buying net-net working capital stocks, as he’dbeen taught by Benjamin Graham, and when his problems went fromtoo many ideas and not enough capital to too much capital and notenough ideas, he really was forced to make the transition into buyingthese much higher-quality businesses that he has the luxury of holdingfor a long period of time.JA: Right.ZA: I was very fascinated by having a case study of a man who, purelythrough rational capital allocation, was able to grow a very smallamount of money and compound it at high rates of return over a 40or 50-year period to become the world’s second- or third-wealthiestman purely based on investing acumen, not based on building a company that turned into a global worldwide monopoly like Bill Gates. Hedidn’t inherit a lot of money.Something about that just really appealed to my nature, and I’m sortof a studious guy by design and love to get in there and figure out thesystem, find out what the probabilities are that this or that will work.I came home from vacation when I was living in Switzerland andstarted a little limited partnership. I got a couple of coworkers whowere in Europe with me—for whom it was very inconvenient toinvest in mutual funds—to toss in $10,000 each or so, and I startedmanaging the money.Not long after that, I submitted an essay on investing to The Motley Fool. They liked it and published a couple of my things, and eventually they offered to hire me and move me to Alexandria, Virginia. Isaw that as a huge opportunity to make the transition from the business that I was in, for which I was rapidly losing interest as well as losing its demand after the euro and the Y2K thing.So I moved to The Motley Fool. I continued to run this little limited partnership on a pro bono basis in my spare time. I looked at1,000 companies maybe in my two and a half years there and wrote acouple hundred articles. I tried to develop myself as an analyst anda money manager. Ultimately in August 2002, I did open up the fundto outside investors, changed the strategy a little bit to make it moreof a hedge fund, and have been doing this for two years. Our trackrecord has been very good.Late last fall, Matthew Richey, who was a good friend of mine andhelped to get me hired at The Motley Fool, came and joined me at
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Centaur, and we’re having a great time. We work very carefully andclosely together and try to invest the capital that’s been entrusted tous with a value sort of orientation, although we don’t necessarily consider ourselves completely traditional.We’re willing to chase or go get value in whatever guise we thinkit happens to be in. We try to not to bind ourselves too rigidly by anyone set of rules, but at the end of the day, it all comes down to howmuch cash you think an asset can produce over its life.And so we try to reduce virtually everything that we can, in someway, shape, or form, to whether we think the price today is a goodprice and has a margin of safety that will give us a 15 percent annualized return, which is generally our equity hurdle rate.JA: How do you quantify the margin of safety?ZA: You know, it’s hard. If we could put our strategy in certain buckets,we have one strategy where we look for smaller, high-quality companies that are trading at, say, single-digit price-to-free-cash-flowratios and they have everything else right—strong balance sheets,good brands, some niches, [they are] managed correctly, this sortof thing.If we had enough of those to go around all the time, we would donothing but that. Some are growing at two percent a year and someare growing at eight percent a year. If you buy a group of those thatare all high-quality, all managed by enlightened people who areshareholder-oriented, you pay an average of, say, seven times freecash flow for that group of fine companies, then you’re going to dowell over time.JA: Let me just play devil’s advocate. Wouldn’t you say the market is pricing these companies in the single-digit cash flows because there’ssome anticipation that they’re going to stop growing, or growth willbe negative?ZA: I don’t think that’s the case. Most are priced to low multiples becausethey’re boring. I believe that in today’s world, you can divide stocksinto two groups: those with a buying constituency and those withouta buying constituency.For example, it’s estimated that the U.S. mutual fund industry isabout an $8 trillion industry. Somewhere around $2 trillion of thatis either S&P 500 funds or S&P closet funds. So there’s a $2 trillionconstituency that has to buy only the companies in the S&P 500.
