Chapter 7: What Warren Buffett Can Teach MicrosoftBuffett Succeeds at Nothing 

Warren Buffett is known as being one of the best investors of all time. But it might come as a surprise to many that his investing strategy often encompasses long periods of what he calls "sitting on my butt." There have been periods of years when Berkshire Hathaway has purchased not a single share of stock, interspersed with some enormous activity. Sometimes doing nothing is the best thing you can do.

Editor's Note: Occasionally, we like to feature articles from readers in this space. Mohnish

Pabrai, the managing partner of Pabrai Investment Funds

and mpabrai on the Fool discussion boards, offers his view on the difficulty investors have --

professional and individual alike -- in just sitting still.

Seventeenth century French scientist Blaise Pascal is perhaps best remembered for his

contributions to the field of pure geometry. In the 39 years that he lived, he found time to

invent such modern day fundamentals as the syringe, the hydraulic press, and the first digital

calculator. And, if that weren't enough, he was also a profound philosopher. One of my favorite

Pascal quotes is: "All man's miseries derive from not being able to sit quietly in a room alone."

I've often thought that Pascal's words, slightly adapted, might apply well to a relatively new

subset of humanity: "All portfolio managers' miseries derive from not being able to sit quietly

in a room alone."

Why should portfolio managers sit and do nothing? And why would that be good for them?

Well, let's start with the story of D.E. Shaw & Co. Founded in 1988, Shaw was staffed by some

of the brightest mathematicians, computer scientists, and bond trading experts on the planet.

Jeff Bezos worked at Shaw before embarking on hisAmazon.com (Nasdaq: AMZN) journey.

These folks found that there was a lot of money to be made with risk-free arbitrage in the bond

markets with some highly sophisticated bond arbitrage trading algorithms.

Shaw was able to capitalize on minuscule short-term inefficiencies in the bond markets with

highly leveraged capital. The annualized returns were nothing short of spectacular -- and all of

it risk-free! The bright folks at Shaw put their trading on autopilot, with minimal human

tweaking required. They came to work and mostly played pool or video games or just goofed

off. Shaw's profit per employee was astronomical, and everyone was happy with this Utopian

arrangement.

Eventually, the nerds got fidgety -- they wanted to do something. They felt that they had only

scratched the surface and, if they only dug deeper, there would be more gold to be mined. And

so they fiddled with the system to try to juice returns.

What followed was a similar path taken by Long-Term Capital Management (LTCM), a fund

once considered so big and so smart on Wall Street that it simply could not fail. And yet, when

economic events that did not conform to its historical model took place in rapid succession, it

nearly did just that. There was a gradual movement from pure risk-free arbitrage to playing the

risky arbitrage game in the equity markets. A lot more capital could be deployed, and the

returns looked appealing. With no guaranteed short-term convergence and highly leveraged

positions, the eventual result was a blow-up that nearly wiped out the firm.

Compared to nearly any other discipline, I find that fund management is, in many respects, a

bizarre field --where hard work and intellect don't necessarily lead to satisfactory results. As

Warren Buffett succinctly put it during the 1998 Berkshire Hathaway (NYSE: BRK.A) annual

meeting: "We don't get paid for activity, just for being right. As to how long we'll wait, we'll

wait indefinitely!"

Buffett and his business partner Charlie Munger are easily among the smartest folks I've come

across. But, as we've seen with Shaw and LTCM, a high I.Q. may not lead to stellar investing

results. After all, LTCM's founders had among them Nobel Prize-winning economists. In the

long-run, it didn't do them much good. In fact, they outsmarted themselves. In a 1999

interview with BusinessWeek, Buffett stated:

Success in investing doesn't correlate with IQ -- once you're above the level of 25. Once you

have ordinary intelligence, what you need is the temperament to control the urges that get

other people into trouble in investing.

Events at Shaw and LTCM show that high-IQ folks have a hard time sitting around

contemplating their navels. The problem is that once you engage in these intellectually

stimulating problems, you're almost guaranteed to find what you think are the correct answers

and act upon them -- usually leading to bad results for investors.

