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Mohnish Pabrai on the Importance of Downside Protection

Opportunities can arise only when an investor first establishes a margin of safety that sufficiently assesses potential risk

In an interview for the Fall 2019 issue of the Graham & Doddsville Journal, Mohnish Pabrai offered his insight into how he seizes investment opportunities based on one of the fundamental principles of value investing: securing an adequate margin of safety. Pabrai, like Seth Klarman and Warren Buffett , is a true value investing disciple of Graham & Dodd and he discussed how he applies judiciously, a few fundamental tenets of the value investing methodology that allows him to intelligently assess potential investment opportunities.

Like Charlie Munger, Pabrai believes in a “keep it simple” approach to investing. By focusing on a few fundamentals, an investor has a better chance of making informed investment decisions, not impacted or skewed by the daily vicissitudes of the stock market and the prevailing conventional wisdom. As Munger notes,

“You don’t need higher math in business and if you learn it you feel tempted to use it – to your detriment. You really have to understand the company and its competitive positions; that’s not disclosed by the math. There is something to be said for ‘keeping it simple.’”

Pabrai understands, that while investing itself is simple, it’s not easy. However uncomplicated the basics of investing may be, few have the temperament required for adhering scrupulously to the few bedrock principles upon which successful long-term investing is based. At the outset, Pabrai articulates this proposition, by stating that, because he is incapable of a disciplined approach to investing, Mr. Market, is the perfect embodiment of an investor who defines uncertainty solely in terms of the daily prevarication of the stock market.

Fickle and risk-averse investors like Mr. Market eschew any attempts at ascertaining the intrinsic value of a company with the intention of holding its stock for the long-term, but rather follows the crowd, which abhors uncertainty, because they have no understanding of the concept of margin of safety

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and how it is an indispensable component of successful investing.

Pabrai reasserts a fundamental truth at the core of Graham & Dodd’s value-based investing philosophy: the futility in trying to determine the future earnings of an enterprise,

“To be honest, you cannot figure out the future trajectory of most companies. Most businesses just don’t have that type of a dynamic. Capitalism is too brutal – most companies won’t even be around in 20 years. I don’t want to try to figure out the future trajectory of companies like that.”

Because of the inherent complexity of analyzing future earnings, Pabrai’s posture is to, “make bets that are as no-brainer as possible, with as few variables involved as possible.”

So, even though trying to determine the future cash flows of an enterprise is untoward and an exercise fraught with risk, the most optimal methodology for making an informed opinion is to try and reduce the complexity of the analytical challenge, or as Pabrai frames the issue, “we can do some hacks to simplify the problem for us.”

Pabrai illustrates another axiom of value investing, specifically, the importance of establishing a margin of safety, within the context of his purchase of IPSCO, a steel company he reviewed in 2003. The company caught Pabrai’s eye because, at that time, IPSCO’s stock was selling for $45 a share.

A review of the company’s balance sheet and income statement revealed that it had $15 per share in cash, no debt and the company projected that it would have $15 per share in free cash flow for the next two years. Additionally, the free cash flow figure was based on contractual obligations from IPSCO’s customers. Pabrai viewed the stock favorably because,

“…if you looked at the cash on hand and the next two years of cash coming in after taxes, in two years you’d have $45 a share on the balance sheet, and you were paying $45 a share. All the plants, inventory, customer relationships, know-how, everything else, were free.”

One of the enduring principles taught by Graham & Dodd in Securities Analysis, is that, “The concept of safety can be really useful only if it is based on something more tangible than the psychology of the purchaser. The safety must be assured, or at least strongly indicated, by the application of definite and well-established standards.”

Pabrai demonstrated his fealty to this core assumption by conducting a fundamental analysis of IPSCO, valuing the company as a going concern, realizing that the $45 stock price, in two years, would match the assets per share.

Pabrai knew the steel business was cyclical and there was the risk that after two years, the company’s earnings could dissipate. However, he reasoned, that it was more likely than not, that the earnings would be positive. Although he didn’t attempt to establish an intrinsic value for the company, Pabrai felt confident making a bet, with the goal of selling the stock after two years if earnings didn’t grow. Pabrai discusses what happened next after he purchased the stock,

“A year goes by, then IPSCO announces that they’ll have one more year of $15 per share in earnings. The stock is now trading around $90. Then a few months later some Swedish company came in and offered to buy them for $160 and the stock immediately jumped to $152. I didn’t even wait for five minutes after I heard that news. I was out of there. It was a great outcome, and all because Mr. Market gives us these hacks.”

Pabrai, explains how margin of safety is an indispensable component in any sound intrinsic value investment decision, “We don’t know the trajectory, but I think the odds of losing money are pretty muted, while there’s a built-in element that could give me a nice double or triple in not too long. What’s not to like about that?”

With an acknowledgment to Graham’s most devoted student Pabrai notes, “Like Buffett said, it’s all about comparing one bird in the hand with two in the bush. So, you ask questions, ‘How certain are we that there are two in the bush?'”

The methodology Pabrai used in his review of IPSCO, is a telling example that demonstrates, making an informed, value-based investment decision is impossible unless an investor first establishes the downside risk, or margin of safety, for any potential investment

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