Thursday, October 31, 2013

Mohnish Pabrai on Cloning as a Strategy

This interview was first published by the Global Association for Risk Professionals on October 29, 2013

As a hedge fund manager, Mohnish Pabrai does not have to be fully transparent with his results- except to the investors who receive his reports. But he makes no secret about his targets and successful results in terms of compound returns, nor about the fact that they are grounded in value investing principles, particularly those espoused by Warren Buffett.

Anyone can gain insight into Pabrai's way of thinking in books he has written: "The Dhandho Investor: The Low - Risk Value Method to High Returns" and "Mosaic: Perspectives on Investing".

Pabrai talks up a principle of his own, which he describes as cloning. Successful formulas are visible for all to see, but, as Pabrai observed in a recent interview, there is something in human nature that devalues cloned ideas and strategies. “Be a cloner… but clone the best”, advises the managing partner of Pabrai Investment Funds.

The Irvine, Calif. firm is billed as a family of hedge funds inspired by the Buffett Partnerships, with more than $500 million of assets.

A Mumbai native and former IT consultant- founder of TransTech in 1990, which was sold 10 years later to Kurt Salmon Associates- Pabrai won the 1999 Illinois High Tech Entrepreneur Award given by KPMG, the State of Illinois and the City of Chicago. In 2005 he and his wife, Harina Kapoor, started the Dakshana Foundation, with the goal of recycling most of their wealth. The foundation is focused on alleviating poverty in India through education and scholarship grants.

The interview with Pabrai was conducted by Dr. Nupur Pavan Bang (, senior researcher, and Dr. Vikram Kuriyan, director of the Centre for Investment, Indian School of Business, Hyderabad.

Tell us about your belief in the concept of compounding.

Einstein called compounding the 8th wonder of the world. Let me tell you a story.

One day an inventor of games brought a game to the king- the game of chess. Since it was about battle between two armies, the king was amused and spent a lot of time playing the game. So impressed was he that he offered the inventor to ask for any reward. The inventor asked that he be given an amount of rice that would be equal to what the board could hold if we were to start doubling one grain of rice from the first square of the board up to the 64th square.

The king thought that this was a petty and stupid request and ordered for the reward to be given. The minister who was in charge of arranging this did not return for a few days. Upon inquiring about the delay the minister said that the whole kingdom did not have the 18,446,744,073,709,551,615 grains of rice required, or close to $300 trillion worth. Much greater than the combined wealth of the earth.

Such is the power of compounding. This is a concept that many great investors have time and again used for wealth creation. The celebrated Warren Buffett is a great example.

Warren Buffett and Charlie Munger have had a lot of influence in your life. How did you first learn about them and what got you interested in them?

In 1994, I was 30 years old and heard of Buffett for the first time. I did not have any knowledge about investments or capital allocation. Around that time, a couple of his biographies were published. I read them and looked at his track record from 1950 to 1993. Over 44 years he had compounded money at 31% a year. If you compound money at 26% a year, it will double every three years; at 31% you will double in less than three years. I thought about the story of the chess board again and realized that if Warren continued doing what he was doing, he would become the wealthiest person on the planet. He did became the wealthiest person on the planet.

I have never been to a business school and thought of investment, but few things stood out to me. In the investing world, hardly anyone followed Warren Buffett and hardly anyone generated returns the way he did. However, I thought that his approach to compounding was right, and these things were related. Buffett’s approach looked replicable, but no one was doing that. I liked compounding and thought of giving it a try.

How did you start? Where did you get your initial capital from?

I had sold some assets in the business I was running at that time [1994] and ended up with $1 million in the bank. I had no immediate use for that money. When I read Buffett’s biography,  I decided to play his game for 30 years. If I compounded at 26% a year, and my money would double every 3 years, a million would become a billion in 30 years. I thought that even if I fail by 95%, or 97%, I would be okay.