Having observed Buffett and Munger closely over the years, and gotten into their psyche

through their speeches and writings, it is clear to me that, like the folks at Shaw and LTCM,

both men need enormous doses of intellectual stimulation as part of their daily diet. How do

they satisfy this intellectual hunger without the accompanying actions that get investors into

trouble?

Consider the following:

While Buffett plays bridge (typically 10-20 hours per week), Munger spends his time mostly on

expanding his worldly wisdom and constantly improving his latticework of mental models. He is

a voracious reader of intellectually engaging books on a variety of subjects, ranging from the

various Ice Ages to The Wealth and Poverty of Nations. He spends considerable time in

applying perspectives gained from one field of study into other disciplines -- especially capital

allocation.

At the Wesco (AMEX: WSC) annual meeting this year, Munger acknowledged that the first few

hundred million dollars at Berkshire came from "running a Geiger counter over everything,"

but the subsequent tens of billions have come from simply "waiting for the no-brainers" or, as

Buffett puts it, "waiting for the phone to ring."

Buffett still has a tendency to run his Geiger counter over lots of stuff. It's just too enticing

intellectually not to. How does he avoid getting into trouble? I believe there are three reasons:

1. Running the Geiger counter can work very well if one knows when to run it. Reflect

on the following two quotes:

In 1970, showing his dismay at elevated stock prices, Buffett said: "I feel like a sex-starved

man on a deserted island."

In 1974, expressing his glee at the low levels to which the market had fallen, he said: "I feel

like a sex-starved man in a harem filled with beautiful women!"

By 1970, he had terminated his partnership and made virtually no public market investments

until 1974. The P/E ratio for the S&P 500 dropped from 20 to 7 in those four years. By 1974, he

had acknowledged selling "stocks he'd bought recently at 3 times earnings to buy stocks

selling at 2 times earnings."

Then, from 1984-1987, Buffett did not buy a single new equity position for the Berkshire

portfolio. Berkshire Hathaway was sitting on a mountain of cash, and still he did nothing. In the

latter half of 1987, Berkshire used that cash pile to buy over a billion dollars' worth of Coca-

Cola (NYSE: KO), over 5% of the company. He invested 25% of Berkshire Hathaway's book

value in a single company that they did not control!

What were Buffett and Munger doing from 1970-1973 and 1984-1987?  Both men realize that

successful investing requires the patience and discipline to make big bets during the relatively

infrequent intervals when the markets are undervalued, and to do "something else" during the

long periods when markets are fully priced or overpriced. I'm willing to bet that Buffett was

playing far more bridge in 1972 than he was in 1974.

2. The Geiger counter approach works better in smaller, under-followed companies

and a host of special situations. Given their typical smaller size, investing in these

companies would do nothing for Berkshire Hathaway today. So Buffett usually makes these

investments for his personal portfolio. A good example is his recent investment in mortgage

REIT Laser Mortgage Management (LMM), where there was a decent spread between the

liquidation value and quoted stock price. These LMM-type investments are significant for

Buffett's personal portfolio and, more importantly, soak up intellectual horsepower that

might lead to not-so-good results at Berkshire Hathaway.

Being versatile, he moves his Geiger counter away from the equity markets to other bastions

of inefficiency whenever the public markets get overheated. These include high-yield bonds

(Berkshire bought over $1 billion worth of Finova bonds at deep discounts in 2001), REITs

(bought First Industrial Realty in 2000 for his own portfolio at a time when REIT yields were

spectacular), or his recent investing adventures in silver.

3. The Munger/Buffett relationship is an unusual one. Both men are fiercely independent

thinkers, and both prefer working alone. When Buffett has an investment idea, after it makes it

through his filter, he usually runs it past Munger. Munger then applies his broad latticework of

mental models to find faults with Buffett's ideas, and shoots most of them down. It is the rare

idea that makes it past Buffett, and it has to be a total no-brainer to make it past both of them.

