The Ten Commandments of Investment Management – Mohnish Pabrai


Here at Canadian Value Investors we are big fans of Mohnish Pabrai.

In October of 2018 Mohnish Pabrai gave a talk at Professor Arvind Navaratnam’s class about the Ten Commandments of Investment Management. This is the first time Mohnish has given this talk where he outlined his money management principles. He notes that most participants in the investment management business violate these commandments.

We have summarized his talk to give you a quick reference point to review.

In October of 2018 Mohnish Pabrai gave a talk at Professor Arvind Navaratnam’s class about the Ten Commandments of Investment Management. This is the first time Mohnish has given this talk where he outlined his money management principles. He notes that most participants in the investment management business violate these commandments.

We have summarized his talk to give you a quick reference point to review.


Commandment One: Thou shall not skim off the top

·Skimming is taking some percentage of fees as a fixed fee and in the case of hedge funds typically 1-2% off the top and an additional performance fee.

·Two of the original practitioners were Warren Buffett and Charlie Munger, who practiced the art with no fees off the top. Buffett once he merged his partnerships was 0-6-25 where he took no fees off the top, and instead received 25% of any return over a 6% annual return hurdle. Mohnish believes Charlie Munger was 1/3 of return over 0% but it was a special kind of operation.

·Practice the art with your own assets. With the power of compounding even a small amount of money will become significant over a few years. If you are compounding at anything north of 15-20-25% which you should be able to do with small amounts of capital, your money will be doubling every 4-7 years. This then gives you the ability to in effect live off that base while the assets are growing.

Commandment Two: Thou shall not have an investing team

·An investing team is in many ways an oxymoron. One of the basic reasons is that any two humans are going to have different circle of confidences. If you have an analyst on your team that is very bright and comes up with some investment ideas, you may reject them simply because you just have a different circle of confidence which is not doing justice to the analyst.

·Secondly, you do not need that many stocks in a portfolio. In a year you have plenty of time to research stocks and find two-three-four that fit the bill.

·Finally, the investment analysis is the fun part of the job.

Commandment Three: Thou shall accept that thou shall be wrong at least 1/3 of the time

·This is from John Templeton. The investment process is one where we are trying to extrapolate the future of many business and by definition that is a very inexact science. There are many factors that are going to affect business 5-10 years into the future, it is fraught with difficulties and a high error rate.

·Let’s say a portfolio is made up of ten stocks. There are at least four of them that will not behave in the future in the way I expect. It doesn’t mean 40% of the time you will lose money; it means 40% of the time you will not make as much as you thought, lose money, flatline, or do better.

·This is an exercise in humility and one has to always accept the fact that the future trajectory and predicting that trajectory is an inexact science and you have to be humble enough that even the highest conviction ideas may or may not get to where we expect them to get to.

Commandment Four: Thou shall look for hidden P/E of 1 stocks

·Say there are around 50,000 publicly traded companies globally, and I set up a screen for all companies that trade at 40x earnings or less. The odds are that there would be tens of thousands of business that would fit that screen. Same with 30-20-10. As you keep decreasing that noose to a very low P/E, some companies will still get through. What you want to look for are the hidden P/E of 1, which do not show up on the screen.

·They can be a P/E of 1 based on future earnings but not today’s earnings. For example, when Mohnish bought Fiat Chrysler it was trading at less than $5 a share and the Company had forecasted that by 2018 they would be making about $5 a share. As we came into 2018, they had spun off Ferrarij but if you include that they exceeded that number. The P/E of 1 materialized in 2018 where the investment increased by 7-8x in that time.

·Example 2: A steel company was trading at 3x earnings, but 1/3 of the market cap was in cash and if you adjusted for that they were trading at 2x earnings, and the earnings in the next two years were expected to increase in two years. There was no visibility of earnings beyond two years and it was possible that earnings would just fall off a cliff. But the thinking is if you hold the stock for two years you get all of your money back and it had to trade for something based on the asset base. One year after purchase the Company announced they had one more year of visibility and earnings were going to continue the same as the last. Two years in someone then bought the company creating a 4x return in less than two years.

·In the last 19 years that I have been running Pabrai Funds, finding P/E of 1 has happened at least 6-7 times. He notes he uses ValueLine. Businesses with P/Es of 2 are quite common and are usually good business to avoid but every once in awhile there is a gem.

·Another example was Stewart Enterprises, a funeral services business. Out of all industry categorization, funeral homes have the lowest rate of business failures. When you have a death in the family most typically don’t shop around and defer to the family connection. Most do not negotiate on the phone and try to find the low bid unless you hated that particular relative.

Commandment Five: Thou shall never use Excel

·If you cannot figure it out in your head, it’s too hard. The investment process is simple.

