I attended my first Mohnish Pabrai hedge fund shareholder meeting in the Fall of 2010, two years roughly after getting interested in the stock market. When I went, I was enamored with Mr. Pabrai and believed him to be a superinvestor, much like Mr. Buffett describes.
However, upon entering the meeting, I received an annual report which showed current Dalal Street holdings. And I was not impressed. Following his presentation, he opened up to Q&A, which I took advantage of, at 19 years of age. The reactions by the crowd were interesting, to say the least. The transcript is below.
Q: I’m Andrew Schneck. I’m from Pittsburgh. I know we’ve been asking you a couple questions now about your allocation of your capital within the specific positions. In looking at the Kelly formula that you use, especially back earlier in the decade, it seems like the odds that you’re playing right now with your two percent or five percent bets are the same as a casino if you’re playing 52 percent in your favor, 48 percent against.
It seems almost that you’re more concerned with preserving your wealth than you are in going forward and trying to actively grow it. I’m just curious if you’re almost less sure of yourself with this whole downturn in 2008 and 2009, or if it’s more just that you feel that there are many more ideas out there now that you really can diversify into? Thanks.
A: That’s a good question because it saves me the trouble of doing the next edition of the book. (laughter) The book is wrong on the Kelly formula. The Kelly formula’s correct, but you could only apply it if you’re doing a large number of repeated bets. If you have, let’s say 52-48 percent odds on coin tosses, then making the bets according to the formula makes sense if you get to participate in 200 coin tosses.
If you get to participate in two coin tosses, it doesn’t make that much sense to use the formula. In Kelly terms, we were under betting the Kelly at ten percent of assets going to one bet. We are even further under betting the Kelly now at 2 or 5 percent. We’ve gone even further. That’s because the way the funds are set up is it’s not like coin tosses where I get to make 500 bets. I only get to make a dozen or two-dozen bets over some period of time.
This year, we only made two bets so far. The good news is I never really applied the Kelly formula because I was applying the ten percent of assets even before I heard the Kelly formula. Then when I heard about the Kelly formula and I applied the ten percent asset test, all it ratified was that I was under betting the Kelly, which is fine.
We never went to the point of going to the full extent of the Kelly which would mean like 90 percent of your portfolio goes into a single bet. Or 95 percent goes into a single bet. That wouldn’t make sense. First of all, the good news is we can set the record straight that the Kelly formula doesn’t apply to a low number of stock picks. Even if the odds are heavily for you. The second is that return of capital is more important than return on capital.
Most of my investors here first care about return of capital, then they care about return on capital. I have always had a deep concern to make sure that we return the capital and then we make money on it. We saw large drawdowns, and the negative of the drawdowns is people redeemed at the point when the drawdowns took place. This means that there’s never a chance I have to ever get them back. They left when the funds were down. When I’m running temporary capital, like I am currently, large drawdowns are negative.
I may not care about volatility but the reality of having temporary capital is the volatility matters. What I was looking for is to temper the volatility. To not so much make it like an annuity or clipping coupons but I wanted to make sure that our likelihood of having large draw downs is reduced. I don’t think we’ve given up on one thing which is to make money for the investors. But what we want to do is we want to make money by being prudent. I don’t want to make irrational bets. I don’t want to make high-risk bets to get high returns.
There you have it. After having beaten the market handsomely from 2000-2007, market underperformance and drawdowns caused him to retreat from his prior strategy. Rather than own, say, 7-10 names, he now owned closer to 20-25. And that was a major change in my opinion.
Mr. Buffett talks about making sure bets with large portions of available capital, whereas here Mr. Pabrai was taking a step back from that and diversifying further, to appease his investors with temporary capital. This is a very real threat to one’s business model if not handled properly.
I didn’t write this piece to pick on Mr. Pabrai – just read the title. He now has the majority of his capital in just 5 names. This excites me. It means one of a few things:
- He is back to his old self (my hypothesis)
- He has fixed relations with his investors, who no longer will be impacted by volatility and will allow Mr. Pabrai to do his work in peace
- He is still diversified heavily but the majority of assets are in overseas companies that do not require disclosure (unlikely given the disclosure dollar amounts, the 13-F has the majority of his assets)
For those of you too lazy or incompetent to find the names (kidding), here they are in order of size:
- FCAU: 42%
- GM-B warrants: 20%
- ZINC: 16%
- PKX: 10%
- GOOG: 8%
I haven’t studied half of these but I do plan on it. Google was a no-brainer a few years ago but I’m not sure where it stands now in terms of valuation.
Happy hunting, and celebrate! One of our best has returned.