Mohnish Pabrai: How to Achieve a 25% Annual Return (5 Investing Rules)
Manish Pabrai is an investor you should be studying if you aren't already. Monish is one of the most highly respected value investors out there and has a wealth of knowledge on the art of investing. In this video, we are going to look at and understand how Manish has achieved a 25% annual return on his portfolio using five simple investing rules. Let's jump right into the video.
“Say it’s a moat and they’d break it down to one word, but basically it’s the ability of a business to have some type of enduring competitive advantage that allows it to earn a better than average rate of return over an extended period of time. Some businesses have narrow moats, some have broad moats, some have moats that are deep but get filled up pretty quickly. So what you want is a business that has a deep moat with lots of piranha in it and that’s getting deeper by the day.”
The concept of a moat—keeping enemies away from the castle with the king and treasure—is simply an analogy for a company with a strong competitive advantage in a free market economy. When a company is making a ton of money and is very successful, this attracts competition. These competitors see a company making a ton of money within an industry, and they want that profit too. A moat or competitive advantage is simply what is unique about a company that keeps those competitors from stealing away their customers and over time, its profits.
A moat can come in many different forms; however, most businesses really don’t have a moat or any type of strong competitive advantage. Think about a landscaping company. If someone else started a landscaping company and knocked down the doors of every single one of the existing landscaping companies’ customers and offered them a 20% discount to switch to this new landscaping company, how many of the customers do you think would make the switch? My bet is that it would be a pretty significant amount. This is an example of a business with a no moat, and this is how most businesses operate.
Compare this to a company with arguably one of the strongest moats of all time: Apple. Apple’s moat is its strong brand and customer loyalty. Odds are you and I both know a lot of people who would never in a million years ever use a smartphone that isn’t an iPhone. If they went to the store to buy a new phone and that store didn’t have iPhones in stock, they wouldn’t just quickly buy a competitor’s phone instead. Rather, they would go to a different store until they're able to find an iPhone to buy. This customer loyalty is a very strong moat and allows Apple to charge a high price for their products and make a lot of money in profit—$94.86 billion in profit over the last year, to be exact.
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“So, summing up, in terms of what do you think you bring to value investing that others perhaps don’t that give you a unique edge? I think the biggest edge would be attitude. You know, Charlie Munger likes to say that you don’t make money when you buy stocks and you don’t make money when you sell stocks; you make money by waiting. So the biggest—the single biggest advantage a value investor has is not IQ; it’s patience and waiting—waiting for the right pitch and waiting for many years for the right pitch.”
“What’s that saying of Pascal that you like about just sitting in there? Yeah, all man's miseries stem from his inability to sit in a room alone and do nothing. And all I’d like to do to adapt Pascal is all investment managers’ miseries stem from the inability to sit alone in a room and do nothing. What Buffett says is that the size of the circle is not relevant; knowing its boundaries is absolutely critical. So what he means by that is that, let’s say, you know, this was your circle of competence; you just gotta understand a very tiny sliver of businesses. Right? You are not at a disadvantage if that is the case. I know that may seem counter-intuitive, whereas having like such a big circle of confidence versus this small—a how can they be?”
“But, you know, Charlie Munger gives the example of his friend, this guy John Arriega. John Arriega is on the Forbes 400; I think he’s worth 2-3 billion after having given away several hundred million to Stanford. And all he has done is he has invested and developed real estate within one or two miles of the Stanford campus. So what is John Arriega’s circle of competence? John Arriega’s circle of competence is not even real estate; it’s not even real estate in California. It’s not even real estate in California, in Northern California or in the Bay Area. His circle of competence is limited to a few square miles of real estate, and that’s it. And what he has done is he’s understood the dynamics of that area, and he’s only put all his energies into that area, and you know—he’s made a fortune doing that.”
“And Munger goes on to say that if you lived in a small town and you never left that small town, you know, let’s say you were in Peoria, Illinois, and you grew up in Peoria, Illinois, and you just were there all your life and so on. You know, you feel like the whole world is around you and you don’t know anything. He says that if you invested in the Ford dealership in Peoria, Illinois, and you invested in the McDonald’s franchise in Peoria, Illinois, and you invested in the best apartment building in Peoria, Illinois, and you invested in the best office building in Peoria, Illinois, and you did nothing for the rest of your life, you had those four investments.”
