Mohnish Pabrai: How to Invest Like Warren Buffett & Charlie Munger

People think that entrepreneurs take risk and they get rewarded because they take risk. In reality, entrepreneurs do everything they can to minimize risk. They are not interested in taking risk; they want free lunches, and they go after free lunches. So if you study any number of entrepreneurs from Ray Kroc to Herb Schultz at Starbucks and even Buffett and Munger, what you'll find is that they've repeatedly made bets that are low risk bets with high return possibilities.

You are one of the noted value investors, one of those who admires Warren Buffett. What did you take from Warren Buffett, and what do you do differently from Warren Buffett? You're not a clone.

Well, you know, we will never have another Warren. I think Warren is a very unique person, and also I think that his investing prowess is so strong that many of his other attributes—and I would say his other qualities—get ignored. I believe the best things about Warren have nothing to do with investing, but they have everything to do with leading a great life.

So many of the things, most of I think, most of the great things I've taken from Warren have more to do with life than investing, such as how to raise a family, interaction with friends, the importance of keeping your ego in check, humility, just a whole bunch of different attributes. The importance of candor, the importance of integrity, just all these soft skills that are very important in life. They do interconnect.

Now, in terms of how you approach an investment, I think you probably pay more attention to intangibles than perhaps Warren Buffett or Ben Graham might have done.

Well, Warren paid attention to intangibles, but Ben Graham was very much a tangible guy, right? So we're looking at the qualitative as well as the quantitative. I would say that one way to look at that is to consider what Charlie Munger would call his lattice work of mental models. When you look at a business, look at it in a broader context of how it fits into the world. Sometimes, if you can see it in a light that the world is not seeing it in, that can give you an edge.

Munger also said you have three choices: yes, no, or too difficult. You subscribe to that too?

That's right, and 98% is too difficult! So that gets to knowing your areas of competency.

You share Warren Buffett's antipathy to technology. Not that you dislike it, but you just don't feel you're going to bring value-added there.

Yeah, you know, my degrees are in computer engineering. I spent a lot of time in the tech industry. I like to say that I don't invest in tech because I spent time in it. I saw firsthand that the durability of technology moats is many times an oxymoron.

Now, quickly define moats in terms of a business that keeps competition away.

Well, you know, if you talk to Michael Porter, he would give you five books on what is meant by strategy and competitive advantage and durable competitive advantage. If you talk to Warren and Charlie, they would just 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 an 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 piranhas in it and that's getting deeper by the day. That's a great business.

So, summing up in terms of what do you think you bring to value investing that others perhaps don't that gives you a unique edge?

I think the biggest edge would be attitude. 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. 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.

So, what's that saying of Pascal that you like about just sitting there?

All men's miseries stem from his inability to sit in a room alone and do nothing. I'd like to adapt Pascal: all investment managers' miseries stem from their inability to sit alone in a room and do nothing.

So you don't feel the need to pick ten stocks a quarter or one stock a quarter, just what turns up?

Actually, I think that the way the investment business is set up, it's actually set up the wrong way. The correct way to set it up is to have gentlemen of leisure who go about their leisurely tasks. When the world is severely fearful, that's when they put their leisurely tasks aside and go to work. That would be the ideal way to set up the investment business.

Does this tie into your ideas and other value investors' ideas of low risk, high uncertainty?

That's right. I think the low risk, high uncertainty is really something I borrowed from entrepreneurs and the Patels in India or the Richard Bransons of the world.

Basically, if you study entrepreneurs, there is a misnomer. People think that entrepreneurs take risk and they get rewarded because they take risk. In reality, entrepreneurs do everything they can to minimize risk. They are not interested in taking risk; they want free lunches, and they go after free lunches.

If you study any number of entrepreneurs from Ray Kroc to Herb Schultz at Starbucks, and even Buffett and Munger, what you'll find is that they've repeatedly made bets which are low risk bets with high return possibilities. So they're not going high risk, high return; they're going low risk, high return.

Even with Bill Gates, for example, the total amount of capital that ever went into Microsoft was less than $50,000 between the time it started and today. That's the total amount of capital that went into the company. So Microsoft, you cannot say, was a high risk venture because there was no capital deployed, but it had high uncertainty. Bill Gates could have gone bankrupt, or he could have ended up the wealthiest person on the Forbes 400. He ended up at the extreme end of the bell curve, and that’s fine, but he did not take risk to get there. He was comfortable with uncertainty.

So entrepreneurs are great at dealing with uncertainty and also very good at minimizing risk. That's the classic great entrepreneur.