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If you’ve ever been to a Berkshire Hathaway meeting, you sitthere and think to yourself, “There are people lined up at six o’clockin the morning to listen to the CEO of this company answer questionsfor about five hours. The doors open and grown men and women runand knock each other over to try to get the best seats.” I call it “therunning of the bulls,” and I think it’s the funniest thing I’ve ever seen,that grown men and women are willing to do this.They listen to this man whom they obviously worship—some in amore enlightened way than others—but you think to yourself, “How isit possible that Berkshire Hathaway can be undervalued when clearlythere’s this constituency of people who are going to buy the stock?”The reason is that the constituency you see at the BerkshireHathaway meeting is such a tiny, tiny drop of capital when you compare it to a constituency like all the S&P 500 index funds in the world.As you know, Berkshire Hathaway is not in the S&P 500. Andbecause it lacks that buying constituency, it’s my theory that Berkshire Hathaway is occasionally very cheap relative to its intrinsicvalue, but even now, when it’s trading at very high historical valuations relative to book value and whatever else you want to use, it’sstill trading at probably 80 cents on the dollar when you look at itfrom an intrinsic value standpoint.You would think that there should be a premium to all of the relative metrics that we use as investors—simply because of the trackrecord, the culture and the man who’s running the money—but itdoesn’t have one.Would you say it’s because there’s an expectation on the part ofshareholders that Berkshire Hathaway’s growth is going to stop? Iwould argue that it’s not. It’s just that Berkshire Hathaway does nothave the huge buying constituency that, say, AIG might have.JA: So with these companies—including Berkshire Hathaway—that don’thave a constituency, it’s not necessarily the case that there’s going tobe a future constituency. They might be forever valued cheap?ZA: Yes.JA: Until they have negative growth, and then they’ll be valued less.ZA: Yeah, the risk you’re referring to is, of course, what we in value circlescall the value trap.I personally believe that if you have enlightened managementthat’s shareholder-oriented, a value trap doesn’t really exist. It can
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exist on a single-stock basis, perhaps. I’m willing to concede that. Buton a portfolio of them? I don’t believe that’s possible because ultimately that enlightened management team will, if they’re good capitalallocators, make smart acquisitions. They will buy back stock atattractive prices. They will continue to pay out a higher and higherlevel of dividend until they bring in various people.But you know what? As long as the stock continues to be relatively valued—i.e., if it never trades at more than eight times free cashflow on a per-share basis, but the company is reducing the outstanding shares by six percent a year and growing the business by threepercent a year—you’re going to still get a reasonable sort of equityreturn relative to the risk you’re taking.Again, a lot of these companies are excellent. Generally they’resmaller, because they’re neglected. Or they’re small stocks or smallcompanies. Some of them happen to compete in industries that don’tget a lot of buzz. But ultimately, they get bought out by a bigger competitor, or something happens—the catalyst comes, as we say in valuecircles—and you end up making the money.JA: Do you have an example?ZA: The fall of 2002 was a very, very good time to be buying some of thesestocks. It was kind of the nadir of the 2000–2002 bear market, which,depending on whom you talk to, may or may not be over yet.In any case, Internet companies had fallen into such disreputethat nobody wanted to own an Internet stock anymore. There werejokes about them. It had almost become the new “swamp land inFlorida” joke.We noticed a little Internet advertising company called ValueClickand went out to visit the company. This was a true Ben Graham net-networking capital play. The company had $3 a share in cash and it wastrading for $2.30. If you looked at the business from an operatingstandpoint, it was just barely breaking even, but it was profitable andcash-flow positive in general because its big cash balances were kicking off some interest income.But the interesting thing it was doing was buying even smaller publicly traded Internet marketing companies at even bigger discounts tocash. The leader in the industry was DoubleClick, and even DoubleClick was pretty much hated and almost fell below cash at one point.We looked at ValueClick’s model and talked to its managementteam. The manager didn’t strike us as a genius in capital allocation,but he was very, very good at the day-to-day operations of the busi-
