Mohnish Pabrai: How to Find and Analyze an Investment (2021)

I put about 10% of the fund's assets into Frontline, and in a few months, shipping rates started to go up. It went up to like $10 or $11 a share. I had a very nice gain in a relatively short period of time, and I exited Frontline, patted myself on the back, and moved on. Then when I looked at Frontline, I think a year or two later, it was over $150 a share, and I missed that entire ride.

But I'll start us off with a couple of our students. You know, I kind of aggregated some of the questions if they were similar. Sean Mahan, in our Kelley Direct MBA program, wanted you to talk a little bit about, just given all the investment opportunities out there, how do you identify which ones you want to dig in on further before deciding what to buy?

So, you know, what types of screens might you run? Are there multiples or ratios that you really favor or avoid? How do you go from this huge universe of stocks to the ones you're actually going to spend your time on?

Yeah, that's a good question. Well, there are a number of different ways one can go about it. One needs a system where one can eliminate large swaths of companies where each company doesn't take more than a few seconds or maybe a minute. So, when I look at a business, the first question that's going through my head is, "Is it within my circle of competence?" A lot of companies would disappear based on that question.

There are also entire industries I don't have much interest in. U.S. healthcare is very corrupt and does not operate with market forces, so pretty much anything in U.S. healthcare I either consider outside my circle of competence or have no interest. If there's a biotech company, if there's a hospital, if there's a pharma company, if there's some, you know, CVS, Walgreens, that sort of thing—I'm basically, generally speaking, not interested in those kinds of businesses, so it's a very quick pass.

Similarly, for defense contractors, I'm a little skeptical about the kind of the long-term nuances and whether things are as clean as they should be, and so on. Not of much interest. Also, a lot of tech names tend to be high flyers, and they tend to lose me on valuation and such. So even there, we're done pretty quickly. I mean, if I look at Snowflake, it would take me about 15 seconds to move on.

So a lot of things get eliminated relatively quickly. There has to be something that's drawing me in. One of the things I do is I look at Value Investors Club, and they have, you know, thousands of companies posted on the cloud, and people are conveniently adding ideas. Generally, that is a somewhat filtered list because there's a lot of restrictions on who can post ideas and the rules thereof, so it's a good place to go hunting.

It's also a very good place to learn because many of the write-ups and the comments are very insightful. So, Value Investors Club is one possible source. Value Line is another source. I have a subscription to SumZero, which is another source. Then I typically get several investment ideas emailed to me pretty much every day by folks across the world, and I look at those as well.

Again, you know, many of those may not fit for a variety of reasons, but when you go through all of this, some ideas and some companies stick out. Then I know I'll spend more time on them. The objective when I'm looking at a business is to, as quickly as possible, say no and move on. If I can say no in 15 seconds, that's great. In some cases, it might take a minute; in some cases, it might go to 15 minutes, and then I might say no. In some cases, it might go to a few days. But the idea is to be really good at saying no.

The business should be able to convince a very deep skeptic that it deserves more time and a spot in the portfolio. So that's generally how I go about it.

As a follow-up, one of our students, Justice Boyce, you mentioned your circle of competence. How do you balance the idea of circle of competence and diversification within your portfolio?

Yeah, so I don't think one needs to compromise on circle of competence for diversification. Diversification actually is overrated. If you look at most entrepreneurs, you know, Sam Walton and others, through their entire lives they had no diversification, and they didn't have any sleepless nights because of that.

There are also examples, like I always give the example of Charlie Munger's friend, John Arriega, who only invests in real estate within two miles of the Stanford campus, and he's a billionaire. His circle of competence is extremely narrow; it's not even real estate; it's real estate in a very specific geography. If you looked at his portfolio, you would say, "Well, this looks very concentrated," but that has not stopped him from doing extremely well.

So even if you understand just a couple of things or a couple of industries, or even a single industry, and your portfolio is focused on that industry or even focused on just two or three stocks—as long as the competence is solid, one should not be compromising to get more diversified.

Could you just touch on, you know, how do you judge if you're, you know, as you're trying to look through your circle of competence where you feel that you have confidence and not? What kind of level of knowledge do you have to feel comfortable that that's included in your circle?

Yeah, so to ask the question is to answer it. If you find yourself asking, "Is this within my circle of competence?" I can just make it very quick for you: it is not. If you find yourself asking a question like, "What is this business worth?" again, it's not within your circle of competence.

So if something is in your circle of competence, you would know it really well. You would know the two or three variables that would drive most of the outcome in the long term. The valuation of the business would be quite apparent. So it is very important to stay dead center in your circle of competence. Usually, there is not a fine clear boundary between competence and incompetence. As you move away from the center, the degree of competence goes down, and the risk factors on investing in those businesses go up.

So, as close as you can stay to the center of your circle of competence is the critical part. Don't be concerned that you don't understand many things. I'd say I probably don't understand 99% of stocks, and I'm not particularly breaking out hives about it. So, you don't need to understand a lot of things; you just need to understand a few things well and stick to those few things.

Great. Chris Morton asked the question in chat: "Are you able to ask it, or do you need me to ask it?" Chris, "Yeah, I can ask if you want."

Yeah, so in the Doncho Investor, you had an example of a business you had to research to become competent. I think it was shipping barges. So my question basically is, in the context of that example in the book, when you're first starting out in the investment world, when do you recommend digging in to become competent in a business versus taking a pass? Does that make sense?

Absolutely. I think the shipping company—you know, at the highest level, shipping isn't that complicated. I was intrigued about a few things I had read, so I said, "Let me dig in some more here to understand."

I believe the business was in the, these are ships that were VLCCs—very large crude carriers—and at the time, there were like 400 of those ships in the world. These VLCCs are specialized ships that transport crude. I didn't think shipping was too difficult of a business for me to get my arms around; I wasn't very familiar—or I wasn't familiar at all—with crude shipping, but I was curious about it.

So I said, "Okay, you know, let me see if I can read up on this and understand how the business and the industry works." It didn't seem that complicated to figure out, and I was able to use a heuristic that one of my friends in commercial real estate had told me. I realized that that same heuristic and that same mental model would work in shipping.

There was an insight that I had gleaned, and I thought that that insight would work in this area as well. In commercial real estate, especially if you're talking about tall office towers—you know, 30, 50-story-type office towers in large metro areas—generally speaking, those office towers may take four to six years to get built.

To come to fruition, from the time that someone has the land and creates a plan and tries to get the permits, it might be easily five years before the building is ready. Generally speaking, what happens in real estate is that when the market is really tight and when rents are rising a lot, a lot of these projects get started because the economics look so favorable.

What happens is—because there's lemming behavior—all these towers get started about the same time, and they get delivered around the same time. You go from a very tight market to a depressed market because there's too much supply. So this five-year or five-to-six-year gestation period in office towers leads to booms and busts in commercial real estate.

We don't see that same nuance in, for example, let's say industrial space or commercial warehouses and those sorts of structures because there, you could be done with construction in 12 to 18 months. So because the timeframes are so short, you're typically able to turn on and turn off the spigot relatively soon, versus while looking at the situation. If you're putting up a 50-story tower, you're already up to the 25th story.

It doesn't matter what the market is doing; that baby is going to get delivered and it's coming out, regardless of whether people want that child or not. So that same—I noticed that when I was looking at the VLCC market, it had a similar attribute. There were only three or four places where these ships get built, mainly the Korean shipyards.

If you wanted to get a new VLCC, you’d go to one of the Korean shipyards and typically put down a deposit. In about three years or so, they would deliver you a ship, and if the queue was long, it might take longer. These shipping rates in VLCCs had very extreme fluctuations; they could go as low as $5,000 a day to as much as $200,000 or $250,000 a day.

So there was a very wide range—way more than commercial rents. Commercial rents in office towers do not have a 50-to-1 variance in rents over even decades, but in the shipping business, you can see pretty large variances. Whatever I had learned about the office tower business, I realized that it was on steroids in the VLCC business. The booms and busts would get even more exaggerated because of that huge variance.

These were some of the factors that made it interesting to look at that business. It was really understanding the dynamics of how daily rates are determined for shipping crude oil and how you couldn't instantaneously increase the fleet, even if demand went up, because it would just take time to build those ships, etc.

I think what you can do is, if you are curious, learning about different businesses and learning about different industries and nuances is always of interest to me. I love to kind of know how the world works, whether we get to the point where we can make an investment or not.

In the second question, sometimes we can read or learn enough where we feel we really got it nailed—we understand the dynamics that would drive that result. Just to go a little further, because there is such great learning in that shipping example, the company I was looking at at the time is called Frontline. They were the largest operator of VLCCs in the world at the time.