This is your almost third career, and this idea you have on uncertainty and risk. You started a company, it worked, you sold it. You start another company, it did not work. What did you learn from that that gave you insights on investing that those who have not been in the trenches don't?

Well, the first company took no capital and generated an enormous amount of capital for me. Then I got fat, dumb, and happy, and my second company I put in a lot of capital. I thought I knew what I was doing, and I violated the low risk, high uncertainty principle. I got my head handed to me, and I got that seared heavily in my psyche.

Now the third business, if you call it "Pabrai Funds," I call it a gentleman of leisure activity. Pabrai Funds is again low risk, high uncertainty in the sense that there is no downside—it never took capital, so it's a great business.

So as a gentleman of leisure, is that why you take a nap each day at 4 PM?

There's nothing better!

Do you have a nap room?

I wish! You know, when I went to Warren's Berkshire headquarters last year, my friend Guy asked Warren, he said, "Warren, Monish has a nap room in his office. Do you have a nap room?" And Warren's answer was, "Yes."

I was surprised. I said, "Warren, you're telling me in Kiewit Plaza there's a nap room for you?" He says, "Yes." He says, "Not every day, but every once in a while I need to go to sleep in the afternoon."

Well, there's something to that. My father called it having a conference.

That's right! No, it does wonders. I have a hard time getting past the day without the nap, so the nap is a must.

So having those two experiences, no capital, then as you say fat and happy, and then you got your head handed to you, what, when you look at an equity, when you look at a possibility, what do those experiences give you in terms of insight?

Well, the insight is the same in the sense that I think that, you know, Warren says that I'm a better investor because I'm a businessman, and I'm a better businessman because I'm an investor.

The thing is that my experiences as a businessman have very direct long-term positive impacts on me as an investor. Because when I'm looking at an investment, I now look at it the way I looked at my first business, which is the first thing I'm looking at is how can I lose money on this? And can I absolutely minimize my downside? The upsides will take care of themselves. It's the downsides that one needs to worry about, which is why even the checklist becomes important.

So the important thing that value investors focus on is downside protection, and that's exactly what entrepreneurs focus on: what is my downside? So that is, I would say, the crossover between entrepreneurship and investing, and value investing especially is to protect your downside.

Now, you're a hedge fund manager, but you're unusual. First, your fee structure—explain that.

Well, you know, one of my attributes about being a great investor is to be a copycat; do not be an innovator. So when I started Pabrai Funds, I actually didn't know anything about the investing business, and the only, if you can call it a hedge fund, that I was familiar with was the Buffett partnerships.

When I looked at the Buffett partnerships, I found that Warren Buffett charged no management fees; he took 25% of the profits after a 6% hurdle. That all made sense to me because I felt it aligned my interests completely with my investors. So I said, "Why mess with perfection? Let's just mirror it." And that's what I did.

What I didn't realize at the time—it took me a few years to realize it—is that that mirroring created an enormous moat for Pabrai Funds. The investors who join me will never leave because it's the first question they ask any other money manager they go to work for or they want to put money with: "What is your fee structure?"

When they hear the fee structure, they say, "I'm just going to stay where I am." So first of all, it creates a moat where the existing investors do not want to leave, and the new ones who join the church are happy to join.

You're also unusual in another way; you don't seem to go out of your way to institutional investors.

Yeah, I mean, I'm looking for people who want to invest their family assets for a long period of time. I really don't want investors who are looking at putting things into style buckets or are looking to look at allocations every quarter or might need to redeem in a year and those sorts of things. Their frameworks are very different.

So in general, someone who comes with you, is a minimum of what? Two years, three years? What before you allow them an exit?

Our exits are annual, so people can get out once a year, but what we suggest to them is to not invest if they don't have at least a five-year horizon. But we don't impose any restrictions because people can have hardships; they can have all kinds of things happen.

Now, low-cost—one of the things that apparently institutional investors are flummoxed by is your total expenses for running the funds, which the investors get charged for is between 10 and 15 basis points a year. That's what they pay for all the accounting, audit, tax administration, and everything. They don't pay for my salary or my staff salary; we take that out of the performance fees and they only pay the performance fees after 6%.

So what a deal!

[Laughter]

Now, you're not big on schmoozing investors.

You know, I think the thing is that every business ought to figure out who the ideal customer is. At Pabrai Funds, what I found is that investors who do their own homework find me and do the research on me on their own without any middlemen involved, and then invest in for IPOs like Amazon, which is wire the money and send the forms, tend to be the best investors.

