goes. The good news with compounding is that the numbers start becoming large and as the numbers start being large, you just need to put more infrastructure and you need to be willing to take lower returns as you scale up. Those are all good problems to get to, when we get to those. I think that we may get to those types of scenarios in the next two or three years.

But, if I go ten years forward — just simple math: Let’s say I assume 15% increase in net worth every year, for example. It means we have two doublings –it may be faster than that because I get fees on other people’s money. The $160+ million would get to something like $650 million or $640 million in ten years. Then, if we are, at that point, giving away 5% or 6%, that’s north of $30 million. As I think about it today, I don’t know how we would spend even $4 million or $5 million, let alone $30 million, so we’ll have to, in the next few years, figure that out.

One of the things about the difference in the for-profit and non-profit world is that in the non-profit world, one should be very willing to swing for the fences and one should be very willing to take big losses. If you want to change human trajectory, you have to go high-risk, high-returns. Whereas, in value investing, we try to go low-risk, high-returns. If we have those types of resources at our disposal, a $30 million a year budget or something similar, Dakshana will be very willing to swing for the fences knowing we might miss a lot, but we will definitely have some hits.

To some extent even people like the Gates Foundation do the same thing, where they’re trying to make significant trajectory changes with vaccines. So, we’ll be looking for a kind of fulcrum-type thing: “Where can I get the most leverage and is it hard?” If it’s hard, that’s fine. In fact, the harder the better. What we’re really interested in is: “Can I get huge bang for the buck and can we scale this?”

I hope, ten years from now, we do more than the 15%. I hope ten years from now Dakshana has, let’s say, a $100 million annual budget. I don’t know if that will happen or not, but I hope that happens. I hope we’re swinging hard at the fences, we may be missing a lot but we’ll also hit sometimes.

Shai Dardashti: Mohnish, thank you so much for sharing your time with us and engaging in such a wonderfully candid conversation together. I hope Best Ideas 2018 participants will take the time to visit http://www.dakshana.org and learn more. Mohnish, it’s an honor to have you here.

Mohnish Pabrai: Always a pleasure, Shai. Thank you.

Watch ‘Dakshana Inspire’

Mohnish Pabrai is the Managing Partner of the Pabrai Investment Funds. Since inception in 1999 with $1 million in assets under management, Pabrai Investment Funds has grown to over $700 million in assets under management in the 3rd quarter of 2017. The funds invest in public equities utilizing the Munger/Buffett Focused Value investing approach. Since inception, the funds have widely outperformed market indices and most investment managers. A $100,000 investment in Pabrai Funds at inception in 1999 would have been worth $1,468,300 as of September 30, 2017 – an annualized gain of 15.8% (versus 6.5% for the Dow).

Mohnish is the Founder and Chairman of Dakshana Foundation. Dakshana Foundation is a philanthropic foundation focused on alleviating poverty. Education is the most powerful and enduring weapon to win the battle against poverty. Dakshana is focused on providing world-class educational opportunities to economically and socially disadvantaged gifted students worldwide. The focus is on providing 1-2 years of world-class IIT and Medical Entrance Exam coaching to gifted, but impoverished students predominantly in rural India.

He uses his value-investor’s need for efficiency and ROI to run Dakshana Foundation. Since Dakshana started operations in 2007, the IITs in India have accepted over 1,579 Dakshana Scholars (out of a total universe of 2,505 Dakshana Scholars) – a success rate of 63.03%. The fully loaded cost per Dakshana Scholar was $3,066 in 2016. When Pabrai first started Dakshana, he estimated that by spending $4,000 per student, he could boost each student’s lifetime income by an average of $158,000.

In addition to providing coaching to scholars in 7 locations throughout India, Dakshana purchased a 109-acre property in 2014 in Ananda Valley, India to develop and create a campus called Dakshana Valley. The campus accepted 300 scholars in 2017, and when fully built out Dakshana Valley will accommodate over 2,000 scholars.

Mohnish strongly believes in a balanced life between work, family, and personal time. He enjoys spending time with his wife, Harina and children, Monsoon (22) and Momachi (20). He loves reading and playing duplicate bridge. He lives in Irvine, California.

