Mohnish Pabrai on Margin of Safety

I believe that public equities as a group are overvalued today (and has been since the inception of the funds). The average US-based public company delivered an average annualized return of 12.45% during the 1954-94 period. One can expect a broad based index to deliver 10-13% over the long haul if stocks are fairly priced. With the overpriced market we find ourselves in, Warren Buffett expects stocks to deliver a 4-7% annualized return over the next 15 years. I fully agree with Buffett’s thesis. Thus it is clear that if we bought a basket of businesses at their intrinsic value, we’d expect the Pabrai Investment Funds to deliver a 10-13% annualized return before expenses – and lag the indices after expenses. If we bought this random basket at present prices, our returns would resemble Buffett’s 4-7% numbers over the next 10-15 years. But I’m not interested in the typical publicly traded company. I’m interested in the great ones. The problem is that the great ones are not a secret. Everyone knows they are great and their typical valuations are stratospheric. Indeed, bought at these valuations, these businesses would probably lag the 4-7% that the market is expected to deliver. 3. I have an internal threshold of making investments only where there is a big margin of safety and a very high probability of a 30% or higher annualized return.

The only exception to the 30% rule is “temporary placeholders” where the expected ROI is between 20-30%, but the margin of safety is even bigger (see point 6 below). How then can our 30% ROI threshold be met? How have we performed so well for the last few years? The answer lies in a few simple facts: Since public equities are overvalued as a group and great businesses are even worse investments at present prices, I’ve managed the funds since inception with a big focus on special situations. To give you some color, as I write this letter, PIF2 has 17 distinct businesses in the portfolio. About 88% of the portfolio is comprised of 10 businesses and the remaining 7 make up the remaining 12%. Our fate will be largely determined by the 10 companies that make up 88%. The only reason we have 17 vs. 10 is that assets have come into PIF2 at a very fast rate and positions that at one time represented 10% are now down to just 2-3%. We were unable to buy more as they had appreciated before new $$$ came in, but have not appreciated to the point of becoming candidates for sale. Of the 10 businesses, 3 are great businesses. However, all 10 were bought as special situations. The 3 great businesses had big clouds hanging over them when they were bought. However, applying Munger’s Latticework of Mental Models allowed me to see beyond the clouds. We’ve done very well on these three (two have appreciated over 80% in the last 8 months and one has appreciated about 25% in the last 4 months).

Since inception, I have almost always had more investment ideas than available investment dollars. That is a great situation, but again another one that I don’t expect to always be the case. As an example, I have no new investment ideas at this time. I have not had a new investment idea for some time now and while I’m confident great ideas will pop up on the radar in the future, I expect them to be far fewer than the past. 5. As we grow assets our universe of opportunities will shrink. We have already had a couple of situations where I was unable to buy the full position I wanted to buy before the price moved up. At $28 Million, our assets under management is a very modest size. I don’t see size as a big problem at this time, but I’d like investors to recognize that size does impact performance negatively. 6. Occasionally, I have made investments where the perceived ROI was expected to be 20-29%, but there is was a massive margin of safety. An example is a REIT investment we made that has an exceptional management team, a relatively high current dividend yield (even compared to other REITs) and selling at about 2/3 of its fair value. In that instance, there was a huge margin of safety and an expected 20% ROI. I viewed that investment as a “temporary placeholder” – until a better idea came along. Temporary placeholders have added to our returns in the past and will probably continue to do so in the future. At this time I have no new temporary placeholder ideas. 7.