The Buffett/Munger approach of multi-year periods of inactivity contrasts starkly with the

frenzied activity that takes place daily at the major exchanges. Which brings me back to the

fundamental question: Why have we set up portfolio managers as full-time professionals with

the expectation that they "do something smart" every day? The fund management industry

needs to reflect on Pascal's potent words and how Warren Buffett and Charlie Munger have

figured out how to sit quietly alone in a room, indefinitely.

Guest writer Mohnish Pabrai is the managing partner of Pabrai Investment Funds, an Illinois-

based value-centric group of investment funds. He owns shares of Berkshire Hathaway. You

can email him at mpabrai@pabraifunds.com, or find him on the Rule Maker discussion boards.

To read his other writings, visit www.pabraifunds.com.

Chapter 12: Latticework - ILatticeworkST. JOHN'S COLLEGE IN ANNAPOLIS, Maryland is an unusual place. Students are rarely lectured, they are never given any tests and there are no electives. In fact, there are no professors at St. John's. Students spend their entire four years reading and discussing a range of great books.

They go from the Greeks (Homer, Sophocles, Aristophanes and the like), to the Roman,

medieval and Renaissance periods (Chaucer, Dante, Machiavelli, Shakespeare etc.), to the

17th and 18th centuries during their third year (Hobbes, Cervantes, Milton, Bernoulli and so

on). Finally, it's all concluded in their senior year with works like the United States Constitution,

various Supreme Court opinions, Darwin's Origin of Species and poems by the likes of T. S.

Eliot and Yeats.

Students get a broad-based education. They get nearly all their input directly from the original

source. When learning about Physics and Astronomy they read the words of Newton and

Galileo. On mathematics, the readings include the formidable words of Euclid, Pascal and

Archimedes. These great books are the real teachers at St. John's.

The common theme that emerges in interviews with alumni is how their years at St. John's

taught them how to think. One emerges from St. John's with a broad cross-section of worldly

wisdom and an unusual ability to analyze new information in the context of all that worldly

wisdom.

The notion of worldly wisdom comes up often when Warren Buffett's partner Charlie Munger is

talking about the art of investing. Charlie gave one of his rare speeches to students at the

University of Southern California's School of Business in 1994. That speech unified the

seemingly disparate notions of Worldly Wisdom, Success Investing and The Latticework of

Mental Models.

Two of my favorite quotes from that remarkable speech are:

"To a man with only a hammer, every problem looks 

like a nail."

and"What is elementary worldly wisdom? Well, the first rule is that you can't really know anything if you just remembered isolated facts and try and bang 'em back. If the facts don't hang together on a latticework of theory, you don't have them in a usable form. You've got to have models in your head. And you've got to array your 

experience - both vicarious and direct - on this latticework of models."

Investing is perhaps one of the broadest of disciplines. When you look at any business today

and then try to extrapolate what that business looks like 5, 10 or 20 years from now, it starts

to get very murky. The number of factors that can affect the future prospects of any business

are mind-boggling. At the same time, if one does not have a clear perspective on what that

business really looks like in a few years, then one will likely join the ranks of 90 percent of

professional fund managers and individual investors whose portfolios regularly underperform

the major indices.

MBAs minted out of the nation's best business schools represent the person with the hammer.

They have analytic tools coming out of their ears when they graduate. They can all make Excel

dance and tear apart financial statements in their sleep. However, the financial statements of

any business simply tell us about the past. Making investment decisions based on past

financials is akin to driving a car with a fixation on the rear-view mirror.

Since the future drivers of most businesses are a function of a myriad of factors, one needs to

draw upon a wide array of mental models to try to build a picture of what factors really matter.

Getting a pulse of the factors that matter most is fundamental to investing success. And one of

the only ways of getting to those critical drivers is to have a very broad base of worldly wisdom

and experience to develop a latticework of mental models. It is this latticework that should

lead to a convergence decision on whether a given investment is a good one to make.

