Sometimes it’s nice to have the rules laid out so you know what to do and what not to do.
Perhaps this is precisely why Christianity, Islam and Judaism are so popular among large populations around the world. Because it simplifies things when you have simple guidelines – and even rules. It makes navigation through life easier.
Well, don’t worry – the value investor Mohnish Pabrai has synthesized stock market investing into 10 commandments.
In this blog post, I’ll go through these 10 rules.
Some of them are written for hedge fund managers, but as a private investor you can still use them.
How?
In case you want a fund to manage part of your portfolio, make sure they live up to those rules (in particular, 1 and 2).
Ready? Here they come:
1. Thou Shalt Not Skim Off the Top
Funds shouldn’t charge a management fee.
Most hedge funds charge a 2% management fee and get a cut of 20-25% of the profit.
ETFs and mutual funds usually just take the management fee.
Mohnish Pabrai copied Warren Buffett’s structure (and so have I in my fund).
In his original partnership, Warren Buffet did things very differently. He took 0% in management fees, but earned a quarter above a hurdle of 6%.
What’s the problem with charging a management fee?
It’s typically a percentage of the entire amount invested – and has nothing to do with the result.
This means that the fund or manager is paid regardless of how the fund performs. Does the fund lose 50%? They still take a percentage of the entire amount invested.
If the fund or manager is only paid when they achieve a return above a certain performance hurdle, it means they are motivated to perform well.
Let’s say a fund gets a fee of 2%. If you invest a million with them, they’ll charge 20,000 for it – even for doing nothing or doing badly. To get the same salary, Warren Buffett or Mohnish Pabrai would have to make a return of at least 10%. More reasonable, right?
A performance-based payment is fairer for the customer, and it creates an incentive structure that’s in your favor.
2. Thou Shalt Not Have an Investment Team
A fund should not hire a big team of traders and analysts to do the work.
Pabrai says that the first bid automatically leads to the second bid because the fund will be more careful with building up fixed expenses.
A large investment team not only makes the process more expensive – it also makes it more complicated.
“They just have to find 2-3 good companies a year, and it only takes half a person,” Pabrai says.
It doesn’t really matter how big the fund is. He explains that Warren Buffett manages billions and does it mostly alone.
Years ago, Pabrai actually wrote a letter to Buffett and offered to work for him for free… which Buffett turned down.
Buffett answered that over the years he has come to the conclusion that he works better alone.
3. Thou Shalt Accept That You Will Be Wrong a Third of the Time
There’s a lot of uncertainty when you try to estimate the future of a company, and you will be wrong – often.
That’s the bad news.
The good news is that you don’t necessarily lose money just because you’re wrong.
Phew.
Being wrong means that things don’t turn out quite as you originally expected.
Maybe you expected the stock to triple, but it “only” went up 50%.
“With this way of investing, you’ll do really well, even when you make mistakes,” Pabrai says.
How come?
Mohnish Pabrai is a value investor, and with that style of investing, you always invest with a margin of safety.
For example: you figure out what something is realistically worth… and then you cut it in half, and that becomes your target price where you are willing to buy stocks.
4. Thou Shalt Look for Hidden P/E of a Stock
A P/E of 1 means that in one year the company earns what corresponds to the market cap.
The market cap is the company’s shares multiplied by the share price. This is the value of the company in the market. If you wanted to buy the whole thing, that is what you would be paying.
Mohnish Pabrai tells many battle stories of how, over time, he has invested in companies that were extremely cheap when looking at the market cap.
For example, he invested in a company (Rain Industries) that had $2 billion in revenue and a market cap of just $200 million. In other words, the market valued them at 1/10 of the revenue.
Sometimes we get mispricings that are very much in our favor as buyers. These kinds of investments are great for your financial health, he says.
5. Thou Shalt Never Use Excel
Pabrai says that if you find yourself reaching for Excel, you are probably doing something wrong.
“You don’t need a calculator – you just need the fingers of one hand to figure it out. The math is pretty straightforward,” he says.
Mohnish Pabrai’s IQ is higher than most people’s. He is also funny and provocative… not unlike his guru Charlie Munger.
When he says something black-and-white, like banning spreadsheets, you shouldn’t take it literally.
I personally don’t see anything wrong with using a spreadsheet. The point is, if you have doubts about the company’s intrinsic value, you probably haven’t figured the case out yet.
Before diving into the spreadsheet, it’s a good idea to look at the overall numbers like Mohnish Pabrai does.
What’s the revenue, and what’s the free cash flow and how much do they earn? And how much is that compared with the overall market value of the company?
