We Study Billionaires - The Investor’s Podcast Network - TIP241: Value Investing w/ Mohnish Pabrai (Business Podcast)

Starting point is 00:00:00 You're listening to TIP. On today's show, we bring back one of the most requested guests we hear about from our audience, and that's Mr. Monish Pobri. As many people know, Monash is a value investor and avid scholar of the Benjamin Graham and Warren Buffett style of investing. Monish got his start as a successful tech entrepreneur in the 1980s, and after selling his business for a huge gain, he started his own Pobri investment fund in the late 1990s. He established his firm after the same principles that Buffett had for his partnership before acquiring Berkshire Hathaway. And nearly 20 years later, Monish continues to outperform and run his hedge fund.

Starting point is 00:00:38 So without further delay, we bring you the crowd favorite, the Dondo investor, Mr. Monish Pabri. You are listening to The Investors Podcast, where we study the financial markets and read the books that influence self-made billionaires the most. We keep you informed and prepared for the unexpected. Manish, welcome to The Investors Podcast. We are so honored to have you with us today. It's such a pleasure. It's been a while. And I love you guys. Love the work you guys do. Looking forward to our session together. Oh, Monish. Always awesome to have you here. And since we announced that you were coming back on our podcast just a few days ago, we had more than 100 people submit questions. So we have some very passionate listeners. In fact, we even had a listener from Sweden, Mattias, who was such a big fan of you. is that he wanted you to become the emperor of India. So I can comfortably say that you're definitely among good friends here.

Starting point is 00:01:45 But Monish, don't worry, we're not going to ask you 100 questions, but cover some of the most frequently asked ones and add a few of our own. We recorded this on the 25th of April, but it's going to be released on May 4th, 2019. And so for anybody that knows that date, they know that that's the same day as the Berkshire Hathaway annual shareholders meeting. And Monish, that brings me to my very first question. what are your plans for the Berkshire weekend? At about 5.30 in the morning on the 4th of May, I will be at the south entrance in line.

Starting point is 00:02:17 Hopefully the weather will cooperate to get into the Berkshire Hathaway meeting arena. I think they'll open those at 7 or so. I get a number of requests for people who want to meet in Omaha from all over the world, actually. Omaha is usually a pretty packed schedule. So I tell all of humanity to come to the south entrance at 5.30 a.m. on the 4th of May and usually there's a decent number of diehards who show up and we have a good time in the morning so if you're so inclined please feel free and would love to meet you Monash we recently had a great interview with professor Sanjibachi he talked about how he read

Starting point is 00:02:52 Warren Buffett's letters and how he learned about different topics from him for instance for share buyback what he would do is to put all the letters into one PDF and then simply search for, for instance, buyback, and then see how Buffett's approach changed over the years in his argumentation. Do you have a specific technique for reading Buffett's letters? I remember the first time I wrote to Warren, it was to get the annual letters. At that time, they were not on the net. I got a letter back from Debbie. Warren had signed it, but basically they sent the bound letters, but they also referred me to Larry Cunningham's book, the rearranged letters by subject. Buffett very strongly endorsed Larry's book, and that book is a godson for all of us,

Starting point is 00:03:38 because it is a lot of work to rearrange Buffett's thoughts in so many different letters by topic. And I have sent that book to a number of folks. In fact, in the last year, I sent it to a lot of Indian public company CEOs, and I said, look, anytime you're thinking about or get stupid thoughts like stock splits, issuing options, or any of those sort of things, just go to. to the relevant section and read it before you do that. I met Larry, I think a couple of weeks ago in Toronto. And I told him, Larry, the problem is you haven't updated that book in so many years. And we need an updated edition, which again, rearranges it by letters. But yeah, the other approach which Sanjay has taken, you know, put in a single PDF and search through it is as effective.