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ness. He was not a big spender, and he knew how to keep costs in linewith expenses.The one thing we realized was that as soon as the advertising market turned around, a huge number of the advertising marketing playershad been cleared off the table by consolidation, and many of them justwent out of business. But those that were any good got taken over byValue Click, DoubleClick, and some of the other players.Second, the business had a massive amount of scale to it, becauseit didn’t cost them very much to run the advertisements out thereonce they had built their infrastructure.The thing did turn around. About nine months later, the economystarted to turn around a little bit and advertising went up. The scale ofthe business was becoming obvious. They had a couple of good quarters. The stock rocketed from $2.50 to $4.We started selling because we thought the thing was only worth$4. I think we sold the last of our shares at $5, and the thing rocketedon to $12. It hovered there, but then the company announced earningsthat weren’t good enough and the stock’s been knocked back since tothe single digits again.That’s the way these things happen. The frustrating thing is thatnot only do they eventually get a catalyst and actually get catapultedin value, but generally once it gets going, it goes way beyond what youthought it could ever plausibly be worth.My friend Whitney Tilson calls it the value investor’s lament. Youalways sell too early, because you have to sell in order to keep themargin of safety. You always have to sell at fair value, or maybe the highend of fair value. But you never want to hold an overvalued stockbecause you could be holding ValueClick when it gets whacked backto the single digits. You don’t want to do that to yourself after you’vegotten the profit.JA: Let’s go back to, say, November 2003, and these Internet stocks havegone up 50 percent from their lows, and there aren’t too many examples of companies trading below cash. How do you switch gears andfind the margin of safety for your investors during a period like that?ZA: The problem as an enlightened value investor is that you never wantto deploy capital unless you really do see a) a reasonable discountto fair value, and b) a reasonable margin of safety in the stock price.So we, like a lot of value investors, inevitably started building upcash as we started selling the stocks that had kind of gone to fairvalue and above.
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Fortunately, the market tends to be fairly merciful. I mean, thereare 9,000 stocks that trade on the three major U.S. exchanges, and atsome point or another, if you dig enough, there’s always some tradingat a significant discount to fair value. We have some statistical screensthat we run through a computer software program that helps us identify the stocks that are obviously statistically cheap.For example, we have one [based on] this net-net working capitalstrategy that Benjamin Graham popularized but that nobody reallyuses anymore. In the fall of 2002, we might have 40 names on that, andas we’d go through and look, for 30 to 35 of them there are legitimatereasons why the things are trading below net-net working capital. Butfor five, they were perfectly decent companies and not horribleassets, and they were clearly trading at below the value that theyshould have been trading.Typically we prefer that most of that value is in cash, not inaccounts receivable or inventories or that sort of thing. We alsoscreen out those that have burnt a significant amount of cash.When we ran that same screen at the end of 2003, there were onlythree names on it. And they were three names that we’d looked at previously and had decided there was something flawed enough aboutthe business that even at that price there was no margin of safety. Sothese things do change.You have to go where the ball is, and of course, if you’re going topay 10 times free cash flow, you have to get a higher-quality companywith a little bit more growth or whatever it is that you’re looking for.JA: Can you give me an example from November or December ‘03?ZA: We found a company—and the reason this one was available becauseit’s just somewhat illiquid—called Atrion. The ticker symbol was ATRI,which is still in our portfolio today.It’s a little medical device company that grows the top line prettysignificantly—or has over the last five or six years—but had actuallybought back over a third of the shares in the last five years. And theircapital allocation was phenomenal.But nobody could own it because it was too small of a stock, andit actually dropped back a little bit on some top-line weakness. It wasavailable in the $20 to $25 range, which made it at seven times freecash flow or something.We continued to buy it—and we paid up to 11 times free cashflow for it—up into the mid-$30s because we thought it was a veryhigh-quality company. We thought the management team was out-
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standing at both managing the business and allocating capital, whichis a very, very tough combination to find.The business was actually highly diverse and had a high marginfor such a small company, and none of the big institutions could buyit because it just didn’t have the liquidity. But for us, managing asmaller pool of capital, the liquidity wasn’t an issue, and the company’s located about 40 minutes north of us, so we were able to checkaround to make sure that their reputation matched our view of it.We’re quite happy to get it, and we continue to hold it.We bought a ton of Berkshire Hathaway in March 2000, whichwas probably the all-time best time to buy Berkshire Hathaway. Theproblem is that if you buy Berkshire Hathaway at a kind of once-ina-lifetime opportunity—at least once-in-our-generation opportunity,when Warren Buffett’s being raked over the coals for his refusal tobuy technology stocks.We bought these shares at perhaps $1,500 and now they’re at$3,000, so four years later, you have a double, whereas if you buy anet-net working capital stock and something good happens, like it didto ValueClick, if we’d have sold at the right time, we could have hadas much as a five-bagger. We ended up getting two bags in a ninemonth period of time rather than a two-year period of time.JA: What percentage of your fund do you typically