G&D:
Do you feel like you have certain circles of competence, maybe in technology
companies, having started out as an engineer?
MP: You know, one thing that
has benefited me greatly in investing was what I learned during my childhood.
My father was an entrepreneur and he must have started, grown, and
bankrupted at least 15 different companies in 15 different industries over his
career. He had a jewelry manufacturing operation, he manufactured high-end
audio speakers for Phillips, serviced and repaired high-end Japanese tape
recorders, started a radio station, made a movie, had a handyman services
company, an insurance brokerage, on and on and on… He was really good at
figuring out opportunities, even in fields that were brand new to him. He was
exceptional at starting and getting these businesses going, but he was always
overly optimistic and highly levered. Then the first large storm would hit and
the business would disappear. Then we’d be back to zero because my parents were
very bad financial planners and we’d have no money for rent or groceries. Yet,
somehow, he’d start another business again. My father used to say you could put
him naked on a rock with nothing and he’d start a business. Starting at the age
of 11 or 12, my brother and I used to be like my father’s Board of Directors.
Eventually whatever company he was running at the time would be in trouble.
He’d sit down with us and we had to figure out how to make it run for one more
day. Then the next night we’d figure out how to make it run for one more day,
and then for one more day… Around age 16, he started taking me on sales calls
with him. I am still amazed he did that. By the time I was 18, I had finished
many MBAs. I had learned plenty about business they’ll never teach you in
business school. One big advantage I gained from all this is I can
understand businesses really well. I can crack business models. I can crack
them on a wide range of industries, and I can do it really fast. I can look at
a business and pretty quickly get my bearings on its basic economics and how it
works and all that. But I can still get some investments wrong, because that's
not where the investing results start and end. You need to think fast and you
need to think slow. On the thinking slow, there are a lot of humans better than
me. I have very good skills on one side, but I have to get a lot better on the
other side, and that's what makes it fun. There's still a lot of learning for
me to do on the thinking slow side. In general, it is really critical to be
right in the center of your circle of competence; you don’t want to be near the
edges or, God forbid, past the edge. If there are any things that are fuzzy for
you, move on. We’ve got 50,000 stocks globally. Ideas are going to keep coming.
If you don't buy one particular stock, you're still going to get rich. It
doesn't matter. There's an unlimited supply of ideas.
G&D:
Can you talk in more detail about your investment philosophy, which you said
you modeled on Buffett’s and Munger’s own investment strategy?
MP: I
think investing is pretty basic. The core principles will never change. We’re putting
out cash today with the goal of getting more cash in the future. 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? How long is it
going to take to get those two in the bush?” That's really what investing is.
At the core, investing is straightforward. It's simple, but it's not easy. It's
simple because we’re just trying to figure out the future trajectory of a given
business. But it’s not easy, because figuring out the future trajectory of any
given business is really, really hard to do, even for the most simple
businesses. There are so many factors that can affect that trajectory. 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. I want to make bets that are
as nobrainer as possible, with as few variables involved as possible. So
although figuring out the future cash flows of a given business is a difficult
exercise, we can do some hacks to simplify the problem for us. For example, in
2003 I came across this steel company called IPSCO. IPSCO was interesting
because the stock was about $ $45 a share. They had $15 a share in cash, no
debt, and they publicly stated that their free cash flow was going to be $15 a
year for the next two years. This cash flow was contractually locked in from
their customers. Basically, 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. Now this was a
widely cyclical industry, so it was possible that after two years earnings
would be negative. But it was more likely, that earnings would be positive. I
said
"Okay, I don't know what
this company is worth. I'm just going to make a bet, keep it for two years, and
see what happens." That's a hack. I never ever figured out the intrinsic
value of IPSCO. 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.
G&D:
Do you have any recent investments similar to IPSCO?
MP: There
is a company called GrafTech that recently showed up on my radar. It’s similar
to IPSCO in many ways. 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?
GrafTech makes ultra-highperformance electrodes, which go into electric arc
furnaces that are used in mini-mills to make steel. Nucor, for example, is a
customer. There are two ways to make steel: you can either make it with iron in
a blast furnace or you can melt scrap in an electric arc furnace. To melt the
scrap, you need these graphite electrodes able to withstand the 2,000- or 3,000-degree
heat in the furnace. GrafTech makes these electrodes. There are only three or
four other manufacturers of these electrodes in the world. It takes three to
five years to construct a new ultra-highperformance electrode manufacturing
facility for greenfield expansion, so supply is very constrained. On top of
this, GrafTech is the only manufacturer in the world that is
backward-integrated. There is a very critical raw material required to make
these electrodes called needle coke and, again, there are just three or four
manufacturers of needle coke in the world. It's a byproduct of refining
petroleum; for example, ConocoPhillips is a big supplier of needle coke.