Starting point is 00:04:20 That works pretty well. And I do want to say that Sanjay runs a tremendous value investing course at one of India's best business schools and very few business schools on the planet, focus on value investing. Sanjay's course is excellent and he's doing some great work. And Stig, one of the most interesting things that happened to me in the last one year, about a year ago, Buffett posted all his annual meeting videos

Starting point is 00:04:44 going back to all the way to 1994 online. You know, the best things in life are free. One can go to Buffett.cnbc.com. All the annual meeting videos from 94 to 2018 are posted. Besides the videos, they've actually annotated and done a whole bunch of other stuff to them. What I have been doing is every day when I get ready, when I'm shaving and showering, et cetera,

Starting point is 00:05:08 I have a waterproof Bluetooth speaker. I play about 30 minutes of audio, and I started in 1994. For most days, those 30 minutes are the most productive 30 minutes of the day. Usually the learning in those 30 minutes far exceeds what happens in the rest of the day. So it's been really good. It's like kind of like, you know, you go on a car ride,

Starting point is 00:05:30 every day where Warren and Charlie are your carpool buddies and they're talking for 30 minutes in the car. Many times I've had to play back certain sections because it was just so filled with priceless wisdom. One of the differences between Buffett's letters and the annual meeting videos is that the letters are exceptional but they're premeditated. So Buffett starts writing the letters in uh like he starts in November and he said in March, they kind of snatch it away from him. He decides what topics he wants to focus on in the letters. In the videos, they have no idea what questions come at them. And they get this very wide range of questions. In many cases, they convert lemon questions into lemonade answers, which is great. But we hear thoughts on subjects that I'm sure they would

Starting point is 00:06:25 never, ever talk about because they haven't prepared. I have a time. I have a attended every meeting since 1998. Even though I've attended every meeting since 98, I have learned so much. So now I am in the year 2013. In the next two, three days, I'll be finished with the year 2013, and I have now 2014 to 2018 to listen to. But somebody recently sent me a PDF, I think it's a 3,000 page PDF, of the transcript of all these meetings in a PDF file. What I was intending to do is after I finished all the audio through 2018, I'm going to go and read the entire 3,000 page PDF because we are basically taking in the data in two different formats into our brain. One is we're taking it through our audio and the second is we're taking it through reading. Monash, you're well

Starting point is 00:07:16 known for being a very humble investor. And one of the things you're often talking about is this idea of cloning your investment approach after great investors like Warren Buffett. So I'm curious, Who else have you modeled your approach after and what were some of those guidelines? When we latch on to certain mental models, we get a huge advantage in life versus other people who might be much smarter than us, who might be even much harder working than us. We will end up doing a lot better than them. So mental models in general, especially the right mental models, carry a lot of freight to make us a lot more effective than we would be otherwise. And a lot of these mental models, someone else has already figured them out. we have to do is reach out and grab them. They're on a shelf. You just decide, hey, I'll take this one.

Starting point is 00:08:05 Cloning is a very unusual mental model and it is one of the most powerful mental models. And just to go back, because I think that cloning has had an impact on me, significant impact for more than 30 years. One of the first mental models, even before I heard of Warden Charlie, I adopted cloning. There was a McKinsey consultant, Tom Peters, in the 70s and 80s, and he wrote a bunch of best-selling books, you know, Passion for Excellence and Search for Excellence and so on. In one of those books, he had this story of this California gas station, two gas stations, actually. That story is just etched to my brain.

Starting point is 00:08:39 It had a huge impact because I actually didn't believe the story. What Tom Peter said was there were these two gas stations that were on this busy intersection in California, you know, diagonal from each other. And they both were self-serve and you go in and get your gas. In one of the gas stations, the owner would come out every so often, maybe every hour or so, pick a random car and tell the owner, listen, sit in the car, and I'm going to give you a full service, which means I'll pump the gas, I'll clean your windshield, I'll check your oil and so on. No additional charge, just extra service.

Starting point is 00:09:12 His competitor, who was diagonal across the street, could see this very clearly. He could repeatedly see this going on, and his perspective was, well, this is really dumb, Because if you can't provide the service for everyone, why do it for anyone? And the second is you actually cannot provide the service for everyone because it will be too expensive and then you'd lose money and so on. So the competitor never flown his competitor's approach on customer service. Of course, we know over time the guy providing the random greater service was getting more business. More and more of the cars went to him versus his competitor. even after losing gas station owners saw that his business went down and he knew the reason the business went down, he still did not make any change in behavior.