If the market cap is lower than their earnings potential, it’s an easy case.
“The market will come to its senses at some point. It won’t continue to value it at that level.”
6. Thou Shalt Always Have a Rope to Climb out of the Deepest Well
Mohnish Pabrai tells a touching story about his father who was a serial entrepreneur that took many risks – and went bankrupt several times.
His father paid an astrologer dressed in orange robes to tell him that the future looked bright. He came to the family’s house and drank tea and spoke of a prosperous future.
Mohnish Pabrai confronted his father and said that it was a scam, to which the father – who was a man of logic and science – replied: “You must always have a rope to climb out of the deepest well.”
Mohnish Pabrai experienced his own private well when his hedge fund fell 70% after the financial crisis.
The fund’s assets fell from 600 million dollars to 180 million dollars from 2007 to 2009.
Since Pabrai didn’t receive a management fee, he had to pay himself a salary and the bills covering the fund out of his own pocket.
The fund had to return to the starting point and then rise above 6% before he could start paying himself a salary again. In order for him to receive a commission, the fund needed to grow to at least 636 million in 2008 and around 675 million in 2009 with no money being added.
“I found myself at the bottom of a very deep well. So what did I do? I violated commandment no. 5 and fired up Excel,” he says.
He imagined what life would be like with 1 billion dollars in the portfolio.
“I suspended all logic and imagined talking to the orange-robed guy… and then life was fine again,” explains Mohnish Pabrai.
In fact, the fund grew to 1 billion and everything did turn out fine, exactly as Mohnish Pabrai imagined.
7. Thou Shalt Be Singularly Focused like Arjuna
Arjuna is a central character in the ancient Indian tale Mahabharata.
The bow master Dronacharya tied a fish high on a branch in a tree above a lake and ordered 12 students to aim at the fish’s eye while looking only at the fish’s reflection in the water.
He asked the disciples one by one what they saw when they looked at the reflection in the water.
The disciples mentioned everything: the sky, the water, the tree, the fish… except Arjuna.
When asked the same question, Arjuna said that he only saw the eye of the fish. The master told him to shoot, and Arjuna’s arrow pierced the fish’s eye.
The point of the story is that too much information is an obstacle for you to focus – and a barrier for you to achieve what you want.
It’s the same when we invest. There’s a lot of noise: inflation, forecasts, speculation, oil prices, interest rates, employment numbers, and so on.
“None of that is relevant to what we’re trying to get done. We want to identify companies within our circle of competence and figure out what they are worth, and if they are available for a quarter or less of the value,” says Mohnish Pabrai.
8. Thou Shalt Never Short
Shorting is betting that something will decline in value, and that’s an exercise that never made sense to Mohnish Pabrai.
“Your maximum upside is double if the company goes to zero and the maximum downside is bankruptcy,” he says.
When we buy shares in a company, we don’t need to put in more capital when it goes down. But when we go short in the market and it goes up, we have to put in more capital, Pabrai explains.
He also explains that Buffett and Munger have said that they are right almost 100% of the time and wrong on the timing almost 100% of the time.
“It’s perfectly fine when you buy shares, because you can just wait. But it doesn’t work when you short, because it’ll cost you money every day. You must both be right in your thesis – and be right in the timing of it,” Pabrai says.
He adds, “We don’t want to do anything that requires us to look at the stock every 5 minutes.”
9. Thou Shalt Not Be Leveraged
“Neither a borrower nor a lender be.”
Pabrai quotes Hamlet’s father giving this advice to Hamlet and he quotes Buffett for rephrasing it into “neither a short-term borrower nor a long-term lender be”.
What does this mean in practice?
You can, of course, have a home loan(here you are a long-term borrower), but in the stock market you must stay away from all rigmarole that involves leverage.
This comes in various forms such as using margin on your account or certain option trades such as selling naked calls (selling calls without owning the stocks that could be called away from you – this is like borrowing the stocks).
10. Thou Shalt Be a Shameless Cloner
Copy the masters, Pabrai says. In other words, you must learn from the good value investors. Watch their technique, investment and process, and do as they do.
I’ll add this: always do your own thinking and analysis so that you feel confident in your investment thesis. Take the company through a checklist and calculate the value yourself.
You can use the actions and decisions of others for inspiration, but you must not copy blindly.
Why not?
Even if the masters are right in their thesis, you might get super nervous when the market fluctuates and dips. You could enter the terrible zone of panic selling.
Knowing what to do and researching things thoroughly will keep you calm in the market.
You can follow the trading of the major value investors here, here and here.
You can learn how to do your own analysis and calculations in my e-book right here.