Swami Vivekananda used to say, "Take one idea, make that one idea your life. Think of it, dream of it, live on that idea. Let the brain, muscles, nerves, every part of your body be full of that idea, and just leave every other idea alone. This is the way to success". That is exactly what I did.

Could you tell us a little bit more about your journey from then on?

In 1995 I started putting the million dollars to work. By 1999, $1 million had become $5.1 million, growing at 43.4% per annum, way above my target of 26%. So I said, I think this could be done.

When did you start Pabrai Funds?

I used to give investment tips to friends and family. They would ask me to manage their money. So, in July 1999, I set up Pabrai Funds with $1 million in assets from nine investors. From 1999 to 2007, we compounded at 37.2% per annum before fees, 29.4% after fees.

Did the financial crisis hit you?

Oh yes, it hit everyone! From the mid 2007, for the next 21 months, we compounded at a negative 47.1%. That came to an end in 2009. Eighteen and a half years after I first started [1995 to mid 2013], I have compounded at 25.8% per annum. Short by 0.2. The good news is that I still have 11.5 years left, and in investments, the more you play, the better you get at the game (unlike tennis). I am excited to see how next 11.5 years unfold.

So how do you compound at 26%- especially since you were not formally educated in finance or investments? [Editor's note: Pabrai left his master's degree program at Illinois Institute of Technology to start his consulting and systems integration company, TransTech.]

When I set up Pabrai funds, I looked at the Buffett Partnership. It was closed in 1969; I opened in 1999. In that 30-year period, I did not find a single fund that replicated the Buffett model. I got all the information that I could about the model from published sources, took it to my lawyer and told him to simply replicate it. I adopted cloning in a very serious manner. I then started investing in stocks in which Buffett and his Berkshire Hathaway invested.

Why is it that we don't see many others succeed like you have? If it's only about cloning, anyone can do it.

That's right. Anyone can do it. But nobody does. There is something strange in the human genome which makes people think that cloning is beneath them. Everyone wants to do something unique.

There are other examples of cloning that have succeeded. If you look at Microsoft, Excel was cloned from Lotus; Windows, Word, and a lot of its other products are cloned. It's not even a great cloner, as most of its products take a number of versions to remove bugs. Even though Microsoft is not a great cloner, it is one the most successful companies in the world.

McDonald's spends a lot of time to figure out locations for their franchisees. They do a lot of analysis. While Burger Kings that compete with McDonald's, just look at where McDonald's is opening up.

There is a lot of debate going on about letting retailers like Wal-Mart into India. What perplexes me is that there is nothing in Wal-Mart's business model that anyone cannot figure out by walking into their stores. There is nothing in their model that cannot be replicated. India does not need Wal-Marts. It just needs an entrepreneur to look at their model and replicate it.

Do you blindly follow Warren Buffett and invest in any company he is investing in?

There were some professors in the U.S. who looked at every stock Warren Buffett bought from 1975 to 2005, and they did an analysis. If you bought what Buffett bought after it became publicly known, on the last day of the month at a higher price and held it until Buffett started selling and sold it after it was known publicly that Buffett had sold, and got the price which was the lowest price on the last day of the month, and you did this for every stock he bought and sold for 30 years, you would beat the index by 11.5% a year.

Bottom line, cloning is a very powerful notion. No good books have been written on cloning yet. If you take what Buffett did, then you are already beating the S&P by 11.5% per year. Mostly what Pabrai Funds did was to copy the other investors. I just give a slight tweak to it. I don't buy what others are buying. I look at what they are buying. Then I buy what I can understand and limit myself to two-three decisions a year.

How has your strategy evolved over the years?

We don’t learn from success. When we stumble we learn a lot. I am grateful that every time I stumbled, it has lead to growth. The period 2007-'09 was wonderful from a growth and learning perspective. Over the entire 1999-'07 period there were no negative returns. Not only did we make 37.7% per annum on a compounded basis, but there were no negative returns. We thought nothing went wrong, and I never saw the housing bubble.