Starting point is 00:10:02 And I found this really puzzling. And then Tom Peter said that you can sit down with your most fierce direct competitors and just tell them all your trade secrets. And what will happen is they will listen to you, but they won't make any change and they won't follow any of those things. secrets. You know, when I read that, I said, well, Tom Peters are stupid. Okay, this is not how the world works. If I tell somebody how to make more money, of course, they're going to listen. And so what I decided to do was I decided to do things after I read this. I said, you know, when I started a business, I said, first of all, when I see someone else doing something smart, I am going to force myself to copy that. And the second is, I am going to carefully

Starting point is 00:10:45 observe this idea that Tom Peters has that humans are bad at cloning to prove him wrong. And what actually happened over the last three decades is I found that Tom Peters is absolutely right. Humans have a lot of difficulty with cloning. And I still don't know why. I have not yet figured out why. Something in our genetic makeup or our history as humans makes us have difficulty with cloning. But the second thing that I did, which is I forced myself to copy things that were exceptional. And what I found is for a small sliver of humans, maybe one or two percent of humans, they will be good cloners. For this small sliver of humans, they get a massive advantage over humanity. And so I have been a cloner for 30 years, and I have cloned small things,

Starting point is 00:11:32 and I've cloned big things, and it's been a huge advantage. So, for example, we would not have a Walmart if Sam Walton was not a cloner. We would not have a microschooling. We would not have a Microsoft if Bill Gates was not a cloner. We would not have an Apple if Steve Jobs was not willing to lift from Xerox Park, etc. So cloners are all over the place. They are everywhere, but they are a very small sliver of humanity. So I think that, and of course, you know, my whole investment philosophy was cloned for Warren and Charlie. I would be a useless third-rate investor if I did not just pick up their principles and copy them. And I've not just done that.

Starting point is 00:12:14 I've actually looked at great investors. I have shamelessly copied those stock picks. It's made me wealthier. And those guys still continue to be my friends. What a wonderful world. What an amazing world. Why do you think that you're a good cloner? You said so many people have problems doing that because it seems so counterintuitive.

Starting point is 00:12:37 What is it specifically about your brain that's wired that you can go in and do that? It's something I have actually not been able to figure out. All I have been able to figure out is that Tom Peters is correct. So many young investment managers or aspiring investment managers come to me and they want advice on setting up their investment fund, etc. And I tell them, listen, clone the Buffett fee structure, the 0625, clone the fee structure. Don't question it. Don't have intellectual debates with me about it.

Starting point is 00:13:08 Just clone it. Six months later or a year later, I look at the operation. And it's a one and 20 or a two and 20. So then I meet the guy. I said, listen, didn't I tell you to do this? Yes, but Monish, you don't understand. You know, I need the cash flow. I said, you have less than 10 million in assets.

Starting point is 00:13:27 The 1% is not that big on amount. You know, you can live without it. It's not like you have a billion dollars and you're getting 1% on it. It's like you have $5 million or $7 million or $3 million. It's an irrelevant number. And what is happening is by having that structure, you have taken away comparative advantage and some people who would have invested with you will now not invest with you.

Starting point is 00:13:50 So when I gave you this piece of advice, it wasn't Moneish advice. This is coming from Buffett. Even after the second conversation, there is no change. And even after the third conversation, there is no change. So these are very good, high-quality people. I like them. And that's just the way it is. And Tom Peters forever will be right. That's so interesting. I remember this story you were telling the last time you on the podcast that you had a young analyst coming to you and said, you need to tell me which the best

Starting point is 00:14:17 railroad stag is. And you said, that's just not interesting. He was like, that's the only thing I cover. I need one. This is so interesting. It's kind of like the financial sector is wrecked against thinking freely in a way. Let's take a quick break and hear from today's sponsors. All right. I want you guys to imagine spending three days. in Oslo at the height of the summer. You've got long days of daylight, incredible food, floating saunas on the Oslo Fjord, and every conversation you have is with people who are actually shaping the future. That's what the Oslo Freedom Forum is. From June 1st through the 3rd, 2026, the Oslo Freedom Forum is entering its 18th year bringing together activists, technologists, journalists,

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Starting point is 00:18:28 Go to Shopify.com slash WSB. That's Shopify. dot com slash WSB. All right. Back to the show. My next question is about how you evaluate your own investment process. For instance, say that you think there is a 70% chance or probability of a catalyst to happen which will significantly influence the price and the value of the stock.