GrafTech is the only electrode manufacturer which owns a large needle coke
facility. It takes a long time to construct a new needle coke facility, maybe
five years or more. To sum up, there are number of factors in this industry
that make it challenging to instantaneously raise capacity. In 2018, prices
for these electrodes went crazy. Historically, they were $2- 3,000, maybe
$4,000, a ton. Last year, they went all the way to $25,000 or $35,000 a ton.
They just went bonkers. Of course, all the electrode manufacturers reaped
incredible profits. These electrodes represent only 3% to 5% of the total cost
of making steel. It's a small part, but it's a critical one. The chemistry
of these electrodes is very important, and so is the consistency of the
supplier. GrafTech went to their customers and said "Hey, these electrode
prices are going crazy, it's hard to get supply. Do you want to sign a contract
with us where we'll guarantee the supply and the price for the next three to
five years?” All kinds of customers took them up on that. As a result, 70% of
their production for the next several years is already sold, at a known margin
and a known selling price. These are lockedin, take-or-pay contracts.
Unless the customers go bankrupt, these are enforceable contracts. Furthermore,
they're spread across hundreds of customers, so the revenue stream is very diversified.
If you look at that 70% of revenue which is locked-in over the next several
years, it covers the market cap. It’s IPSCO 2.0. Now it's not coming in two
years because it's not 2004 – it's coming in five years. But such is life;
that's still okay. The other 30% of production is sold on the spot market. This
gives you a variation on what can happen. If electrode prices go crazy again,
they will make super profits. They've only sold the production where they know
what their costs are. No other ultra-highperformance electrode manufacturer can
offer their customers these types of contracts because they don't have control
of the raw material, so they don't know what their cost of raw materials is
going to be three years from now. GrafTech is the only manufacturer that can
offer this. From my point of view, it's the same thing as IPSCO. Who knows
what's going to happen here? I certainly don't. But why do these opportunities
exist in the first place? It’s because markets hate uncertainty. The market,
just like me, has no idea what the other 30% of production is worth. And Mr.
Market has no idea what cash flows look like for 100% of production after five
years. But we've got the downside covered, so we just sit on it. If at some
point we get a deal done with China, we get a deal done with the rest of the
world, if the world starts humming again, maybe things go crazy. But maybe none
of that happens and we get our money back. There’s a wide range of outcomes,
but virtually all are acceptable.
G&D:
How do you find opportunities such as IPSCO or GrafTech? What’ does your
process look like?
MP: I
depend on the readers of Graham & Doddsville! Hopefully they can Google me
and find my email address, and can you please put down that I am in desperate
need of their great ideas. There's a fan of Mohnish in Canada who sent me the
full write-up and thesis on GrafTech. All I had to do was to have mastery of
the English language, and thankfully the education system did teach me that. I
read it and I said "Okay, let's verify the facts." And the facts all
checked out. So, many people keep sending different ideas. I’m going
through Value Line every week, too, and some stuff comes in that way. I’ll read
Graham and Doddsville, I’ll look at Value Investor’s Club, Sum Zero, the usual
suspects. I’ll look at DATAROMA to see what other people are buying. There are
a lot of places to find ideas.
G&D:
You came to investing because you wanted to compound, but it seems that in
your portfolio you don't tend to have a lot of compounders. Is that a fair way
of looking at it?
MP:
That's a really good question. I am hoping that when I grow up, I can invest in
the compounders. The problem is that out of 100 businesses, maybe two or three
of them are good. Most of them are crap. When we look at these compounders,
especially the “obvious” compounders, everyone else can see them too. Is
MasterCard a compounder? Yeah. But what's the multiple? I can't even look. Investing
is not about buying great businesses, it’s about making great investments.
A great compounder may not be a great investment. Look at Coca-Cola. If
you bought it in 2000 and you held it until 2015, you had a pathetic return
because it went from 40-plus times earnings to 14 times earnings. And 15 years
is a long enough time to call yourself a long-term investor. At the end of the
day, price matters. I wish I can get better at this. I think many times
companies that look expensive are actually cheap. It's all a matter of the
future cash flows. But I am such a cheapskate, as you saw with IPSCO and
GrafTech. Should I buy GrafTech or should I take a flier on MasterCard?