In 2008-'09, financial system was out of oxygen. I had companies which depended on access to capital markets and financing. They just went into a tailspin. In one case, our investment went to zero. We had permanent losses. We had things which were knocked down on price and we had no ability to be offensive. We had no cash. I learned the rule that cash is king. Most of last year I was sitting with 20% cash. That was a big change.

Another change in my approach was the development of a pre-investment checklist, which is very powerful. It looks at mistakes made by other investors. This checklist helps me in catching those mistakes. One of the Warren Buffett biographies reveals that as a kid he used to walk in a strange way. It was to absolutely take out the probability of falling. He picks stocks similarly. He looks at the downside- how can he lose money. So  I did the same...questioning and re-questioning many times about how can I lose money on an investment. The checklist helps me there.

Also, I started having conversations with another investment manager. I got this advice from Charlie Munger, who said he always has someone to talk to about his investments. Until 2008 I never talked to anyone about investments. We mostly never agree, but conversations are helpful.

What about your fee structure?

My investors love my fees structure- which is copied straight from Buffett. Zero management fees for assets under management.  First 6% of returns go to the investor. Above that 6%, I get one-fourth and they get three-fourths. So if the portfolio is up 10%,  I get one-fourth of 4 percent (that is, 1%). If it is up 5%, we get nothing.

Warren Buffett is a Value investor. Isn't it very restricting to just copy him? There may be many more opportunities out there that may not strictly fall under the Graham and Dodd definition of a value investment, and yet be a great opportunity.

Well, Buffett is a multi dimensional investor. Dozens of investments that he has made are not moat based or may not be value investments. For example he has done a lot of restructuring and arbitrage deals. It is not so much about moat or value investing. It is about what you pay for a business. If you pick four or five investors and decide to pick the best of their ideas with some of your own criteria put in, you will be fine. You can skip the businesses which you don't understand or which are in conflict with your own criteria, and you will still have enough options to invest. Keeping it simple and buying at a great price are important. It is also important that if you are cloning, you clone the best.

Tuesday, October 29, 2013

Superman or not, Raghuram Rajan has indeed made a difference

This article was first published in the business section of on October 28, 2013; Co-author: Puran Singh (ISB)

"I am not a superman", he says, but the reaction of markets to his initiatives has been super indeed. He took over the office of RBI Governor amongst much hustle and media gush on September 4, 2013. Having predicted the financial crisis and carrying an image of an internationally recognised economist, Raghuram Rajan was seen as the savior for the Indian economy that had multiple economic issues to grapple with.

He had his guns ready and fired right away on the day he took over. He endorsed transparency and financial stability in addition to issues related to inclusive growth and development. A range of measures were announced that included elimination of license requirements for new bank branches, appointment of committee to assess RBI’s approach to financial inclusion, allowing rebooking of cancelled forward exchange contracts by exporters and importers, issue of cash settled ten year interest rate future contracts, interest rate futures on overnight interest rates, special concessional window for swapping FCNR (B) dollars, increase in foreign borrowing limit of banks to 100 per cent of unimpaired Tier I capital, etc.

On Financial Infrastructure front, he expressed an intention to implement Electronic Bill Factoring Exchanges to facilitate prompt bill payment facility to Micro Small and Medium Enterprises (MSMEs). He acknowledged the need to have Debt Recovery Tribunals and Asset Reconstruction Companies for efficient loan recoveries.

For households, the governor announced that they will issue Inflation Indexed Savings Certificates, come out with national giro-based Bill Payment System to facilitate bill payments any time, start mini ATMs operated by non-bank entities for better financial access.

These measures were well received by markets as the key economic indicators improved swiftly. Depreciating rupee that had been a cause of concern for some time, gained considerably from a low of Rs 68 per dollar on August 29 to stabilise at Rs 62 per dollar by September 16.

