Mohnish Pabrai on Market Psychology

The annualized performance % numbers for The Pabrai Funds were off as I had been using an errored formula. There is no error in the NAV/unit numbers. Thankfully, the mistake understated annualized performance. Our actual annualized performance is better than previously reflected. This has been corrected. I’m sorry about this. The diligent reader will notice that PIF2 had a strong December and a very good 2001. I had not published our 1/1/01 NAV before, but it was $9.87/unit. For the year 2001, our gain was 57.1% before fees and expenses. Considering that all three indices were down, we had an exceptional year – one that is clearly unsustainable. When compared to 2001 mutual fund performance, PIF2 would have come in as the 5th best performing fund of the year including ALL mutual funds. Of the 4 funds ahead of us, 2 are country specific funds (Russia and South Korea). The data indicates that we’ve outperformed over 99.9% of mutual funds in 2001. As I’ve stated earlier, I think we’re fairly good, but not that good. Long term, I’d expect more funds to outperform The Pabrai Funds while we continue to outperform the indices and atleast 90% of fund managers. We achieved these returns with modest realized gains in 2001. Our portfolio continues to trade substantially below intrinsic. I’m not sure when Mr. Market will assign an appropriate value to the holdings, but I have some confidence that, for most positions, this will happen within 24 months. So, we have a few “Aces in the Hole.

A few years ago John Bogle wrote an outstanding book entitled Common Sense on Mutual Funds. John was the Chairman of Vanguard and an exceptionally brilliant and direct person. He’s an excellent writer as well. In the book, John gave a lot of good empirical data on the probabilities of the typical portfolio or fund manager beating the market. Over 85% of mutual and hedge funds lag the market after all fees and expenses. He further showed that the empirical data suggests that just 1 in 200 fund managers is able to beat the market by over an average of 3% annually. I am confident that the deeply rooted grounding in Buffett/Graham/Munger principles of investing that I have embraced will result is outperforming the three indices over the long haul. I don’t think a 25% annualized outperformance of these indices is a rational expectation for the Pabrai Funds. So, while the results of both funds have been exceptional so far, we should remember that: 1. The funds are just 26 months old. We can look back on the track record after 5+ years. 2. The stock market is nearly fully efficient. However, occasionally, Mr. Market will underprice a company or two substantially. Our investment style is very opportunistic. We play in the crevices of inefficiency within an otherwise nearly fully efficient market. Occasionally as I crawl through these crevices, I’m able to uncover great investment ideas. I’ll act upon a good idea when I see one.

category. Their cash flow may decline for a few quarters, but they’ll be back on track after that. 3. Companies whose prospects are not impaired at all by the events of 9/11. Of particular interest are those whose stock prices have taken a hit (e.g. Liquidation World). I wrote an article in Silicon India that explains Liquidation World’s business model. These are interesting to analyze as their market caps have dropped substantially with no change in their future cash flow. We have a few holdings in this category and I expect that Mr. Market will soon realize the folly of his pricing aberration on these businesses. 4. Companies whose prospects are improved as a result of the Greenspan rate cut and are indifferent to the Sept. 11 tragedy (e.g. Stewart Enterprises, Radiologix etc.) As the Silicon India article shows, both these companies have business models that largely insulate them from events like Sept. 11. Stewart is in the Funeral Services business and Radiologix runs stand-alone and outsourced medical x-ray and CAT scan facilities. Both businesses have substantial debt tied to the US prime rate. When Greenspan cut rates their respective earnings got a boost going forward. Both stocks should have rallied in the aftermath, but instead both fell as Mr. Market went into a depressed state. I have always enjoyed studying businesses like these because they are so resilient to what might be severely traumatic for many other businesses.

regardless of the relationship between IV and Market Value believing that eventually Intrinsic Value and Market Value would be in sync. The flaw is that if we are holding a business that the market is valuing at a significant premium to Intrinsic Value, then we are almost sure to see a drop back to Intrinsic Value. So in Q32000, I changed my modus operandi and decided that I will not hold equities at significant premiums to Intrinsic Value. Its unfortunate. This change will lead to us selling what are still great businesses due to Mr. Market’s mood swings. In addition there were a couple of events that give me some thought for concern. They are not big issues, but they are at the back of my mind. • DTPI did not have a big dot com client base, but their traditional clients were through Q22000 spending a lot of $$$ with DTPI because of the “dot com scare”. The Fortune 2000 was scared. As Q32000 came around and dot coms started to fold, these traditional companies have seen the pressure ease off from their shareholders and boards and some may curtail digital strategy spending. I see this as an issue, but not a big issue. • DTPI announced a major European acquisition in Summer 2000. Having run a “people business” I’m very skeptical of acquisitions in the space. It seems like a good match, but most acquisitions don’t work. DTPI has very talented managers. They may pull it off. Again an issue, but not a major one.