put in the average position that you have?ZA: We’ve gotten less concentrated than we used to be for a couple reasons. Number one, the bargains are probably less now than when westarted doing it, but also just because we’re not as comfortable holding, say, 10 percent positions as we used to be.But if we have absolute confidence in, like, Berkshire Hathaway,it was upward of 10 percent of the fund, which was a very small fundat the time. So it probably doesn’t even qualify as a fund. It was just apool of friend-and-family capital when we did that.But usually our maximum position, which we call the double, is7.5 percent. Our standard position on what we think is a truly outstanding investment that will reach our 50 percent annualized hurdlerate and has a margin of safety is usually five percent.On our net-net working capital strategy, you’re buying a mediocreasset at best that’s priced as if it’s going out of business. So our position sizes there range between one and two percent, usually depending on the quality of the business.JA: How many positions can you hold at any one time?
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ZA: We’ll hold between 25 and 30 long positions at any one period of timevery easily.JA: Here we are in August ’04. How many positions do you have onright now?ZA: We’ve got probably 27 longs and six shorts.JA: How do you decide to short a stock?ZA: We basically look for the mirror image of all the stuff we look for onthe long side. We think of the market as this big bell curve. A bellcurve is based upon value per dollar, per investing dollar that you get.Most of the time, unlike a standard bell curve where the bulge isin the middle, in our markets, the bulge is usually on the right side,i.e., the overvalued side, because more stocks typically are overvaluedor fairly valued than we would like for them to be.We try to pick our long investments out of the far left end tail ofthat bell curve; that’s just the cheapest stuff on the market and hopefully, in terms of value, to get the most value for the dollar.When we’re shorting, we try to pick out the five or the six stocksthat we think are the most overvalued. We call it “the cream of thecrap”—the most overvalued stocks with the worst business withthe most hideous management that are doing everything that willbasically guarantee their shareholders will never see a dime of theircash back.We typically like it when they’re a little bit bigger in size so there’senough float out there. A lot of scam companies will issue a pressrelease or try to get their CEO on CNBC, and they’re not above bringing on a boiler room shop to send out mass emails to people saying,“Hey, buy this stock at 80 cents. It’s sure to go to $3 tomorrow.” Toprotect ourselves from that, we try to get companies that have enoughof a float that it would take a significant amount of buying power topush their stock up dramatically.Typically we like to short them just after they’ve done one ofthese PIPEs or after they’ve done a secondary or something wherethey have brought in a significant amount of new investor base that’slikely to not want to take any pain.JA: What’s an example of a short that you’ve done?ZA: Commerce One Software was a $15 billion company back in 2000.This was the company that was going to be B2B. The share price
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reached over $1,500 per share, split adjusted. They’d done somereverse splits since.We started shorting it at about $3 a share at a time when we basically knew this business was a cash incinerator. They were burningseveral hundred million dollars a quarter. They had taken out massivereal estate liabilities at the top of the market to house their 1,000employees, which are now down to 200. So the real estate was sittingempty, and they were paying the rents.Their biggest customer was SAP, the big German software company with whom they’d done a partnership back in the heady days,and SAP had just terminated the partnership and was now theirbiggest competitor.So they had about $300 million or $400 million left. They wereburning it at somewhere close to $70 million a quarter. Their marketwas drying up. Nobody was paying for these things, and in fact, theyended up selling what was left of their original B2B software and arenow trying to sell this new conductor software.So we shorted it and let them burn cash for another seven oreight quarters. We covered at about 60 cents simply because it got socheap that we were worried that SAP or somebody might decide totake it over.We got a really good return on it. There was a tremendousamount of float out there, because this thing used to have a $15 billionmarket cap. There were still some institutional holders that wereholding on, and we knew they had to sell at some point. It was burning so much cash. We knew there was no market for their softwareanymore. We could tell that all of their revenue, which used to belicense revenue, which is what you get when you sell the software,was now maintenance revenue, which is just very low margin, andrequires that you have a lot of highly skilled guys who will help support the software.They were diluting the stock by about 20 percent a year. Andthey were in the capital-raising tailspin whereby they would have todo these kinds of toxic bonds or toxic equity offerings, where theywould sell some stock at a buck a share, but then they would issuewarrants for a similar number of shares if the stock went up above$1.30 or something.One thing we’ve learned about shorting, though, is that the longeryou short, the better the chance that something unexpectedly goodcan happen.