Starting point is 00:18:54 Now, you don't want to fall into the trap of resulting and then only look at the result, like what happened, because after all, if there's 70% probability, there's still a 30% probability that it's not going to incur. Keep in that in mind, how do you evaluate your own decisions and your own results? You know, you can segment investments into kind of two different classes. Value investing, let's say broadly is in two different buckets. One is a company is trading at a very significant discount what it's worth. So you're buying a pie at a third of the value of the pie. The second is there is a pie. It's likely to grow a lot. But the discount that you get for buying that pie is not 70%. Maybe it's 20% or 30%. So you have a growing pie with a smaller discount or you have a

Starting point is 00:19:47 constant pie with a large discount. So usually catalysts tend to come into play. in these constant pies. They tend to be more prevalent or predominant in constant pies where you would say, hey, look, this company has a lot of real estate, and in the next two years or three years, they're going to monetize it, and the real estate is not being valued by the market, but it would double the stock once they monetize it. The thing that I've learned and actually still trying to learn is don't focus on the pies at a discount.

Starting point is 00:20:20 focus on the growing pies. The growing pies is where the game's at. What we really want, if you really want to get to the promised land, is you want great businesses run by great managers, and it would be awesome if they are available at huge discounts, you know, if you can get that. But you would still do well if you bought the great business with a great manager at a not-so-great discount with no catalyst.

Starting point is 00:20:50 than looking at some business where some of the parts is a lot bigger, and there is some potential catalyst in place. So first of all, in both styles, I never focus on catalysts. Ben Graham said value is its own catalyst. And so that's one of those core mental models that you have to adopt. Whenever we as value investors make an investment, we are implicitly agreeing with Ben Graham that in the long run, the stock market is a weighing machine,

Starting point is 00:21:20 and the long run things will get weighed appropriately. One doesn't need to focus on catalyst for value to be unlocked. But I think that if one shifts the, it's very tempting to buy discounted pies, especially heavily discounted pies. You know, the bargain hunter in us loves that. But what I've learned is that what you want is these great franchises. And the most important thing is to find these great franchises with what I would call hidden modes. These are businesses.

Starting point is 00:21:51 So if I look at a business, like let's say I look at MasterCard, it's maybe followed by 30 analysts on the street. Most people who understand the competitor advantage of MasterCard, very strong franchise, huge returns of equity, rate management, continuously buying back shares, and since the IPO, it's delivered almost 40% annualized. What's not to like about that? But the thing what a MasterCard is,

Starting point is 00:22:17 if you buy that, you're probably buying it 30 times earnings or something. At least from my vantage point, there are two problems. The first is you're paying a significant multiple. It may still turn out to be okay, but you're paying a significant multiple. And the second is there's nothing hidden about the moat, which means humanity has a good grasp on Microsoft. But the best investment ideas are ones where you have figured out something about the business, that the market has simply got no idea about.

Starting point is 00:22:51 When you figure that thing about that business, so the moat can be subtle, the moat can be hidden, and the moat will eventually reveal itself. And so at some point, the market will say, oh, yeah, yeah, I get it now. I can now go buy this,

Starting point is 00:23:05 and that's fine. You already bought it. They can buy it three times the price you bought it. No problem. And that's okay. So that's, I think, the key mantra is focus on, you know, the index, any index we look at, the S&B index or any index, most investment managers,

Starting point is 00:23:23 active managers, have a hard time beating the index. And why do they have a hard time beating the index? The reason they have a hard time beating the index is because the index owns the haystack. In the haystack are several needles. The index did not go hunting to find needles in haystacks. They just bought the entire haystack, and all those needles came with it. So when the SMP 500, you invested the S&P 500,

Starting point is 00:23:53 Apple just comes with it. Microsoft comes with it, Google comes with it, Facebook comes with it, all kinds of businesses that have incredible economics and tailwinds are just part of that haystack.

Starting point is 00:24:05 An active manager goes and tries to find the needles in the haystack and just buy those. what ends up happening in many cases is they also end up owning haystacks, but many times their haystacks have no needles in them. Because the index is too dumb to know that it owns Amazon. And the active manager is too smart to pay up for Amazon.

Starting point is 00:24:32 These are the reasons, one of the reasons that why indices are not the easiest thing to be. Say that you already own the stock. Which steps to go through as you track the performance of the company? This is one of the, I would say, the strangeness about investing. The rate at which change occurs in companies and progress occurs in companies that one can, you know, look at and measure is a lot slower than the rate at which our brains process information. The human brain can process information pretty quickly. Meaningful change in businesses that you invest in may come after one year, three years, nine months, five years, it could take a while.

