How Much Can You Know? What Pabrai Didn’t Know Hurt Him Badly

A couple of interesting Bloomberg links for readers this morning.

First, the recommended Open Exchange program (weekday mornings 8am PST) interviewed one of my favorite money managers, Mohnish Pabrai. I caught most of the program but missed the beginning. I will probably go back and listen to it today as I am curious if they discussed Pabrai’s recent performance. Some people have questioned Pabrai recently as he has really gotten his ass kicked due to some bad investments in companies like Delta Financial and more recently, Pinnacle Airlines (PNCL).

Pabrai is noted for his rabid devotion to Warren Buffett but I’m going to ape Charlie Munger and focus on learning from Pabrai’s mistakes. I know that most folks like to follow the winners but I think the book that would most interest me at this point would be one from Pabrai examining his recent missteps in-depth. In a recent issue of Smart Money, Pabrai insists that the DFC investment (and would probably say the same for PNCL) was a good bet and that he just caught some bad cards on the turn and river, i.e. his two pocket aces got beat by some fluke run. But my feeling is that perhaps, Pabrai strayed outside his core competency and paid the price. To continue the poker analogy, he thought he had a good hand but there was someone out there with the nuts (the best possible hand in any given deal) and handed him his head. In DFC, the credit crunch triggered by the subprime debacle (which many people saw coming) completely destroyed his thesis. The PNCL thesis centered around no-risk contracts with Northwest and Delta Airlines which aren’t so no-risk once fuel costs skyrocket and viability becomes an issue.

Another interesting point in the interview was Pabrai’s discussion of macro considerations. At several points, he was asked about oil prices, interest rates and consumer confidence and his answers suggested that he really doesn’t spend much time thinking about these things. I know that the masters such as Buffett and Klarman advise that investors use a bottoms-up approach as opposed to top-down (picking a theme and finding stocks that fit it) but I am skeptical that they advocate disregarding the macro picture completely when evaluating investments. In fact, when they speak publicly, all they ever talk about are macro conditions. I realize part of this stems from the refusal to discuss specific investments but take a quick glance at Klarman’s MIT talk in Oct. 2007 or Buffett’s Squanderville article written six years ago. It’s clear they spend a lot of time analyzing the macro situation and how it affects their investments strategically. Warren Buffett reads 5 newspapers a day. What’s he reading all these papers for? There’s not much bottoms-up company analysis in these papers (including the Wall Street Journal & Financial Times, which focus more on short-term earnings anyway). Knowing what’s going on in the world is a huge part of participating in the markets and value investors aren’t excluded from that requirement.

The strangest part of Pabrai’s venture into Pinnacle Airlines is that it conflicts with his Buffett worship. Here’s an excerpt from another site regarding Buffett’s feelings regarding airline stocks:

Norbury was one of the rare cases when Holmes was not at his best. He asked Watson to use this as a reminder to make sure that he did not become over-confident in the future.

This reminds me of Buffett after his investment in USAir in 1989. Within a few years the airline was in such difficulty that Buffett wrote down the investment by 75 percent while trying to sell the shares at 50 cents on the dollar. Fortunately for stockholders in Berkshire Hathaway, Buffett was unsuccessful in finding a buyer for within a year or two USAir returned to profitability. In the end, Buffett’s action brought a healthy profit to Berkshire Hathaway.

On a personal level, Buffett admitted that the purchase was a result of sloppy analysis that may have been caused by hubris. To guard against a similar lapse in the future, he once joked, “So now I have this 800 number, and if I ever have the urge to buy an airline stock, I dial this number and I say my name is Warren Buffett and I’m an airoholic. Then this guy talks me down on the other end.”

On that note, here’s another interesting article which discusses a variety of topics about Buffett. Here’s the quote that caught my attention:

Buffett often decides to buy a company after what looks like a cursory examination of its operations. He agreed to purchase Larson-Juhl after a 90-minute talk with its founder, Craig Ponzio. During his European tour, Buffett told questioners that he had bought Iscar without any due diligence and after just a few days of talks with its top executives, who traveled to the U.S. three times to meet with Buffett and his investing partner, Charles Munger.

No one from Berkshire ever stepped inside an Iscar factory before the deal was done, Buffett says.

“He’s buying on faith, and especially with larger acquisitions, that’s certainly perilous,” says analyst Chuck Hamilton, who follows insurance at FTN Midwest Securities Corp. “If he were to spend $20 billion-$30 billion on a major company, without due diligence, that would really be cause for heartburn.”

Seth Klarman discussed the important ability to assess and act on a situation with incomplete knowledge in his seminal book, Margin of Safety but perhaps the best summation of this principle comes from an unlikely source:

“…as we know, there are known knowns; there are things we know we know. We also know there are known unknowns; that is to say we know there are some things we do not know. But there are also unknown unknowns — the ones we don’t know we don’t know.” — Donald Rumsfeld

My 10,000 ft view is that Pabrai got blindsided by unknown unknowns that were knowable. Perhaps he’ll talk to Buffett about “recogniz[ing] and avoid[ing] serious risks, including those never before encountered.”

As I alluded to in my glowing review of his book, Pabrai’s biggest weakness may be allowing his Buffett-worship to impede his own voice. There is a Zen saying: “If [on the path to enlightenment] you see the Buddha, kill the Buddha.” You can’t reach your full potential by trying to be someone else.

3 Responses to “How Much Can You Know? What Pabrai Didn’t Know Hurt Him Badly”

  1. The Enlightened American » A Change In Strategy Or Just Finetuning Tactics? Says:

    [...] For what it’s worth, I generally agree with both Tilson’s and Pabrai’s new insights. In fact, I previously discussed both Pabrai’s performance/outlook and macro views in value investing in this June 2008 post. [...]

  2. Thomas Simon Says:

    I am not sure I agree with Monish Pabrai’s new insights (if he has any). I follow his results closely and I do not think his problem was holding a concentrated portfolio. His problem was ignoring a major long time downtrend in the market and refusing to respond to it. Diversification, if this is his answer, would not have helped him much, only marginally. My feeling is that buy and hold strategies stopped working a while ago, mainly because large investors, mostly hedge funds and major banks, manipulate the markets for short term results. The market used to be a capital market where businesses could find investor money to start or grow businesses. It morphed into a casino where gamblers way outnumber investors. You either accept it and play it accordingly or you get killed, as Pabrai and his investors have been in the past year and a half, being down by 70+%.

  3. Davy Bui Says:

    Yeah, I’m not sure if Pabrai’s problem was lack of diversification either. I wouldn’t go so far as to say buy & hold is dead. It all depends. I think the biggest takeaway is that you can’t invest “by-the-numbers” or using some reliable playbook. Just because someone like Whitman or Pzena made a lot of money off bank crises in the past doesn’t mean now (or last year) was the time to buy banks just like the last time. Each situation has to be evaluated in its own context.

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