I think the global fleet was around 350 to 400 ships, and they had about 80 ships. The unusual thing about Frontline was that 100% of their fleet was on the spot market. There are two ways, if you are a shipowner, that you can run your fleet. One way is you can sign long-term lease agreements with, let's say, for example, Aramco or Exxon or whoever—some refiner—so that they would say, "Yeah, I will lease your ship at, you know, $20,000 a day for the next two years."

In that case, whether they're using the ship or not, or whatever's happening, you're getting paid, and your cash flows are really stable. Or you could be at the other end of the spectrum, where you're saying, "I'm only willing to rent per voyage." So when you have a ship that needs to go from Saudi Arabia to Louisiana and that journey may take maybe 25 days or something, you can rent the ship for 25 days on the spot market at that time.

So Frontline had their entire fleet on the spot market. They also had debt tied to their ships, but the debt was tied to individual ships, so it was like a mortgage on each ship, and it was non-recourse to the parent. At the time I was looking at Frontline, shipping rates had collapsed, mainly because demand for oil had gone down, and shipping rates collapsed to less than $10,000 a day—$8,000 or $10,000. At that price, they were losing money; they could not make ends meet.

When shipping rates collapse like that, there's a second nuance that kicks in. I'm sorry I'm taking a little bit of time, but just to explain kind of how things work, because these are all things I learned when I was looking at it. After the Exxon Valdez went aground in Alaska, there were a set of new regulations that came out around oil-carrying ships.

They mandated that all new ships that get built needed to be double hulled. All the ships built after the Exxon Valdez crash were required to be double hulled, and the ships before that Exxon Valdez incident were single hull. In the shipping business, when you rented these single hull ships—which still existed—they were older, rented for lower rates per day than double hull ships.

But when rates collapsed below $10,000, what that meant was there were too many ships, and so nobody was renting single hull ships because the delta between single and double hull disappeared. Typically, there were these maverick Greek owners of these single hull rust buckets, and they were sitting on this fleet and no one was renting them.

Scrapping of those ships skyrockets during those times. The ship owners look at it. One thing that real estate guys do is they project present circumstances to infinity. If current rents are high, they believe rents will always be high. The ship owners are even more extreme than the real estate guys. If the shipping rates are a quarter million a day, they believe they will always be a quarter million a day, and they all go to the Korean shipyards and place gazillion orders for ships all at the same time.

Okay, so when the ship rates are low, like $8,000 or $10,000, all these Greek ship owners rush to all the scrapping yards and say, "Take my ship and give me the price of the middle," because they assume they’ll never be rented or whatever else. They know that there are these maritime regulations that make it harder.

What ends up happening, when rates are low, is the fleet might decline from 400 ships to 370 ships or 350 ships because of all the scrapping. Then when oil demand comes back up, now you don't have those 50 ships. Typically, what you would see is that it would go even more asymptotic than Bitcoin. The shipping rates would go from $10,000 a day to $200,000 a day in the space of three weeks or two weeks.

It would go really fast because literally, you couldn't find a ship, right? So everyone's clamoring for them. When I looked at Frontline, I did a very simple calculation. I said there was a website that would tell you what the selling price of these ships was. So I just looked at their fleet and said, "Okay, you know, if you shut down the business and sold all the ships, what would you get?"

I asked, "How much is the debt, and what would you end up with, and what's the stock price?" The stock price was, I think, $4 or $5, and the liquidation value was like $8 or $9 per share. I said, "There's no way to really lose money over here because if all hell breaks loose, they can keep selling ships, and as they keep selling ships, they'll make more than the stock price."

So I put about 10% of the fund's assets into Frontline, and in a few months, you know, shipping rates started to go up. It went up to like $10 or $11 a share. Had a very nice gain in a relatively short period of time, and I exited Frontline, patted myself on the back, and moved on.

Then when I looked at Frontline, I think a year or two later, it was over $150 a share, and I missed that entire ride. Because, like I said, it went to the other end, which was euphoria. Of course, my whole thesis was around just something where I couldn't lose money, but I could have been a little bit more savvy about the fact that when you have these extreme compressions, you're probably going to see a pop on the other end.

I could have, for example, kept a small position or something, but such is life. Sorry to tell you more about shipping than you ever wanted to know.