Mohnish Pabrai: How to Stop Picking Losing Stocks (Mohnish Pabrai's Checklist)

Studying investing legend Manish Pibrai has made me a better investor, and as a result, has helped make me more money when investing. In this video, we are going to talk about a concept that, in hindsight, seems so simple and easy to apply to your own investment process. However, most people don't apply this concept, and it is costing them a ton of money. This is having an investing checklist.

Once Manish Pibrai has done research on a particular stock, he then runs through a series of questions related to the business to see if it passes the test for a great investment. We are going to spend the rest of this video revealing what exactly is on that checklist. For context, Manish Pibrai compiled this list by looking at mistakes legendary investors have made in the past. By preventing those mistakes, you can avoid bad investments and losing money.

An example of those mistakes includes Warren Buffett and the company Dexter Shoes, or Charlie Munger in the investment in Court Furniture. Never heard of those companies before? There's a reason because shortly after the investment in those companies, things went south pretty quickly.

Now, let's jump into the list. One of the most important items on the checklist is the amount of debt this company is using, and especially how much debt it is using relative to its peers. One of Charlie Munger's most famous, or maybe you can call it infamous, quotes is that there are three main ways people go broke. He calls them the three L's: liquor, ladies, and leverage, aka debt.

Now, we won't spend any time talking about the first two L's, but let's use two companies as an example. Company A and Company B are both in the same industry. Let's be super simple and say that each company makes 100 in sales and has 80 in expenses, so that leaves them with twenty dollars in profit. However, let's say Company B uses a lot of debt to fund its operations and the cost of that debt is ten dollars a year.

This is completely fine in a normal year when the company has plenty of profits to pay for that debt. However, let's say the economy slows down and as a result, sales decrease from one hundred dollars to eighty dollars. Assuming the company isn't able to cut costs quickly, these costs stay at eighty dollars, meaning each of these companies don't turn a profit that year.

That is definitely annoying for shareholders of Company A but absolutely disastrous for Company B. Remember that Company B has to pay 10 a year to service that debt. Company B didn't make any money during the year and unless they have enough cash reserves, the company is heading for bankruptcy. The shareholders of Company B are likely to see their stock going to zero dollars.

This reminds me of one of my favorite quotes from Peter Lynch: "Remember, it's hard to go bankrupt if a company doesn't have any debt." And before we move on to the next item on the checklist, just one more quick note on debt. It is important to compare a company's debt load to that of companies in the same industry and not in different industries.

For example, real estate companies operate with large amounts of debt, and that is normal for the industry. So if you are looking at a real estate company, it doesn't make sense to compare it to a tech company like Netflix. Instead, compare those debt amounts to other real estate companies.

Next up on the Monish checklist is, can low-cost overseas competitors put the company out of business? This item on the checklist comes from studying Warren Buffett's investment in a company called Dexter Shoes. It's okay if you haven't heard of this company before because, as Buffett tells the story, as soon as the check cleared from him buying the company, the company started down the path of going out of business.

The reason behind this was that Dexter's Shoes made shoes in the United States and was undercut on price by shoe manufacturers in low-cost countries that could make the shoes for significantly less. Buffett bought Dexter Shoes in 1993 when still a large percentage of shoes that were used in the United States were also manufactured there. However, by 1999, approximately 93 percent of the 1.3 billion pairs of shoes purchased in the US came from abroad, and by 2001, the shoe business at Berkshire Hathaway lost nearly 50 million dollars that year, leaving Buffett no choice but to close down shoe production in the United States.

Buffett has frequently called this investment the worst investment of his career, and low-cost overseas competition is the reason behind that. Now you can see why this is a pretty important element to be on Monish Pibrai's checklist. To research more about a company and its competitors, I use the free investment research app, Quarter. I reached out to them to sponsor today's video because they have become a valuable tool in my own personal investment research process. They make learning about a company, its future growth plans, and the main questions Wall Street analysts are asking the company incredibly easy. The best part is that the app is completely free to download and use.

Now let's get back into the video. Next up on the checklist is, is this company's earnings currently at a peak? This comes from studying Munger and Buffett's investment in Court Furniture in 2000. Court leases office furniture. The problem was that at the time Buffett and Munger were studying Court, Court's revenue and free cash flow was abnormally high and attractive because of the internet bubble.

With the rise of the internet bubble, many new startups were getting founded, and this was before the days of remote work. As a result, all these new startups were opening offices and needed to rent furniture. As you can imagine, the furniture rental industry had a great year in terms of profits. But shortly thereafter, the internet bubble popped and Court's business prospects fell.

In hindsight, Buffett and Munger overpaid for this business because they paid as if the company's peak earnings were going to continue at that high rate into the future, when in reality, what is referred to as their normalized earnings potential was much lower.

