How Mohnish Pabrai DESTROYED The Market By 1,204% (MUST Watch Interview)

The first thing an investor ought to ask themselves before they buy a stock, even before we get to price and so on, is that buying a stock is a far more complicated activity than most people seem to think. What's happened with the development of markets is that on a smartphone, a tablet, or a laptop, we can, in seconds, buy one of thousands of companies. There's no effort required to buy a stock, no effort required to sell a stock. But in order to do well, one really needs to understand the underlying business and to have a point of view on kind of where that is versus the market capitalization.

So I'll give you an example. Many times in the US, like I'll go to my health club, for example, and one of the members will ask me, "Hey Mish, should I buy Apple? Should I buy Apple stock?" I turn the question around to them. I say, "Hey John, what's the market cap of Apple?" They look at me with a puzzled look. They said, "The stock is at 170." I said, "No, no, what is the market capitalization?" And they don't know.

Okay, so the first thing if you're going to buy, if you're going to go buy some rice in the market, you're going to know what is the price per kilogram. So the first thing is that if you're going to buy a stock, at least know what you can buy the whole company for. Most investors don't have that knowledge, which is amazing.

So the first thing an investor ought to ask themselves before they buy a stock, even before we get to price and so on, is: "Is this within my circle of competence?" Now, the circle of competence is a very important concept; one of the most important concepts in investing. A person like Warren Buffett would consider something like 95% of stocks outside his circle of competence. He says that, you know, probably 97%, 98% of things that show up on his desk go into a box called the "too hard" pile; he can't figure them out.

Okay, so there's just a sliver of businesses. Now, if Warren Buffett can't figure out 95% of businesses, for the rest of us humans, we can't figure out 99% of them. So most things are going to be outside the circle of competence of most investors.

So now, let's say an investor answers the question correctly: "Yes, I understand Apple, and I understand it's within my circle of competence." Right? So the next question then comes up: "What could you buy the whole company for?" Then the second question an investor should ask is, let's say the investor knows Apple is worth a trillion dollars, for example.

So the question I would ask them is that if your family had a fortune of 4 trillion, would you be willing to put 1/4 of that fortune into Apple? If the answer is yes, buy the stock. If the answer is no, don’t buy a single share. And so these are just very simple, which is: look at your net worth, look at your family's fortune, and are you willing to put a quarter of it into buying the whole company that you want to buy 100 shares of?

These are basic things that most investors, unfortunately, don't focus on. I feel that investing in stocks, figuring out what they're worth, what your circle of competence is, these are complicated issues. So for most investors, it's a really good idea to index. Because indexing, you can buy a Nifty 50 index or any broad index in India for basis points. You know, the frictional cost for ETFs and all is very low.

The second is you average out over time. So every month when you get your salary check, take a small portion, first put it into savings, and then don't worry about it. What I would say is: set it and forget it. Fill it, shut it, forget it. Theo Honda, yeah, exactly.

So that's why I think that buying stocks should really be an exception rather than the norm.

The second topic, and before we move on to the more nuanced investor, a second thing that I wanted to talk to you about—again, we discussed this on email—about this whole notion of stop loss that you find amusing in India. Apparently, in the US, nobody deals with the concept of stop loss.

Now let me tell you a peculiarity here, Mish, because we do this day in, day out for a living. A lot of technical experts who come in give stop losses; they are mandated to, as well, because it's trading that they have. They don't care about the fundamentals; they're only bothered about the charts. Right?

You would still believe that the notion of a stop loss from a serious investor's perspective should be done away with. We don't find too many people talking about stop losses if they are serious investors, but you believe that there is enough and more talk about stop loss happening on fundamental investing as well.

That's right. So just to clarify, we're not talking about the speculators and traders, so more power to them. But when we come to investors, I actually find plenty of pundits on TV who have done fundamental analysis, and they give targets and they give stop losses. I find that really so...

The nature of markets—one of the reasons why we can make a lot of money in equity markets is because they are auction-driven, and auction-driven markets are very different from almost any other kind of market. To give you an illustration, let's say I bought a flat in Mumbai for 1 crore. I don't know if we can get one for 1 crore or not, but let's play along. We got one, maybe on the periphery of Mumbai.

Okay, so we paid a crore for the flat, and we did research and we found that it's the right price, and we bought it. Now we want to know how the price of that flat changes every day. I have a friend who is a real estate broker, and I tell my friend, "Listen, we're going to have chai with pav bhaji every day. You, and I are going to have a cup of tea, and every day just come and tell me what the price, the market price of my flat is."

Okay, so I bought the flat. Next day, I invite my broker friend, and I ask him, "So what's the price on my flat?" He'll say, "Listen, idiot, it's still 1 crore." Okay, I call him after two days; he still says, "Still 1 crore." After maybe two months, he says, "You know, a little change in transactions; it's actually 1.05 crores now." It's gone up a little bit.

If you did this every day and just recorded the price he was giving you, and did it for 365 days, you'd find it went to somewhere between 95 lakhs and maybe 1.1 crores or 1.15 crores in that range. Right?

Now, let's say my flat is a listed company on the Bombay Stock Exchange, but the only asset is this flat, and every day the price is doing whatever it's doing in the market, and we chart that daily price movement. What we're going to find is, in a 52-week period, the range may be something like between 70 lakhs and 1.3 crores. The reason is that auction-driven markets undershoot and overshoot, and it is the undershooting and overshooting that creates the opportunity for people like me.

So basically, the idea of a stop loss would be like: I bought the flat for a crore, and after 6 months, my broker tells me, "You know, prices have dropped about 5%." I say to him, "Okay, that's my stop loss, and I'm now going to sell you my flat for 95 lakhs. Please sell it."

It would be the equivalent of doing that. The reason you bought the flat for a crore is that you thought that was fairly priced, and the second reason you bought it is because you wanted to hold it as a long-term asset.

The same thing with stocks. If you bought a stock for 200 rupees, or it has a market cap of 1,000 crores, you bought it because you thought it's worth 2,000 crores. So if it goes from 1,000 crores to 900 crores, you will sell it with stop losses, and it makes no sense.

So, I own a company called Rain Industries, right? I bought that stock about two and a half years ago. When I was buying the stock, it was at about 30 rupees a share, and by the time I finished buying it, it got up to 45 rupees a share. It went up almost 50% because I almost bought 10% of the business.

After I finished buying, it proceeded to go down, just like everything I buy. Okay, the stock knows I bought it, and it decides, "Mish is done; now let's go down." If I had engaged in stop losses, Rain went down to 40; it even went down to 35 after I finished buying. I did nothing, and so now Rain is north of, I don’t know, 360 rupees. That whole opportunity would have been gone.

It would have made no sense for me to put a stop loss at 30, or 35, or 40 because I thought it was worth a lot more. So I think investors ought to focus on making sure that the stock is within the circle of competence, that it's worth a lot more than it's valued at, and once you have those two things, a stop loss makes no sense.

Wow! So circle of competence, I think that's the most important thing.

Yes, the three most magical words for Ben Graham.

Okay, great. Now, if circle of competence were the three most magical words from Ben Graham, I think one of the most amazing things that I've seen you speak about a lot—I’ve also saved that image, I can't find it right now—but you remember I sent that image to you which said something like, "Most of the times when I'm looking for an idea, I need the idea to scream at me saying 'buy me.' Until then, I don’t go out."

In the US, you know we have these wooden things called 2x4s which we use in housing construction. "I need to be hit on the head by a 2x4 before I should buy a stock."

Yeah, so before buying a stock, it has to be a complete and total no-brainer. If I have to turn on Excel, it's automatic rejection. If I cannot describe the idea to a 7-year-old in 2 or 3 minutes, it's an automatic rejection. It needs to be painfully obvious—painfully obvious to the village idiot why we should be buying.

Where are such opportunities currently in such an overheated market?

Okay, let me rephrase. I'm not using the term overheated loosely. I'm just saying the markets have rallied. We may not be in bubble territory for certain markets, and all of that is a subject of everybody's individual opinion. Only the future will show whether we were there or no. But let's assume for a moment's sake we are not in bubble territory, but we are in a space where the markets are, at worst, fairly valued. You will probably not get opportunities where you get hit by 2x4.

Well, you know, we are in wonderful lower Paril right now, and within, I would say, 10 or 15 km of the lower Paril from here to the next 15 km is a boatload of opportunities in real estate.