·For example. A company with a market cap of a billion dollars and trading at a P/E of 20x, so trailing earnings are $50M (and let’s assume those are owner earnings that can be withdrawn to keep it simple). One can only make a judgement of whether it is over or undervalued based on the expected cash flows of the next 10-20 years. If it is trading at 20x and you have high conviction that earnings are going to grow at 10-15% a year for several years, you can run the numbers. $50à$55à etc and discount back. If you use a 20% discount rate that $55M next year is only worth only ~$42M as you are not getting it today. If you discount all cash flows it is very hard to get to one billion dollars. You can lower your discount rate but it is still not a no brainer, especially when you should expect to be wrong at least 1/3 of the time. To get around this, you make the math really simple and go back to a P/E of 1. The math is simple.

·If you find yourself reaching for Excel you take a pass: Apple example – Mohnish assumes a 26% discount rate (at least for this example - Mohnish’ license plate is compound26). Apple is trading at 20x earnings and even if you assume a generous growth rate of 20% a year in bottom-line earnings for the next decade he cannot get to the price and can say no and move on immediately. We didn’t even need a calculator, nevermind Excel.

Commandment Six: Thou shall always have a rope to climb out of the deepest well

·In investing and in life you need a rope to climb out of deep wells.

·In the investment business you are going to have gyrations – periods where performance is great and where performance is not. In the financial crisis – Pabrai Funds from the peak in June 2007 from ~$600M to the bottom in March of 2009 the funds dropped between 65-70%. Going back to rule #1 – The base level required to earn a fee is $636 and the funds are worth only $200M, that is a very deep well. He needed a rope to climb out. He went on to violate rule #5 and fired up Excel. He put in prices for all the stocks in the portfolio and put the prices he thought they would all trade at in 2010 and 2011. When he added up the numbers they were over $600M, partly because he had control over the cells. As Steve Jobs’ demonstrated through is ability to distort reality – Mohnish focused on the 2010 and 2011 numbers when he would be back at the fee earning level and it worked. Every once in awhile he looks at the spreadsheet.

Commandment Seven: Thou shall be singularly focused like Arjuna

·There is an Indian epic about an archer named Arjuna. When he was being trained as an archer, one day his teacher told the class that they would have a practical test. The teacher set up a long pole in water and at the end of the pole he put a fish with blue eyes. He then asked his students to shoot the fish by looking in the water. [Abbreviated} –Finally it is Arjuna’s turn and he says he can see the center of the center of the eye of the fish. The teacher says shoot and Arjuna hits the eye of the fish.

·The lesson – We need to be focused like him. When you are looking at business with a P/E of 1, there are usually several clouds hanging over the business and there are always a lot of macro clouds (if not macro clouds then concerns). We have to focus on the business and only the business. To figure out the future of an economy is really hard, if not impossible to predict. We have to simplify the world and focus on the business and don’t focus on the noise. Mohnish notes that he just came back from a business trip in Istanbul and there was a lot of noise. If you look past the macro concerns there are a lot of opportunities.

·They key is to buy a good business at a fraction of liquidation value or a small fraction of future earnings. It makes it much easier to be right.

Commandment Eight: Thou shall never short a stock

·We don’t need to go long or short on Tesla. It is just in the too hard pile. For Mohnish, Tesla stock is there for pure entertainment purposes to watch from the front row seats instead of in the arena.

·#1 The timing can get very painful - Warren Buffett and Charlie Munger have noted that they have always been right on the stocks that they thought should be shorted but have always been wrong about the timing.

·#2 The math is against you  – The best you can do is double your money and the worst is you can go bankrupt. This is the opposite of what you want. There is no point in making bets where the highest upside is a double and the highest downside is that you are out of the game. “I shall go to my grave without ever having shorted a stock and I think you should do the same.”

Commandment Nine: Thou shall not be leveraged. Neither a lender nor a borrower be.

·Warren Buffet’s tweak is – neither a long-term lender or a short-term borrower be.

·You do not want to introduce leverage into your life. To finish first you have to first finish, where you want to get to play the game for a long time.

Commandment Ten: Thou shall be a shameless cloner

·Cloning is very good for your health.

·There are many smart people who are great investors. In many cases their portfolios are visible to us because it is required by law and so it is a great shortcut to look at what the highest conviction ideas of some very smart people.

·You can check which is tracking a bunch of investors and telling you what their highest conviction bets are.

·We have a full article on cloning here -


The Foundation: Circle of Confidence

Circle of confidence is not in the commandments but it is the baseline. The first filter has to be circle of confidence. If something is not in your circle of confidence it should immediately be dropped from consideration regardless of the price. We have to stick to our circle of confidence. Once we find something is within our circle of confidence then we can look at the P/Es of 1. Sometimes the P/Es of 1 make it easy to get something into the circle of confidence.

 For example – His previous investment where the next two years of earnings plus cash on hand equaled the market cap. He handicapped of just that statement being true and did not need to understand the business much beyond that. There was no debt and if this was true any fool can see there was still the plants, the management, and all of the pieces that will likely make some money in the future. I did not have to get into the weeds of how strong the moat was, rather just the resilience of the two years of cash flow more than anything else. If you get into these very low priced stocks it can make your life easier.


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