In fact, the investor base we have is mostly entrepreneurs who created their wealth themselves, and they're very smart. They're in a wide range of industries. In fact, my analyst pool is my investor base, so I have investors in all kinds of industries. When I'm looking at investment ideas in particular industries, I can call them, and I get the best analysts at the best price with no conflict of interest. So it works out great!

Free—that sounds—oh yeah, exactly. It's great!

You're not even registered with the SEC?

I think the hedge funds so far have not had to. I don't know if the rules will change; if the rules change, of course we'll follow the rules. But, you know, we have audits by Pricewaterhouse. We have to report 13F to the SEC, so I think there's plenty of disclosure and transparency.

You also don't engage in things like short selling.

You know, why would you want to take a bet, Steve, where your maximum upside is a double and your maximum downside is bankruptcy? It never made any sense to me, so why go there?

You focus on a handful of individual investors, maybe institutional investors, but people who know you, right? With you, you're not part of a formula, not spit out of a computer.

That's right.

What's an individual investor to do? Do you have some unique advice for individual investors?

Well, the best thing for an individual investor to do is to invest in index funds. But even before we go there, you know, Charlie Munger was asked at one of the Berkshire annual meetings by a young man, "How can I get rich?" and Munger's response was very simple. He said, "If you consistently spend less than you earn and invest it in index funds, dollar-cost average, because you're putting in money every paycheck, in about 20, 30, or 40 years, you can't help but be rich; it's just bound to happen."

Any individual investor, if they just put away 5%, 10%, or 15% of their income every month and they just bought into low-cost index funds and just two or three of them, just split it amongst them, you're done. There's nothing else to be done.

Now, if you go to active managers, the stats are pretty clear. 80% to 90% of active managers underperform the indices. But even the 10% or 20% who do, only one in 200 managers outperforms the index consistently by more than 3% a year. So the chances that an individual investor will find someone who'll beat the index by more than 3% a year is less than 1%; it's half a percent.

So it's not worth playing that game. In terms of index funds, S&P 500, I'd say Vanguard is a great way to go. I think you could do S&P 500 index, you could do the Russell 2000, and if you wanted to, you could do an emerging market index.

But, you know, I think if you just blend those three—one third each—you're done. If you're in your 20s and you start doing this, you don't need to even go into bonds and other things; you can just do this for a long time and you'll be fine.

On TV, when these folks make recommendations, you compare it to if you buy something that you heard somebody recommend on TV as going into the roach motel. Can you please explain?

Well, you know, you remember those ads that ran where the roaches check in but they never check out? So the thing is, you watch some talking head on TV and he tells you to go buy whatever company, waste management or Citigroup, when its price gets cut in half. He's nowhere to be found, and now you're like that roach in the roach motel, and you don't know what to do. You don't know whether you should hang on or sell or stay.

So the only reason—or if it goes up, yeah, get out! Yeah, if it goes up 10% or 50% or 100%, what are you supposed to do? Do you want to go for long-term gain, short-term gains? Basically, you have no road map.

So the only way one should buy stocks is if you understand the underlying business. You stay within your circle of competence, you buy businesses you understand, and if you understand the business, you understand what they're worth. That's the only reason you ought to buy a stock.

Looking around the world, you mentioned in the past, if you want an index fund with emerging markets, okay, but you have a skeptical eye toward investing in other countries around the world. You don't preclude it, but you see some...

Well, you know, Steve, there are plenty of great opportunities in many countries, but I would say it’s probably a no-brainer to avoid Russia, Zimbabwe, and even if you look at a place like China, which I think will create an incredible amount of wealth for humanity in this century, the average Chinese company has three sets of books: one for the government, one for the owner's wife, and one for the owner's mistress.

The problem you have is you don't know which set of books you're looking at. So I think in Chinese companies or even in Indian companies, you’ve got to add another layer, which is you have to handicap the ethos of management. That can get very hard, especially when someone like me is sitting in Irvine with naps in the afternoon trying to figure that out.

You also say you don't think you get much talking to CEOs because they're in the business of sales.

Yeah, you know, the average public CEO is a person you'd be happy to have your daughter marry—any five of them—but they got to those positions because they have charisma and they are great salespeople.

You cannot lead; you cannot be a leader without being an optimist. CEOS are not deceitful; I think they are high-integrity people. But if you sit down with a high-charisma CEO of an oil company, and he knows everything about oil and you know nothing about oil, by the time you finish that meeting, you just want to run out and buy all the stock of his company that you can.

It's just not the right way to go about it. So you're better off not taking the meeting but looking at what he's done over the last 10, 15, or 20 years. So not being mesmerized by charisma will probably help you.