Starting point is 00:25:15 They've got to make their moves and those moves take time. Very few businesses can have a lot of change happening in them every few weeks. And even every few weeks is much lower than the human brain. There is constant data coming out of these entities. Most of the data that is coming out of these businesses, I would classify it as noise. It's irrelevant data. But the brain can be many times tricked into thinking that this irrelevance, relevant, what is irrelevant noise is actually very relevant data.

Starting point is 00:25:47 We as investors, our jobs are to make sure we hopefully have figured out that we have latched on to the right variables. So if I go back to the example of MasterCard, again, for example, they are in the payments business. We live in a world where payments is an area of very significant change. there's a lot of change happening across the world in how people are paying for transactions. At the same time, MasterCard or American Express or Visa have extremely dominant franchises. So they face threats, but they also have dominance.

Starting point is 00:26:29 If you follow the industry, almost daily you're going to have noise coming at you. Oh, there's this fintech startup and there's this different way for payments. and PayPal is doing this and that and all these different things going on with payments. One needs to have clarity. Now, I have no investment in MasterCard, probably because I could never get it at three times earnings. But if I did have an investment in MasterCard,

Starting point is 00:26:58 I would, before making the investment, need to have clarity, hey, listen, Monish, you're investing in MasterCard. Now, for the next five years when you try to own this thing, you're going to be clobbered with data coming at, which will contradict your thesis. And that data could be correct or that data could be incorrect. But you need to have some conviction about why five years from now,

Starting point is 00:27:24 MasterCard is more valuable than it is today and why they are not going to get affected by these very strong, you know, different kinds of headwinds that they're going to encounter. So what I'm saying is it's a noisy world. that's what makes investing not so easy. So Monish, you're a lifelong learner. I've seen your reading list and it's absurdly long. And we'll have a link to that in our show notes if people want to check out Monisha's reading list.

Starting point is 00:27:56 But my question is based on changing mental models. What is something you've changed your mind about in the last five years based on your learning and your reading? When I was young and naive, let's say five years back, I used to think insurance was a great business. Why would I not think that? Warren Buffett became a billionaire insurance, Prame Watson became a billionaire insurance, et cetera. You know, what's not to like about insurance? What's not to like about having other people's money and they pay you to hold that money? Such a wonderful concept.

Starting point is 00:28:32 I think about five years ago, I decided that I wanted to. to set up a permanent capital structure, which in that structure owned a insurance business, and using the float and the surplus and capital equity and float, make investments and ride off into the sunset. And I did that. I set up an entity called Dhandau Holdings. And I realized after hitting my head against a brick wall

Starting point is 00:29:05 for a few years that insurance is a terrible business. One should never be in the insurance business. I did not read the fine print. The fine print got read to me after I bought the business. In fact, I bought the insurance company. I agreed to buy it in early 2014, and by early 2015, we owned it. And I think even before the deal closed,

Starting point is 00:29:35 I was getting doubts in my head that this was a mistake. But I said, I think it can still work out. I was kind of delusional. I think I was not able, because I was going down this path, we had raised so much money, and we had agreed to buy the business from the seller and all of that. I wasn't brave enough to pull the plug. But almost immediately after we closed on the business, it started becoming clear to me that I had made a mistake.

Starting point is 00:30:02 Another mental model, which is a very important model to follow, is if you make a mistake, you need to see how quickly you can unwind that mistake. If your ship is burning, you don't need to wait till it's all burnt and drowned. You need to start taking action well before that point. And so that's another thing where a lot of people, what happens is that when they make a decision, And in my case, this was a very significant public decision. I had raised the $150 million. I had told investors we would be following a certain game plan.

Starting point is 00:30:42 Investors have had confidence in giving me that money, and they were expecting that game plan. I now had to go back to them and say, hey, listen, guys, I think we are kind of hosed over here. We need to unwind. But I said that that was the right thing. So I went back to my investors and said that we're going to unwind, and I said that, they would at least get their money back. And, you know, one thing I've learned about mistakes is if you make a mistake in investing and you get your money back, that is an exceptional outcome.