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JA: What sort of screen do you use to find margin of safety in a shortsituation?ZA: We have a screen that basically tells us which companies are runningon fumes when it comes to cash flow. You’ve probably heard thisanalogy before, but cash flow is oxygen for the organisms we know ascorporations. Businesses have to have positive cash flow to live, andanytime a company is burning a significant amount of cash, particularly if they don’t have very much left in the bank, then they’re goingto eventually die of cash asphyxiation.Only two things can happen with a company that’s burning cashand [whose] business is not working. They’re either going to be ableto raise more capital, which usually means the shareholders aregoing to be massively diluted, which is good for the shorts, or they’renot going to be able to raise additional capital, which means it’s goingto be good for the shorts, because the company then goes to zero.I’ve been amazed at how many ways there are in the moderncapital markets for these companies to try and get more capital andstay alive another quarter. So that’s why we never try to hold themto zero anymore.You know? As soon as they—we look at shorting as an IRR game.We try to maximize our annualized return. So basically if we’re shorta stock and the thing takes a 30 percent dive, you know, in six weeksor eight weeks, we typically are gone.We never invest based on ideas that are kicked out by a mechanical screen. There’s always a very, very intense qualitative reviewthat goes along with it. The screens are just designed to kick out candidates, nothing more.
INTERVIEW WITH MOHNISH PABRAIThis section is an interview with a hedge fund manager who focuses onBuffett-style investments. Mohnish Pabrai is manager of Pabrai Investmentsand also a frequent contributor to RealMoney.com and TheStreet.com.JA: Give me a little background on yourself and how you went fromthe IT services business to Buffett-style investing and the hedgefund business.MP: You know, first of all, I cringe whenever anyone says hedge fund, but—JA: Why is that?
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MP: Well, I think the connotation is that [the fund is] in some way hedging,leveraging, shorting, or delving into derivatives. The fund does none ofthose things, so basically a better description of it is a private mutualfund or a private investment partnership. That’s just semantics, but people just short-form all private investment partnerships as hedge funds.JA: Did Warren Buffett consider his partnership a hedge fund?MP: I was surprised when he talked about it recently. He basically said,“Well, you know, Charlie Munger and I ran a hedge fund of sorts.” Ithink he used that as a sort of short-form. But I think if you go backto the Buffett partnership letters, there’s no such term; it’s veryclearly a private investment partnership. Again, the style of that fundincluded either special situations or just great businesses at a discount. But all the action and all the money are in the workouts in special situations.JA: You mentioned in one of your letters that Laser Mortgage takes upintellectual energy. You know, it allows him to keep his hands dirty sohe doesn’t have to mess around with Berkshire’s $50 billion in thesesituations.MP: That’s right, and I think Munger’s exact quote was, “One hundred andseventy thousand employees and $150 billion of capital are inadequate to utilize that motor.” So we need all these other special situations to keep Warren amused. A few years back, there was a charityevent where they auctioned off his wallet, and he put a stock tip in thewallet, and the stock tip was First Industrial Realty, a REIT.JA: All right, so tell me how you got into all this.MP: I had an IT services company that I sold in ’98 and then got more intoinvesting and the fund business. My entry to investment funds wasvery accidental. I think when you learn about Buffett, it’s like peelingan onion. There are many layers that you have to go through beforeyou get to the essence, and I think I’m still not at the essence becauseall these nuances about management and so on are more difficult tograsp onto.The first layer for Buffett is that he just buys these great businesses at a discount to what they’re worth and holds them forever. Iwas very intrigued by that in the mid-’90s, and I thought, “OK, thisthing is pretty simple.” I love figuring businesses out.I was still running my IT services company at the time, and I had amillion dollars of cash with me in ’95. So I said, “I’m going to start