“And you don’t even need to own the whole thing—part of a McDonald’s, part of a Ford dealership, part of the best apartment complex, and part of the best Class A office building. And the key is you bought those four at the right time, at the right prices, right? And then you just sit on your ass and do nothing for 60 years or 80 years, and you’re done.”
“Yeah, so the checklist I have currently has about 80 items on it. Even though 80 sounds like a lot, it doesn’t take a long time; it takes about 30 minutes to go through the checklist. What I do is when I'm starting a business, I go through my normal process of analyzing the business. When I’m fully done and I’m ready to pull the trigger, that’s when I take the business to the checklist, and I run it against the 80 items. What happens the first time when I run it is there might be seven or eight questions that I don’t know the answer to, which is great—which what that means is listen, dummy, go find out the answer to the eight questions first. So which means I have more work to do.”
“So I go off again to find those answers. When I have those answers, I come back and run the checklist again. Any business that I look at is going to have some items on which the checklist raises red flags. But the good news is that you’re looking in front of you with all your facilities at the range of things that could possibly cause a problem. And when you look at that list, you can also compare it to how those factors correlate with the rest of your portfolio. At that point, kind of you have a go/no-go point where you can say, ‘I’m comfortable with these risk factors. Here I come. I’m comfortable with the prior probabilities, and I’ll go ahead with it.’”
“Can you give a couple of the things that are on your 80 items? Oh yeah, sure. The checklist was created looking at my mistakes and other investors’ mistakes. So for example, there are questions like, you know, can this business be decimated by low-cost competition from China or other low-cost countries? That’s a checklist question. Another question is, is this a win-win business for the entire ecosystem? So for example, if there’s some company doing high-interest credit cards and they make a lot of money, that’s not exactly helping society. So you might pass on that or it’s a liquor company or tobacco company. Those can be great businesses, but in my book, I would just pass on those, or a gambling business and so on.”
“So the checklist will kind of focus you more towards being—playing center court rather than going to the edge of the court. And there’s a whole set of questions on leverage; for example, you know how much leverage? What are the covenants? Is it recourse or non-recourse? There’s a whole bunch of questions on management, on management comp, on the interest of management, on you know, just a whole—on their historical track records and so on. So there are a number—there are questions on unions, on collective bargaining. So you know, and all of these questions were not questions I created out of the blue. What I did is I looked at businesses where people had lost money. I looked at Dexter Shoes, where Warren Buffett lost money, and he lost it to low-cost Chinese competition, so that led to the question. And I looked at Court Furniture, which was the Charlie Munger investment, and that was an investment made at the peak of the dot-com boom, where they were doing a lot of office furniture rentals. And the question was, are you looking at normalized earnings or are you looking at boom earnings? And so that question came from there. So the checklist questions I think are very robust because they’re based on real-world arrows people have taken in the back.”
“The simplest way to find bargains is to be a cloner, and I am what you would call a shameless cloner. In the U.S., we have 13F filings, where every quarter people have to file what they own. So just figure out who the smart people are, look at what they’re buying, reverse engineer them. You don’t need an analyst; it’s actually fun. There is an old saying that imitation is the greatest form of flattery. I don’t know who said this saying way back when, but it sure does apply to finding great investment ideas. According to Monish Pabrai, finding out what stocks your favorite investors own is easier to do than at any other point in history, and it doesn’t take an expensive subscription or technology. All it takes is a quick Google search to find what stocks your favorite investors are buying and selling.”
“Simply pull up Google, type in Datadrama, and go to the website. Once you get to the homepage of the site, just simply click on one investor’s portfolio you want to see. In this example, let’s pick Warren Buffett’s portfolio. Here we can see that Buffett’s largest position within the portfolio he manages on behalf of Berkshire Hathaway is Apple. You can also see that he has recently been buying shares of Chevron, Royalty Pharma, and Floor Decor Holdings. Obviously, don’t just buy a stock because a well-respected investor is doing it, but this is a great strategy to help you get potential investment ideas.”
“If investors like Warren Buffett, Charlie Munger, or Monish Pabrai himself are buying shares in a certain company, it may make sense to take a harder look at these stocks to better understand why great investors are investing in a certain stock. So there you have it. If you like this video, make sure to give it a like and subscribe to the Investors Center, because it is my goal to make you a better investor by studying the world’s greatest investors. Talk to you next time.”