Starting point is 00:31:15 Anytime we make these bets and the bets don't work and we get to take our principal back, hallelujah, that's a great outcome. I looked at that business. I said, okay, we need to unwind. I know it's ugly and painful and everything else to unwind because unwinding means you have to lay off people. you have to let go. There's a lot of things that unpleasant to work with. But now we are quite a ways into that unwinding and we were able to sell it at a slight profit to what we bought it for, which I was surprised that. I was willing to let it go at 30% less than what we bought it for.

Starting point is 00:31:51 So why is insurance a bad business? Well, you know, and I think if you listen to these the Buffett videos, an example of what doesn't show up in the letters, but it does show up in the annual meetings. So, simplistically speaking, let's say there's an insurance company which has a hundred million dollars of capital and a hundred million dollars of float, which is they've written a bunch of policies and they're paying claims, but a hundred million they're sitting in float. There are two entities that oversee these insurance companies. There's your regulator, which is usually a state regulator, and they are the rating agencies. am best, which assigns a rating to the insurance company. The rating determines how easy or

Starting point is 00:32:37 difficult and the kind of pricing you can get in the market. So high ratings are very important. And the regulator is very binary. They're going to allow you to do certain things and not allow you to do certain things. And the regulator's most important task is to make sure that anyone who bought a policy, when they have claims, that those claims are possible. paid. And in some cases, when you're writing these long-tail policies, you might write a policy in the year 1980 and the claims might still be being paid. So the ability for the business or the insurance company to be around to pay the claims for decades is the primary concern of the regulator. Neither the regulator nor the rating agency are concerned with the returns

Starting point is 00:33:30 that an insurance company generates, completely irrelevant to them. It's very relevant to you, but it's irrelevant to them. What you're going to do with the float is you're going to buy investment-grade bonds or a high percentage of investment-grade bonds. So the float is restricted in what it can be invested in. One can typically invest the $100 million of equity in equities, in stocks and so on. but they need to follow certain guidelines. So they're not going to allow you to put it into three stocks.

Starting point is 00:34:06 They want to see wide diversification. They want to not see a lot of currency risk. If you put it into a foreign stock, they want to ding you in terms of your ratios and so on. So at the end of the day, when you have these restrictions on float and on equity, so let's say I bought the insurance company for $100 million. and I end up with a hundred million of surplus and a hundred million of float.

Starting point is 00:34:32 Actually, I'm better off not buying the business at all, especially in a zero interest rate environment. So if interest rates are decent to high, without inflation being that high, then I can make some money on the float with fixed income. But in this environment, you cannot make much money on fixed income. So this revelation, which should have been obvious before 2014 to me, was not obvious. So I made a mistake. And I got a huge lesson on insurance in the few years that I owned the insurance company. So I'm very grateful for all those lessons. I know insurance really well now compared to what I was in 2013.

Starting point is 00:35:15 One of the learnings of the last few years that I'm so grateful for. Lesson Learn. Let's take a quick break and hear from today's sponsor. No, it's not your imagination, risk and regulation are ramping up, and customers now expect proof of security just to do business. That's why VANTA is a game changer. VANTA automates your compliance process and brings compliance, risk, and customer trust together on one AI-powered platform.

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Starting point is 00:38:34 found in the income fund fund fund rise.com slash income. This is a paid advertisement. All right. Back to the show. Monish, thank you so much for making yourself available for the Master's podcast. Before we let you go, where can the audience learn more about you? I do a few talks and such like with you. The value investing community, primarily because of Buffett and Munger, has a ethos of sharing. And that ethos is very deeply embedded in the community. So I have learned a lot because these two gentlemen and Ben Graham were so selfless in there, willing to educate people like me. To the extent that I can help others, I'm more than, and willing to do that.

Starting point is 00:39:18 Fantastic. Moniz, thank you so much for, again, for making yourself available. I think I can speak for everyone when I say that all of us learn a ton from you here today. Stig, both you and Preston are doing human service to the community.

Starting point is 00:39:32 Love your podcast. East or West, the Investors' podcast is the best. I like that. There will be a new slogan from now on. All right. Make sure you clone it. I know it's going to be hard, but make sure you clone it.