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investing this million in public markets, and I think it will do betterthan market indexes.” I wanted to find out how much better I could do.If you compound money at a healthy rate—let’s say 20 percent or 30percent a year—it grows pretty spectacularly. So I thought it’ll be justinteresting to see where this million ends up, and if I were to compound it [at] 26 percent and I ignored taxes, it would double everythree years.So I said, “Let’s play a 30-year game.” I was 30 years old at thetime, and I said, “Let’s see at 60 how close I can get to a billion.” Mythinking was that even if I missed it by 80 percent or 90 percent, that’dstill be fine.JA: That’s not bad, right.MP: So I started to spend about 15 or 20 hours a week doing investmentresearch and starting a concentrated portfolio—a few big bets, andthat did very well. I think from ’95 to 2000, I averaged 60 percent ayear. I would tell a bunch of friends, “Hey, I found this great business;you should buy the stock.” And these guys also made a lot of moneymaking some of these investments.In early ’99, a group of them approached me and said, “Look, youtell us stuff, and we sometimes act on it, sometimes don’t.” Theywanted to set up a fund for the friends, and they wanted me to manage it. So they said, “We’ll give you $100,000 each, pull together a million bucks, and you can manage that money. That way, we’re notdealing with stock tips and whatnot.” And I thought for me to manageanother pool of capital would be basically no work, because I wasalready doing the research for my own assets anyway.I said I would do it if they let me set it up in a format exactly like theBuffett partnership. I like those partnership rules—no fee until six percent and then one-fourth profit above that comes to me, three-fourthsto partners, no disclosure of holdings, and I like that format of writinga letter to partners and so on. They didn’t really care, so that’s how thefund got started. I was still running my business at the time, and it wasreally a part-time endeavor with a million dollars. In 2000, the businessgot sold, and in the fall of 2000, I went full-time into running the funds.I have a rule that if on Monday morning, I’m not fired up to go towork, then I do two things. One is I don’t go to work, and the secondis I hit the reset button on my life. So in early ’99, I was getting somuch more ingrained into Buffett and whatnot, and with declininginterest in IT services, that I didn’t feel like going to work. So I started
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a search to bring in a CEO [for the IT firm], and I actually then appliedfor a job with Buffett to learn from him. I got turned down.JA: Did you go out to meet Buffett?MP: No, no, I just sent him a letter with a résumé, and he sent me aresponse in a week saying, “Look, I work alone, and the kind of position you seek doesn’t exist at Berkshire.” So he says, “Good luck reorganizing your life; I’m not the answer.”I was very disappointed when I got the letter, but after I got it, afriend said, “Look, why don’t you set up your own fund and get theCEO search going?” I never thought of the fund as being a full-timevocation; I thought it’ll be something on the side. By November ’99,the CEO I brought in had started at the company, and then I think inearly 2000, he said that he got a phone call from someone who wantedto buy the business. So now the buyer was looking at this new CEO ascontinued new management—not me, which was awesome. So thenwe did a transaction, this person stayed on, and they didn’t even talkto me about any sort of employment contract. In hindsight, just dumbluck worked very well.In the fall of 2000, the fund had about two and a half or three million [dollars] in assets, and I really wanted to spend full-time on justthe investment funds. At that time, I thought, “You know, let’s runthis for at least 13 years and see how close we can get to the Buffettpartnership.”There were two or three nuances. One is that he went from$100,000 to $100 million in 13 years without spending much time raising money, and he had a 29-percent-a-year return. Both of them werespectacular, so I said, “I just want to see how close I can get to bothbenchmarks.” The fund rules won’t allow you to advertise or solicit oranything, so I was just curious to find out if you just sort of put yourhead down and run the fund, will your partners actually send youmoney and will they refer you to others? On both counts, it’s workedout far better than I thought.The way