GrafTech or Amazon? Every once in a while, you can get a compounder that’s like
a diamond in the rough; people can't see that it's a diamond, but it is. Every
once in a while, that happens with me. Those are the ones a cheapskate like me
can buy.
G&D:
How do you think about risk and portfolio concentration?
MP:
My portfolio is very concentrated. By the time you get to the sixth or seventh
name, we are talking about 80% to 90% of our assets. Yet, everything is
probabilistic. There aren’t any sure bets in investing; the best we can do is
just put the odds very heavily in our favor. That’s one good reason not to make
something like GrafTech 100% of your portfolio. But I think if you had
something like GrafTech, someone like Charlie Munger would say if you had two
other positions, you'll be fine. In fact, Charlie would probably say that if
you were 1/3 Berkshire, 1/3 a compounder like Costco, and 1/3 GrafTech, that's
probably okay.
G&D:
Do you use any leverage in your portfolio?
MP:
No. Leverage is a very bad idea, and I’ll tell you why. When I met Buffett for
lunch in 2008, I asked him a question: "What ever happened to Rick
Guerin?" Rick was one of the original Superinvestors of
Graham-and-Doddsville. Warren said that he and Charlie always knew they were
going to get very rich, and they were not in a hurry. He said Rick was in a
hurry. When the stock market crashed in 1973- 1974, it was down 60% and, if the
market is down 60%, there are stocks that are down 90%, 95%. Because auction-driven
markets are not rational, the lowest price a stock can trade at is one cent,
regardless of the economics of the business. Instantaneously, it can trade at
any price. In 1974, Rick got margin calls, and Warren bought Rick’s Berkshire
holdings from him at $40 a share. Each of those shares is worth $300,000 right
now, but Rick was forced to sell them to Buffett at $40, and he didn’t get the
chance to play out his hand. By the way, I have since gotten to know Rick
Guerin. He is a good friend and a fantastic human being and has done very well
with his compounding endeavors. A small capital base, a long runway and a good
compounding rate can do wonders. And I should add that Rick’s recollection of
these 1970s events differs from Warren. When I look back at the Buffett lunch,
if the only lesson I got from it was this conversation, it was well worth it. I
was already not interested in leverage before I went for the lunch. After God
himself told me this story, I said "We're never going to do that." So,
Pabrai Funds doesn't use leverage, and I'm not going to take a stock like
GrafTech and make some supposition that auction-driven markets can act in a
certain band. They can do whatever they want, instantaneously. Just look at
Long-Term Capital Management. There are a lot of history lessons out there. No
leverage, please. I know that's blasphemy in private equity, but I think one
can have a very good and wealthy life without leverage. Same thing with
shorting, it’s just dumb. Maximum upside is a double. Maximum downside is
bankruptcy. What kind of stupid bet is that? I look at the Forbes 400 list and
I don’t see any short-sellers on it. Someone like Jim Chanos, who’s really
good, will tell his clients “Listen, the market was up 10% last year and I was
down 6%.” And he's doing flips because he did so well, because he beat the
market by four percent. That's how the scorecard is kept by shortsellers.
Market is up 15%, I'm down 9%, you should be so grateful; and that's actually a
really good feat for shortsellers. Shorting is one of the dumbest things you
can do.
G&D:
Can you talk about your international exposure? Recently, you were owning only
one US stock.
MP:
Now we have three, but one of those is Chrysler, which is technically European.
The other two are GrafTech and Micron Technology. Yet, as Charlie says, go fish
were the fish are. I feel like the U.S. fishpond has been pretty depleted, so
I’ve gone to countries where I think the ponds are a little more wellstocked
with fish. We have significant exposure in India. Recently, I’ve been making
trips to South Korea and to Turkey. When the Turkish Lira collapsed and the
ship was going down, I booked a flight to Istanbul. Just as everyone was
exiting, I decided, "Let's go take a look." By the way, the tea
was really good – and the bargains in the stock market are awesome. One of the
best bets I have is in Turkey. I won’t talk about it here because I’m still
buying, but we have massive upside potential there with a pretty muted
downside. Unfortunately we aren’t able to put much capital into it. South
Korea is very interesting as well. Just look at the KOSPI index: 30 years ago,
it was at 1,000, and now it’s at 2,000. It’s kind of like if the Dow was at
3,000 today. But in fact, 30 years ago there wasn’t a South Korean
civilization like the one today. It’s been a miracle. The other thing is that when
I went to Seoul, I talked to South Koreans and asked them: “Where do you put
your money? Do you buy stocks?” They said, “Are you stupid? No. Stocks only go
down.” They buy apartments because prices have doubled in the last four years.