Preview of KKR Presentation: Venerable PE Firm, Attractively Valued

December 19, 2017 in Best Ideas Conference, Equities, Ideas

This article is authored by MOI Global instructor Rodrigo Lopez Buenrostro of Kue Capital. Rodrigo is an instructor at Best Ideas 2018, the online conference featuring more than one hundred expert instructors from the MOI Global community.

“Protect the downside, and the upside will take care of itself.” –Howard Marks

It’s hard to get things for free. No such thing as a free lunch is a cliché among economists and a widespread truth in the stock market, However, once in a while Mr. Market offers great businesses at prices that don’t make sense. These companies tend to be forgotten at the bottom of the Bloomberg screen because they are not in tech or do not belong to an index or simply because owning them is a fiscal hassle. Furthermore, financial analysts tend to focus too much on earnings, which generally contain a lot of noise, while the balance sheet is saved for later.

KKR & Co. is an example of one such company. KKR is one of the most successful private equity firms on the planet and is most famed for Barbarians at the Gate. It turns out managing money for external clients and investing it alongside yours in alternative, long term compounding vehicles is a great business. Today, KKR manages $153 billion, mostly from large pension funds and endowments. Its market cap stands at $17 billion of which 40% is owned by management. KKR makes money essentially from a recurring revenue stream of management fees, a volatile yet profitable incentive income, and income from the GP investments.

Members, log in below to access the restricted content.

Not a member?

Thank you for your interest.  Please note that MOI Global is closed to new members at this time. If you would like to join the waiting list, complete the following form:

SiteOne: Formerly Trapped Within John Deere, Now Free to Excel

December 18, 2017 in Best Ideas Conference, Ideas, Letters

This article is authored by MOI Global instructor Charles Hoeveler, managing partner of Norwood Capital Partners. Charles is an instructor at Best Ideas 2018, the fully online conference featuring more than one hundred expert instructors from the MOI Global membership community.

“We are what we repeatedly do. Excellence, then, is not an act, but a habit.” –Aristotle

At Norwood Capital, we seek excellence in investing by repeatedly searching for mispriced cash flow per share compounders. In this never-ending search, in Q1 we discovered SiteOne Landscape Supply (‘SITE’, or ‘the company’). SITE is the leading US distributor for landscape supplies. The company was trapped inside John Deere and under-invested for most of its corporate history. It was carved out of Deere by private equity in 2013, hired a new management team in 2014, IPO’d in 2016 and is now free to spread its wings.

SiteOne is 4x larger than the #2 industry competitor, but importantly, has only 10% of a $16 billion industry. This is a unique combination and can be a powerful investment theme. SiteOne combines the scale advantages of being the largest player (purchasing power driving higher gross margins + more revenue over a similar fixed cost base driving operating margins), with a long runway of both organic growth and industry consolidation.

We particularly like this distribution model due to extremely fragmented suppliers and customers increasing the company’s negotiating/pricing power with each. There have been a number of similar and very successful distribution models (Fastenal, Watsco and Pool Corp), and we think SITE combines the best of these three. Plus, it has virtually no ‘Amazon risk’ as the sale requires technical knowledge and consultation, and is generally heavy parts that are difficult to ship. 21% of sales are proprietary brands (similar to private label, but actually self-manufactured), allowing for better gross margins.

Members, log in below to access the restricted content.

Not a member?

Thank you for your interest.  Please note that MOI Global is closed to new members at this time. If you would like to join the waiting list, complete the following form:

The Phillips Conversations: L J Rittenhouse

December 18, 2017 in Audio, Full Video, The Phillips Conversations, Transcripts

The following interview is part of The Phillips Conversations, hosted by Scott Phillips of Templeton and Phillips Capital Management.

MOI Global has partnered with Templeton Press to bring you this exclusive series of conversations on investing and the legacy of Sir John Templeton, one of the greatest investors of the 20th century.

Members, log in below to access the restricted content.

Not a member?

Thank you for your interest.  Please note that MOI Global is closed to new members at this time. If you would like to join the waiting list, complete the following form:

About the interviewee:

L.J. Rittenhouse is a trust and valuation expert, as well as a financial strategist and innovation coach to FORTUNE 500 and small cap companies. She is founder, CEO and President of Rittenhouse Rankings, Inc.

MOI Global