Okay, fine. I didn't want to get down to real estate so soon. We'll get to that. But you, even right now, what I'm trying to find out, Bish, is that you are still in a market like this looking for ideas that are just too painfully obvious.

You're not going?

Well, I think—even in rampant bull markets, there are always misunderstood businesses. Now, rampant bull markets will cause a lot of overpricing, and I think a lot of things are overvalued. But there are plenty of things that may be fairly or deeply undervalued.

In a market like India, with 5,000 listed companies—more than 5,000 listed companies—it is just not possible in auction-driven markets that all of them are efficiently priced. We are going to have underpricing, and we're going to have overpricing; it's just the nature of the beast.

The reason why I asked this question is a lot of your peers, a lot of people within the same space. We did a small series with Ramdev Agarwal sometime back—a wonderful guy, good friend.

Yeah, okay. So, Ramdev says often that he finds value in growth. The stock may not be underpriced or may not be a screaming buy, but if there is growth that he sees over the period of four or five or six or ten years, maybe added to by the buyers, then that becomes an opportunity.

Are you looking for such opportunities in India? Because India is per se a growth market. You are definitely better off buying a growing company over a cheap, no-growth company.

Okay, so if I buy an asset that is cheap but has very limited growth, all I'm going to do is cover the gap between it may be worth 100 rupees a share. I'm getting it for 50, 60 rupees a share. I'm just going to make the 40 or 50 rupees over whatever period of time it takes to get there.

Now, if I'm buying a company that has secular tailwinds, great management, and long growth engines, as long as I'm not paying up too much, it’s the best place to be.

I think Ramdev, in my opinion, is one of the best investors in the country. The only critique I would have is that Ram is a tad too optimistic at times, but he’s got it absolutely right: you bet on the growth engines and you bet on the long-term secular growth engines which have got a lot of tailwinds.

Those in general are going to do really well. So, I think they've got it mostly right.

Now, the reason why I asked you this question is very recently, in one of the interviews or quotes that you gave out, you mentioned that it might be really important to buy compounders from a long-term perspective.

There are some questions that I've gotten with regards to that as well. Somebody is asking, and I have a question of my own as well. How does Monish decide if a compounder is egregiously priced and has reached the tipping point for selling versus your earlier stance of selling at about 90 to 95% of the perceived fair value?

How do you decide this? How do you decide that a compounder has reached a value that is overpriced and therefore you would want to get out of it?

Okay, so let's unpack the question a little bit. Sure, so we've got two types of things we got to do with companies right—the points at which we buy them and why we buy them, and the points at which we sell them and why we sell them. Sure.

Buying is complicated, selling is ten times more complicated.

Okay, so when we're trying to buy relative to selling, it's relatively straightforward. We want to know what the growth engines are. If you're going after a growth company, we want to know what we're paying for that growth, and we want to try to figure out where this company is in 5 years or 10 years versus what we're paying for it.

Those are relatively straightforward compared to the selling question.

The selling question is a more complicated question because one of the things we are forced to do is we’re forced to look out into the future, maybe a few years out, to try to figure out what is the future of this business. For most companies, even the insiders have a very fuzzy idea about the future.

The thing is that if we buy a compounder at a value price, that's a relatively easy exercise because we're not paying up. But the difficulty comes when it goes up in price and it looks fully priced but still has a lot of tailwinds and still has great management, still has a lot of great growth in front of it.

So the best that I've been able to answer the question is: a great company with great growth and great management—give them some leeway. So don’t sell them when they're fully priced, don’t sell them when they’re overpriced, sell them when they’re egregiously priced.

What each of these levels are, I'll leave to the viewer, but it should be obvious: when is it fully priced, when is it overpriced, when is it egregious. So what I've learned—one of my biggest mistakes has been selling too early. I have watched 100 baggers that I bought who went on to become 100 baggers so many times after I was out and I had only captured the double or the triple.

I didn’t capture the remaining 98 or 97 times that it went up. But when you buy, you don't know it's going to be a 100 bagger.

Absolutely! In fact, you learn about a business only after you own it. So you may do all the analysis in the world, but you're really going to learn the business after you own it.

And that still doesn't mean, viewers, that you don't try to learn about the business before you buy it. It should be within your circle of competence.