We have some bets in South Korea, and I like those too. Yet honestly, with the
South Korean market, I think if you just bought the index, you could do quite
well. The entire market cap of the country is less than Microsoft or Google or
Apple. You can just buy the whole country for less than Microsoft.
G&D:
One issue with South Korea is corporate governance and that not all
shareholders are treated equally. How do you get comfortable with that?
MP:
The companies we bought don’t have those issues. I screened those out. We have
rock-star governance. They listen to me, what a concept! I went to them and
said, "Listen, you guys control the company and it's your company. But how
about doing X?" Guess what? A few months later, they're doing X.
Hallelujah! I didn't even twist their arm.
G&D:
How much does the management team factor into your decision making?
MP: I
think management is incredibly important. I’ve been burned many times when I
didn't pay enough attention to that. Businesses, as I already told you, are
very fragile. Most of them don't survive very long. Leadership, both depth of
leadership as well as quality of leadership, matters a huge amount. The Fiat
Chrysler bet I made was a very heavy bet on Sergio Marchionne. You could buy
the whole thing for $5 billion. Most of Ferrari, which is now a $38 billion
market cap was buried inside Fiat Chrysler. But even after we got many times
our money back, I kept it because I realized that, my God, there’s an incredible
capital allocator at the helm, who really understands how to create value. When
you run into those kinds of people, you really want to hang on. Those are very
unusual. Then, on the other hand, I had an investment in a company in China
which I just completely exited. During the entire time I owned the company, I
had no idea who ran it. We put about $21 million into it and got $100+ million
four years later, and still left a lot of money on the table. I still don’t
know who ran the company. But it’s one of the widest moat companies one can
ever think of. It’s called Kweichow Moutai, and they manufacture a branded
Chinese liquor. None of us can drink it – we can't handle it because it’s so
strong. It'd be like drinking gasoline. Still, it’s incredibly expensive and
seen as a luxury. You've got a product that I can't imagine costs more than $5
a bottle to produce, being sold for over $150 a bottle. Globally, 50% of all
the liquor sold at more than $150 a bottle is Moutai. It has the greatest
market cap of any liquor company on the planet. About four years ago, when
I bought it, the Communist Party was cracking down on corruption… See, a lot of
Moutai was being consumed while government officials were meeting with private
people. What happened is people would take pictures, and if you were a
government guy and there was Moutai on the table when you were meeting anybody
for lunch, you just went straight to prison, because they said nothing good is
happening in that conversation with the Moutai open. Yet, the company just has
an unbelievable moat. I still don’t know who runs it, but it doesn’t matter. I
think the village idiot can run Moutai, and still mint money. All he has to do
is to jack up the price by 15% every January 1st. They can sell that stuff at
any price they want, and it’ll all be gone. They come up with a special edition
at $40,000 a bottle, and it’s gone in an hour.
G&D:
Did you trim your position with Fiat Chrysler at all after Sergio passed away?
MP:
No, I didn't. I recently started trimming. It was a really sad thing that
Sergio passed away. He was a one in a 100-year kind of manager. A very unusual
guy. He was quite confident about the future of the business. Still, he was
going to retire in a few months anyway, and his hand-picked successor is
running the place now. In fact, from then until now, the execution has been
great. I haven't seen Fiat Chrysler do stupid things after Sergio was gone. I
think he gave them a game plan for the next four years, and they're executing
very well on that plan. They have great owners, too. John Elkann and the
Agnelli family are exceptional stewards and they've been very fair to outside
shareholders. They've conducted themselves with the highest ethical standards.
No complaints. But I wish Sergio was still running the place.
G&D:
Do you have any parting advice for MBA students who are looking to get into the
investment world?
MP: I
think all of you should have an investing account. You should have a
three-stock portfolio, in honor of Charlie Munger. And those 3 stocks should
all have prospects of compounding capital north of 30% annualized. Not the stupid
$10 worth $13 stuff. It's okay if one of the three is GrafTech, I'll give you a
pass on that. But the other two need to be solid compounders that no one
understands or can figure out, and they need to be squarely in your circle of
competence. In terms of career, take the job you would take if you
weren’t getting paid. As Buffett says, go work for someone you like, admire,
and trust. Those are the jobs you want. Don’t take the job with the most
prestigious firm or offering the most money. Those are both very stupid things.
Lastly, remember that it’s all about length of runway and rate of return.
Starting capital is not that relevant. All of you will have plenty of income.
The key is to spend considerably less than you earn. There are two sides to getting
rich. One is spending less than you earn, the second is compounding.