Starting point is 00:39:47 Oh, we definitely will. I love it. Thanks so much, Monish. Coming from you, we will absolutely take that. Thanks so much for coming on the show, Monash. Always awesome to have you. All right. So at this point in time, we're going to play a question from the audience,

Starting point is 00:40:05 and this question comes from Evan. Hey, Preston and Stig. This is Evan from Dallas. You guys often talk about probability that a company would grow at a certain percentage. say 60% or 30% or 10%. My question is, how do you assign probabilities of different growth rates in your assessment of various companies? Thanks for your time, guys. I love the show and keep the good work.

Starting point is 00:40:30 Great question, Evan. So what you refer to is when you estimate the intrinsic value of a stock pick. The traditional approach is to say that it might grow with, say, 6% annually. What Preston and I do, and the tool we created around that and we'll also give to you for free for asking this question, is really to make this applicable to real-life investing. So instead, we're saying that we assign probabilities to three different scenarios that could happen, most likely scenario, and then a positive and a negative scenario deviating from that. For the most likely scenario, I typically assign at least 50% probability, and I look into

Starting point is 00:41:13 the outlook of the industry as my starting point. For instance, if I was looking at the airline sector, the huge underlying factor for the growth is economic growth. Even though I'm looking at a higher performing company with a strong mode, so much it's still determined by the sector and the general tailwind and headwind it faces. Of course, it's not as simple as just saying whatever the industry is grown with, that is just what I would use. But again, it would be a good starting point for you. Of course, this is more tricky when you deal with a company like Google or any other monopoly kind of business that is almost its own industry. But for most businesses, it's typically simpler to look at the industry as a whole.

Starting point is 00:42:00 Then to make it more specific to depict that I'm looking at, into my assessment, I also look at the organic revenue growth. Revenue is the starting point for all businesses. and I would like to ensure that potential more free cash flow is not coming from cost cutting, for instance. We can't continue to cut cost and use that in our growth assumptions. As Mnich was talking about here in this interview, it has to come from growing revenue. Keep in mind that even though the company I'm looking at has a strong mode, I'm typically reluctant to use a high growth rate. Always like to be conservative, especially in my most likely scenario.

Starting point is 00:42:36 And again, perhaps I miss judge the size of the mode. So the first scenario looked at, there was the most likely scenario, the base case scenario. For the more positive scenario, I'm looking at which catalysts that can positively impact the company. Often I find that analysts look at catalyst and say, this is how the company would grow with, for instance, 10%, and then they would use that as the growth. For instance, if I looked at an airline like Southwest Airlines, I might assume that the new routes to Hawaii will be profitable and very successful. And I might also argue that the oil price will stay low,

Starting point is 00:43:14 which will provide another boost to the profit. Of course, this could happen, but I would rather assign a probability to the most positive scenario, which I think and hope will happen, but as a conservative value investor, I typically do not assign more than 25% to that scenario. In the long run,

Starting point is 00:43:33 you will find that your own biases from picking that stock will just blind you, and you'll find that the positive scenario is often way less likely than your thought. And I'm sorry to say that I learned that from bitter experience myself. So we talked about the base care scenario, the positive scenario, but let's talk about the most pessimistic scenario also. For this scenario, I often do not use any growth at all in my assessment, perhaps even a negative growth rate. I especially pay attention to whether or not it's a cyclical business, and where I think we are in the cycle. And again, I could be wrong. So, I typically assume that the stock will perform worse than the sector and one or two negative

Starting point is 00:44:17 events will happen. For many stocks, I don't even shine away from using up to a minus 10% growth rate, even for a company that has performed okay in the past. So, Evan, the best way I can describe the probability approach is thinking about the map of a hurricane projection. So for anybody that's watched the weather channel during a hurricane event, you'll see that they have a projection array of where that hurricane might go. So let's say the hurricanes three days from making landfall, there's the point of where it's at right now, and then the array of potential outcomes of where it can go. And in the middle is the most likely, and then on the left and the right of the approach is this cone and the potential array, and maybe the probabilities of it hitting that outer line,

Starting point is 00:45:06 of that array is 5% or 15% or whatever. And I think of future cash flows in a similar way that we're making a projection about what the future is going to be, what those cash flows might be, where our center line is our most likely. And then on the left or the upwards angle, you could say is the optimistic view. And then on the line underneath of that would be your pessimistic view. And so now that people can visualize what we're talking about here, let me get to the heart of your question, which is how do I assign a value for the most likely

Starting point is 00:45:41 path versus the worst case or the best case path? And for that, I can't really give you a concrete answer, but instead what I'll tell you is I tend to err on the side of caution whenever I'm doing this. If I see a company that has very inconsistent earnings, they're very volatile in the past, and then in the future, they're equally variable as my expectation, then I'll be much more likely to heavily weight the downside portion of my projection, regardless of where the most likely trend is pointing. On the contrary to that, let's say I have a company that's top line is growing like crazy. It's a large cap business, which means that those revenues have more of a solid foundation.