Sensex rode on investor expectations of favourable policies by the RBI and rallied by a maximum of 700 points, eventually crossing the psychological mark of 20,000 points. Forex reserves also remained stable during the time. Gold imports remained low at 7 tons in September helping India's current account deficit. Only thing that remained unleashed was inflation that rose to 6.46 per cent for the month of September 2013 (see Figure 1).

Figure 1: Key Financial Indicators before and after Raghuram Rajan’s taking over

Source: Reserve Bank of India;;;

In order to arrest inflation, in his first monetary policy review on September 20, Rajan increased the interest rate to 7.5 per cent (by 25 basis points), against the common expectations. This might have irked Finance Minister P Chidambaram, but he remained quiet, while he had openly criticised Rajan's predecessor Subbarao for a similar move.

Rajan maintained that controlling inflation was important which eventually provided a growth environment pretty much in line with his predecessor’s line of thinking. He made up for the increase in interest rate to some extent by rolling back the rate on Marginal Standing Facility (MSF rate is the rate at which the RBI lends emergency funds to the banks) to 9.5 per cent from 10.25 per cent earlier (it helped reduce the cost of funds to banks and hence their lending rates).

In one of the measures, norms for Non-Resident Indian (NRI) deposits and overseas borrowings by banks were relaxed. This helped the foreign exchange reserves of the country. When Rajan took over, the reserves were at three year low of $274 billion. A month after, the reserves are up by $5.6 billion.

The month of September also saw gold imports go down that resulted in trade deficits to trim down to a 30 month low of $6.76 billion, resulting in a much lower second quarter (July-September 2013) deficit of $29.9 billion as against $50.3 billion in the first quarter (April-June 2013).

On October 3, Rajan met Chidambaram and decided to provide additional capital to banks for lending to auto and consumer durables sector. On October 7, RBI reduced the Marginal Standing Facility rate by another 50 basis points (now 9%) to bring down the cost of funds to the banks (RBI had increased the MSF rate from 8.25 per cent to 10.25 per cent in July 2013). Two reductions in MSF indicated that the rupee position of India was comfortable. According to Rajan, current account deficit of $70 billion was achievable at a stable rupee.

On October 10, RBI allowed banks to raise funds from international institutions until 30 November 2013 for general banking purposes (not for capital enhancement). On October 12, Rajan announced that major reforms in the form of allowing foreign banks to enter and takeover domestic banks were to be introduced in the coming months.

He promised near national treatment to the foreign banks subject to couple of operational conditions. In a meeting at IMF on the same day, he pointed that India must not be seen as a country in crisis as he did not see India running for IMF money in next five years and even beyond.

In a speech at Harvard University, Rajan stated that Indian economy was to pick up in fourth quarter of the financial year as government cleared stalled resource projects worth $115 billion. Also, good monsoon season was expected to boost agricultural production. He also pointed that economic troubles of India had to do with unwinding of stimulus during financial crisis and increased spending on things such as gold rather than any structural problems.

RBI launched new Real Time Gross Settlement (RTGS) system for large-value funds transfer for settlement of inter-bank transactions (first implemented by RBI in 2004) on October 19. Its advanced liquidity and queue management features were expected to make financial markets more efficient.

On October 21, Confederation of Indian Industries and Association of Chamber of Commerce and Industries urged Rajan to cut key policy rates for better liquidity conditions. However, the seven month high inflation figure of 6.46% for September does not go in their favor. Given Rajan's reputation, we may see another hike in interest rates on October 29 and given his ability to communicate to all stakeholders, the finance minister may not even be in a position to criticize his policies as it may not be received well by the markets.

In this short span of time, Raghuram Rajan has introduced/announced many initiatives, most of them yielding positive reactions from markets. Whether this is first aid or permanent solution, is too soon to tell.

Thursday, October 24, 2013

Raghuram Rajan goes home

In an exclusive feature on Raghuram Rajan, columnist Savita Iyer-Ahrestani writes about the challenges of running India's central bank. I have been quoted in the article published by the Global Association of Risk Professionals. Do read it by clicking on the link below: