UCLA Anderson Investment Assoc. BRUINvest Blog
A Visit with Mohnish Pabrai in Irvine

On May 11th, 2012, about 7 member of the UCLA Anderson Student Investment Fund went to Orange County to visit a few investment management firms.  The highlight was a visit with the star hedge fund manager Mohnish Pabrai, who took the time to talk to us and have dinner.

Some of Pabrai’s favorite principles:

  1) Align your outer/performance self with your inner/real self.  Basically, most people aren’t aligned with their gut/heart/subconscious beliefs and their explicit/stated/conscious beliefs and preferences.  The “pipeline” from the conscious to the subconscious is clogged and you need to learn how to unclog it.  It’s the difference between meeting a potential mate that meets all the boxes on your checklist, versus falling in love from your heart/gut.  Ideally you have both aligned, like historical figures (Ashoka, Buddha, Jesus, etc.).   One thing is to understand the inner map of who you are - everytime you do something or meet with someone, ask: “Did I really enjoy that?”  If not, cut that activity or person out of your life over time.   Test things but be honest.  Streamline your life to things you are good at and where you add value (important to serve others and have a purpose). Great investors and traders like Buffett and Bill Gross do so well because they are more aligned than ordinary people - it’s not just cerebral smarts (both are geniuses, but many geniuses fail at investing) - it’s also emotional alignment with lots of rationality.

  2) Tell the truth because it’s the rational thing to do and if you do it all the time you will increase alignment.  If you are a honest truth-speaker you will attract similar people to you and increase your odds of succeeding.  It’s OK to make a mistake and tell the truth, not OK to lie and cover it up.  So if you run someone over accidently with your car, if you are truthful and contrite people will forgive you.  Not so if you lie (examples of Teddy Kennedy and Bill Clinton lying about car accident and Monica Lewinsky).  Even if you fool people rationally with your lying, their subconscious self will mark you as a phony.  Complete candor is ideal.  One example come from small, convenient lies.  If your wife asks you what you think of her dress before you go to dinner, you can lie and save time.  Or you can tell her the truth and lose time if she wants to change, but it will immensely help the relationship over time.  All relationships and certainly all of business and finance is built on trust.

3) Copy, steal, and clone ideas and processes started by other smart people (if they make sense).  Most people have a hard time copying due to ego.. they want to be original.  The best businessmen were unabashed copiers, like Bill Gates, Sam Walton, Andrew Carnegie, etc.  Microsoft was bad at copying and took their time, but they eventually got it “good enough” that they could crush competition with their capital and distribution ability.  Even Picasso said:  ”Good artists borrow, great artists steal.”  In the investment context, this means you should identify star money managers and limit your set of ideas to what they are looking at (if you are small, herding here works).  Spend a lot of time with 13Fs… it’s a large set of ideas to examine (10 managers with 20 large positions gives you 200 possible ideas).

 4) Examine mistakes closely, both yours and others, and create a checklist to avoid common mistakes.  The FAA does this after every plane crash and creates a checklist for pilots.  We don’t do it for nuclear power plants since we don’t tolerate failure there… prob. too risk averse.

  5) Reciprocity:  Give first, and then later ask for help.  Ex. of Hare Krishna people giving “free” flowers at airports and later asking for a donation.  Pabrai sends investors a physical package of documents and a free, nice Cross pen ($50 value).  He often sends books to his investors and gives people free stuff.  Size of favors and calibration is important - the brain is bad at sizing.  So a con artist can take advantage of this by doing you a small favor and asking for a big one… watch out for this and immunize yourself.

Pabrai’s Ideas on Investing and Portfolio Construction:

  1) Concentration versus diversification:  Pabrai went from 10 positions of 10% in his portfolio to about 20 positions of 2, 5, and 10%.  He is more in the Seth Klarman camp and disagrees with Munger’s view that you should focus on your top 5 ideas.  He says its a matter of personal risk preferences… it’s OK to do top 5 or 10, but you and your investors need to have the gut for the volatility.  Most people don’t.  So follow your comfort zone.  If you have permanent capital, you can take a lot more volatility and be more concentrated.  The 2% positions are for riskier, more option-like bets that could go to 0 or 5x return with a 50/50 odds… good bet with many of them done independently.

  2) Pabrai’s investing style:  Prefers deep value and looks at balance sheets and normalized earnings… doesn’t like growth stocks because harder to analyse and feel comfortable about the business and growth meeting elevated valuation.  Still fairly concentrated, neutral between US and Intl. (but avoids countries with systemic accounting problems like China).  Like small to mid cap Indian companies if you are on the ground there.  Pabrai has a 90-point checklist from his own failures and systematically looking at investment failures of other top firms over the last 20 years.  Every new investment will raise 10-15 red flags and 5-6 new questions from the checklist.  You need to decide to invest despite the risks, or wait for another pitch.  Pabrai has only part-time staff and no analysts - he does all the thinking himself and occasionally talks to industry experts and other great investors.  His screens are:  13Fs of star managers, large % drops in price, unloved industries not in the news, etc.  Avoids industries and sectors with a lot of change, like most tech.  Always need to watch portfolio turnover and tax impact.

  3) Research:  Solely consists of reading 10-Ks and Qs and talking to industry experts.  He wants to understand the business and industry.  

  4) Talking to management:  Often a waste of time.  They are great salesmen and will mislead you (even if they are honest, prob. too biased to optimism).  Best managers are not working for $$ but for game and control… they are in their playground and church - they work for their mission and purpose.  Just figure out if management is honest and will deal fairly with everyone, with an eye to protecting shareholders.

  5) Reading people:  Look at past track record… much better than resume.  The ability to read people is a competitive advantage, but can’t be taught (it is innate or must be learned).

  6) Mr. Market analogy of Ben Graham: Is completely correct… markets have a poetry.

Bond Bubble in the US

1. OVERVIEW

Within the US, UK, and Europe, there is likely a bond bubble going on currently with artificially low yields due to central bank intervention and asset purchases in bond markets.  A sluggish economic environment combined with further quantitative easing and uncertainty surrounding the European debt crisis will most likely weigh on long-term yields.  With unemployment high and inflation low, the Federal Reserve is likely to continue to maintain extreme monetary policies, thus depressing US Treasury yields.  We expect long-duration bonds will fare the worst, while sectors of the fixed income market with credit risk outperform as risk appetite returns.  Most effective ways to access bonds are through active or passively managed ETFs (lowest transaction costs plus good diversification).  We prefer to take some credit risk to seek yield but we generally want shorter maturities and duration with high cash flow yields. Hence high yield corporate bonds issues, through an ETF, is our preferred space.  To the extent that spreads compress further and yields stay low, we would prefer cash or other liquid measures over any fixed income.

2. SOVEREIGN AND MORTGAGE BONDS

We have decided to allocate 8% of the portfolio to fixed income, which is one-half of our long-term fixed income portfolio target allocation of 16%.  We are underweight fixed income relative to previous allocations because we are concerned about its near-term performance outlook.  A further fall in 1-year UST yields seem extremely improbable, while a rise over 12-24 months seems likely.  Our rationale for this concern is (i) fixed income is currently trading at a premium on a historical basis and appears overvalued; (ii) benchmark UST yields are near 50-year lows in the US and gilt yields are near 300-year lows in the UK; and (iii) there is limited upside potential for principal appreciation.

We expect that over 10-years the purchasing power of the USD and fixed income securities will be significantly lowered due to:

i) high and volatile inflation as economic growth picks up and the velocity of money increases (we think inflation will be 100-300bps higher than the current ~2.5% breakeven level implies);

ii) continued financial repression (negative real yields in many core instruments), as detailed in the Reinhart paper “The Liquidation of Government Debt”;

iii) Further quantitative and qualitative easing asset purchases, after which the Fed won’t be able to contract its balance sheet, leading to classic monetary inflation in 2-4 years.

Finally, mortgage bonds also seem unattractive due to extreme Fed intervention through Fannie and Freddie to support mortgage bond markets.  We would like to note that the 30-year conventional mortgage rate is significantly below its 40 year low.  Hence any upside in mortgage bonds is superseded by the downside risks.

3. INVESTMENT GRADE CORPORATES, HIGH YIELD CORPORATES, AND STRUCTURED BONDS

Most investment-grade bonds look unattractive due to 50-year low yields last seen in the 1960s. Yet investment grade spreads and high yield spreads over USTs look decent compared to last ten years.  We think this is deceptive due to the artificially low UST yields due to monetary and quantitative easing.

High-yield bonds are the best of a bad lot because they have low duration (due to a higher coupon) and decent cash flow yields.  Yet high yield bond spreads are not necessarily cheap/low either.  Spreads at 750bps above USTs are interesting and 900bps above are attractive.  Current spreads in the 600bps range are merely acceptable, given our low allocation.  Our preferred vehicles for high-yield bonds are ETFs like JNK, HYG, and PHB.  Our strategy here is to hold a shorter duration index and clip the coupons – the risk behind this is if rates rise quickly, we can get hurt fast.  Finally, structured finance vehicles like CMBS are too new and have high product risk – it’s hard to get exposure there and so for now we would like no allocation to them.

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