Starting point is 00:46:27 In the past results are very steady in the future results that I can tell from all my research is also projecting an upwards direction. In this scenario, and I know it's very generic, I might provide a slightly higher weight to the upside. But in that scenario, which I would describe as the best case scenario, I'm still going to have a heavy weight to the most likely expectation of whatever the trend has shown and what the trend would be moving towards in the future.

Starting point is 00:46:58 So at the end of the day, this is where estimates really kind of become an art form. You're mixing qualitative and quantitative factors, and it's the reason that Buffett and Munger always say that they come up with two different intrinsic values for the same business. My best advice for you is to build a margin of safety and always have a deep appreciation for what it is that you do not know, opposed to what it is that you do know,

Starting point is 00:47:24 when you're conducting these weights and whenever you're estimating what that trend might continue to look like, moving into the future. All right. So, Evan, as a token of our appreciation for leaving your great question, we're going to give you access to one of our paid courses on the TIP Academy page of our website. The course that we're going to give you is our intrinsic value course. And our intrinsic value course teaches people how to determine the value of an individual stock. It also teaches you how to think about the market cycle and when you're buying your stock. And it also teaches you some stuff about options trading. So we're really excited to give you this course. If anybody else out there wants

Starting point is 00:47:59 So check out the course. You can go to tip intrinsic value.com or you can just go to our website and click on Academy, link at the top of the page and courses right there. So if anyone else wants to leave a question on the show, go to Ask the Investors.com. And if your question gets played on the show, you'll get a free course. All right, guys, thanks for joining us today. And thank you to all you for helping us with all the questions to Monish. The Investors podcast is really all about empowering the TIP community. And thank you for making that happen. Since this is the weekend of the Berkshire Holloway's shareholders' meeting, before our traditional outro, we will instead play the Mr. Margaret song by the ever-talented Britney Collins.

Starting point is 00:48:42 Brittany is an avid listener of the Amster's podcast, she's president of a local chapter in Houston, and more importantly, she's just a wonderful human being. Enjoy. Good morning, Mr. Margaret, well, what do you say? What do you say about your price to you? Every day does it fit within my requirement? It means it provides a high margin of safety to protect my principle when things get crazy. I'll minimize risk to prepare for retirement.

Starting point is 00:49:24 Identify the intrinsic value. When the market's overvalued and the stocks are undervalued, it's still the goal. Well, Buffett taught me it's okay to buy you with a low P ratio. Of course there's no guarantee, but it works with my buying old strategy. So Mr. Market, I'll give you this opportunity. Let's go out to you. I won't buy a company just because of your quote. I must understand it and it must have to be.

Starting point is 00:50:24 emotions let's not forget about the trustworthy management team if your price hasn't decreased from yesterday what makes you think I'm gonna buy today I'm okay waiting for the perfect opportunity research and I can identify the intrinsic value when the market's overvalued and the stocks are undervalued, it's still a goal. Well, Buffett taught me it's okay to buy it with a low P ratio. Of course there's plenty, but it works with my buy and hold strategy. So, Mr. Market, I'll give you this opportunity to just go a lower, I'll say no, Because you work for me, Mr. Market, Mr. Market.

Starting point is 00:51:43 You work for me, Mr. Market, Mr. Market. Oh, yeah. Market's overvalued and the stocks were undervalued. It's still a goal. Buffett told me it's okay to buy you with a low P.E. Thanks for listening to TIP. To access the show notes, courses, or forums, go to the Investors' Podcast.

Starting point is 00:52:18 To get your questions played on the show, go to Asktheinvestors.com and win a free subscription to any of our courses on TIP Academy. This show is for entertainment purposes only. Before making investment decisions, consult a professional. This show is copyrighted by the TIP network. Written permission must be granted before syndication or rebroadcasting.

We Study Billionaires - The Investor’s Podcast Network - TIP241: Value Investing w/ Mohnish Pabrai (Business Podcast)

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