Equity investors endured some quick sledding in 2008, with the S&P 500 down over 39%. Though the hill was even more icy in 1931 (with the S&P down over 43%), this historic drop has left its mark on both the portfolios and investing habits of even the best investors.
Mohnish Pabrai, managing partner of Pabrai Investment Funds and author of The Dhandho Investor, is one such marked man. In his January letter to investors, Pabrai relayed that he was changing the size of his portfolio positions due to recent market foibles. In the past, Pabrai had sought to put 10% of a Fund’s assets into 10 investments. In practice, this was difficult to achieve, as market prices would move higher before the position was filled, some investments were too illiquid or thinly traded, or the market capitalizations of the target company were too small. Most often the Funds held 80% of their assets in 10 positions, with the remaining 20% invested in a handful of smaller positions. This strategy of concentration has served Pabrai well, and it coheres with the advice of his mentors Buffett and Munger, who counsel professionals to concentrate their investment portfolios.
However, Pabrai has now decided to size his normal positions at 5% of a Fund’s total assets. Strongly correlated positions will only warrant 2% of the portfolio, to prevent sector weakness from inordinately depressing annual results. In the rare case, perhaps every couple of years, Pabrai will size a position at 10%, but only “if seven moons line up.”
This is a significant change for a successful investor to make, and it contradicts the specific advice of two of his esteemed mentors, Buffett and Munger. And the primary reason for the change is “to temper volatility.”
At the risk of sounding disrespectful, I say turkey feathers (or choose your own animal excrement). As Pabrai himself acknowledges, this change will lower future returns for the Funds, though he assures that “we’ve given up a modest amount of the upside to gain a meaningful drop in volatility going forward.” Despite reassurances, the change runs directly contrary to his long-term investors’ interests. As Pabrai knows, volatility is a statistical device, and not a reliable proxy for risk. Volatility is the effect of Mr. Market’s manic-depressive behavior. Volatility is the intelligent investor’s best friend, for without volatility (particularly the depressive side of it), bargains would be less cheap.
The truth of the matter is that Pabrai has opted to allocate some funds from his best ten ideas to his second best ten ideas, in order to moderate the effect of any “mistakes” on his overall returns. This “solution” strikes me as far worse than volatility or mistakes. Even worse it suggests that Pabrai no longer fully appreciates the difference between his best idea and his twentieth best idea.
I don’t know if I quite agree with that assessment. As much as we can idealize taking an ultra-concentrated approach, during times like these, the volatility can kill a manager and their portfolio’s returns. Ideally, you should be able to sit out volatility and making a killing in a market like this, but when you’re a fund manager you have to face the confidence of your investors. If they start asking for redemptions, it’s going to force you to sell positions and force you to permanently lose money. In this case, volatility actually creates REAL risk which needs to be accounted for. Secondly though, to me I think it’s likely that Pabrai is also seeing just more opportunities to deploy capital in. The market has gotten a lot cheaper after all.
That’s true, Tariq, your investors may lose confidence and redeem (as some of Pabrai’s have), but that doesn’t justify selling from your best ideas to allocate funds to merely good ideas. If you have to sell at the low to pay redemptions, then the investors get what they wanted (cash instead of current holdings), and it doesn’t hurt the Fund at all, or Pabrai’s share. If your investors can’t stomach the volatility, then they shouldn’t have that money with you anyway (assuming of course that you ARE a capable investor whose long-term results beat the averages). If Pabrai lowers volatility (and returns) in order to keep investors in the Fund, then isn’t he acting in his own interest more than investors?
If Pabrai sees better opportunities, then he should sell out of marginally good positions and take the full stake in the new ‘best’ position. No shame in that; Buffett sold 50 cent dollars to buy 20 cent dollars. It’s a sign of the times.
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I totally agree with the fact that if investors cannot stomach volatility, they should not be investing. They should just buy an index and sleep well. Pabrai has a competitive advantage by running a concentrated portfolio. Now his returns are going to be closer to average.
“If your investors can’t stomach the volatility, then they shouldn’t have that money with you anyway (assuming of course that you ARE a capable investor whose long-term results beat the averages).”
You’re going off the “value investor true believer” deep end. Non-professionals who invest don’t have the discipline, experience, and mental fortitude that the pros have. To expect them to act the same during a draw-down as how they might imagine they’d act before (perhaps when they’re filling out their risk tolerance questionnaire) is to completely ignore psychology. Pabrai and money managers in general are not islands unto themselves, especially when they manage other people’s money.
Furthermore, where is your arbitrary line drawn? Why not disapprove of Pabrai not knowing the difference between his 5 best ideas and 5 next best ideas when he ran a 10 stock portfolio. Where and why do you draw the line and do you have any evidence to back it up besides “Graham and Buffett say so”?
“Non-professionals who invest don’t have the discipline, experience, and mental fortitude that the pros have. To expect them to act the same during a draw-down as how they might imagine they’d act before (perhaps when they’re filling out their risk tolerance questionnaire) is to completely ignore psychology.”
I’m not sure “professionals” (i.e., daily buy/sell market participants) are much better on average in discipline and fortitude, but true fiduciaries should consider it part of their job to test those qualities in their investors before those drawdowns, and educate them during. In my view, a large chunk of an investors’ returns will derive from these virtues, so any communications from the principal should do as much as it can to advance them. Sufficient transparency about the portfolio, its value, and the principal’s rationale should go a long way.
When a business is stupidly cheap, it is most likely that the buyer looks stupid before the market realizes it’s cheap. Every buyer who buys a publicly traded security will see its price decline (for a time), unless he is the ONE buyer who buys at the lowest tick. It will happen, the unknown is how one will respond.
“Furthermore, where is your arbitrary line drawn? Why not disapprove of Pabrai not knowing the difference between his 5 best ideas and 5 next best ideas when he ran a 10 stock portfolio.”
What some call arbitrary, I would call a matter of judgment. If the distance between your best idea and n-th idea is sufficiently large, then an investor makes the mistake by allocating to the n-th idea for the sake of diversification. If the distance between the two is unclear, one has a problem worthy of his utmost assiduity.
None of this should imply that one’s valuations or rankings can’t change over time. Research and opportunity will present alternatives anew.