The next question that's on the checklist is, is there some temporary tailwind enhancing profits, or in other words, is there some short to medium-term trend that is going to make this company more profitable than it normally would be? A perfect example of this is the stock Clorox. Clorox manufactures cleaning products. You don't have to be a genius to see why 2020 was a great year for them.

Every business and person started disinfecting every surface in their business and home multiple times a day. Clorox's products, which include bleach, disinfecting wipes, and other cleaning supplies, were constantly sold out at pretty much every store in the country. However, this was a temporary tailwind that was benefiting the business.

If you bought Clorox stock in 2020 on the assumption that current demand for the products would continue forever, you would have been very much disappointed. This is demonstrated by the share price performance. Another example of this is Zoom, the company that creates the video conferencing software that has become a part of everyday life for tens of millions of students and employees over the past 18 months. Would it be wise to invest in Zoom based on the assumption that their growth rate over these past 18 months would continue for the next 10 years? Likely not, as that growth was significantly accelerated by a tailwind that is temporary.

If you consider yourself a value investor, the next topic on the checklist is something that you probably struggle with all the time: does this stock actually have a moat, or do I just like it because it is cheap? This is where you, as an investor, see a stock trading at a low P/E ratio and you get excited because you think you have found your next great investment.

However, what many investors fail to consider is that maybe that stock is trading at such a low valuation because it simply is not a good company. This is what is referred to as a value trap. A stock that entices you with a low P/E ratio that you think is a good investment, but in actuality, the company isn't that good, and the low P/E ratio is actually deserved because it is a terrible business.

Remember Warren Buffett's quote: "Time is the friend of the wonderful company and the enemy of the mediocre." Simply put, it's hard to make money by investing in bad businesses, even if the P/E ratio is low. It's much better to pay up for quality and buy a stock at a slightly higher P/E ratio if it is truly a better business.

One of the most important series of questions on Monish Pibrai's checklist is around moats, or what is referred to as a company's competitive advantage. One area I want to focus on is the question of whether a company has a shrinking or expanding moat. Let me explain what Monish means.

To demonstrate an example of a shrinking moat, let's look at the company Kraft Heinz. Kraft Heinz owns brands such as Oscar Mayer, Kool-Aid, Philadelphia cream cheese, Velveeta, and Heinz ketchup. Years ago, people used to be extremely loyal to consumer brands they grew up eating. Kraft macaroni and cheese, and they are going to keep eating that same brand for the rest of their life. This was a pretty strong moat; consumers would pay extra to purchase that brand because they value that brand significantly over its competitors.

However, relatively recently, customers have started to care less about brands and their food choices. They are more than happy to buy the generic version of a certain food product in order to save some money because they know the quality is more or less the same. Look at Costco with its Kirkland branded products and how they have been able to take customers away from legacy brands such as the brands owned by Kraft Heinz. This is an example of a shrinking moat.

Now let's talk about the flip side. Let's talk about a moat that is expanding. The first company that comes to mind of an expanding moat is Amazon. Every year, Amazon gets larger, and it is therefore harder for a competitor to compete with them. Every year they add more selection to their website, build out more distribution centers, and a larger transportation network, hire more workers, get more consumers to sign up for their membership offering Prime, and reduce shipping times. All of these things make it more difficult for a competitor to compete with Amazon.

Amazon has spent tens of billions of dollars expanding their moat, and they have become the perfect example of a company with an expanding moat. The next topic relates to the management team of a company that you would be buying a stock in: is this company run by able and honest managers? As an investor in a company, you want to make sure the CEO is focusing on the long-term results for shareholders and not just trying to maximize his or her short-term compensation as the CEO.

A great way to see if the CEO is focused on the long-term results of the company is to see how many shares of the company the CEO and other top managers own. You don't need fancy research tools or any paid subscriptions to find this information out; just simply search Yahoo Finance, "insider ownership," and then the name of the company you are looking at.

In this example, let's look it up for Apple. In this case, we see that the CEO of Apple, Tim Cook, owns around 3.3 million shares of the company. At Apple's current stock price of around 170 a share, this means Tim Cook's stake is worth over half a billion dollars. Given that pretty much his entire net worth is tied to the performance of Apple stock, don't you think he will be more likely to act in the best interest of long-term shareholders, especially compared to a CEO of a company that does not own much stock and is instead paid in cash based upon hitting short-term performance objectives?

If you consider yourself a long-term investor and your plan is to hold that stock for years and benefit from the magic of compound interest, seeing that a CEO also owns a large amount of stock should make you more comfortable that he or she is focusing on the long-term success of the company and ultimately rewarding you as a shareholder.

So there we have it. Make sure to like this video and subscribe to the Investor Center, because it is my goal to make you a better investor by studying the world's greatest investors. If you want to watch a video I did on Charlie Munger's investing checklist, you can check that out here. As always, thanks for watching, and I look forward to speaking with you again very soon.