Let's consider Berkshire Hathaway's investment in Coca Cola common stock in 1988. Virtually

all of Berkshire's investments are made by Warren Buffett in consultation with Charlie Munger.

Their modus operandi is one where Buffett comes up with investment ideas and calls Charlie

who applies his broad worldly wisdom and latticework of mental models and usually shoots

nearly all of them down.

From 1984-87, Berkshire Hathaway was sitting on over a billion dollars in cash and did not

make a single investment in any public equity. Then, in 1987, they invested about $1.2 billion

in Coca-Cola Common stock - buying every share they could get their hands on over a six

month period. Berkshire ended up owning about six percent of Coca-Cola. Amazingly, they

invested 25 percent of Berkshire Hathaway's entire book value in a single company. Since

1987, Berkshire has not bought (or sold) a single additional share of Coca-Cola. Berkshire

bought its stake at a split-adjusted $6 per share and has earned over a nine fold return on its

investment over the last 14 years - excluding dividends. Its Coke investment has outperformed

the market by a massive margin.

Coca-Cola has billions of customers around the world who are intimately familiar with its

products and consume it every day. In 1988, it had over 20 Wall Street analysts following the

stock (most analysts were bearish on Coke's future prospects). How can a company in such a

limelight be undervalued to such a large degree? By Buffett's own admittance, Berkshire made

the investment in Coke relying primarily on Coke's past annual reports. He and Charlie never

spoke to Coke management and indeed Coke's board learned about Buffett's purchase when

he had nearly completed acquiring his stake. What did Buffett and Charlie see in Coke that

over a billion people couldn't see?

Here is a cross-section of some of the factors that went into their building a latticework of

mental models on Coke.

1.Buffett is a huge sugar-addict and had been a lifelong passionate consumer of Pepsi Cola -

until 1987. He used to add cherry syrup to his Pepsi before Cherry Coke was concocted. When

he was seven years old, he used to count the discarded bottle caps around vending machines

and carefully tabulate which drink people were having the most. He remembers being

astounded with the overwhelming numbers of Coke caps (over 80%) relative to the numbers

for all other drinks.

2.Buffett is rumored to have a subscription to Advertising Age magazine. He asked himself

what it would cost to replicate the Coca-Cola brand in a few years. The conclusion Charlie and

he reached was that it probably could not be done - even with $100 billion given to the best

marketing team on Earth. At the time, one could have bought the entire Coca-Cola company

for under $20 billion. So, here was a company whose brand alone was worth well over $100

billion and the entire company could be bought for under $20 billion.

3.Buffett pored over the last 80 years of Coca-Cola annual reports. He found that, like a

software company, their gross margin on their syrup sold to bottlers is well over 80%. Coke's

future success was a function of the number of servings of coke sold worldwide. The more the

servings, the more the cash flow. He found that over the last 80 years, their syrup volumes

sold had risen every single year. The last 80 years included many ugly world events - World

War I, the great depression, World War II, The Korean War, The Vietnam War, The Cold War,

numerous recessions, being kicked out of India in the 1970s et cetera. Through all of that,

Coke has grown every single year. The question Munger and Buffett posed to each other was

simple - What volume of syrup might The Coca-Cola Company conservatively be expected to

ship in the year 2000…2025…2050? They probably came up with some mouth-watering

numbers, then extrapolated free cash flow (about one cent per eight-ounce serving) and finally

arrived at a present value of all that future cash flow.

4.In 1886, when Coke was first concocted, it sold for five cents per eight-ounce serving. Today,

one can buy eight ounces of Coke on sale for under 17 cents. If Coke's pricing had moved in

lockstep with inflation, we'd be paying several dollars for a single can. This is a very unusual

product whose unit price has declined dramatically over the years. Very few consumer

products have demonstrated the level of decline in prices that Coke has over the last century.

5.Billions of people around the world have yet to have their first Coke. In addition, the daily per

capita consumption of bottled beverages around the world is miniscule compared to that of the

United States and Europe. However, it has risen dramatically in various countries as per capita

incomes have risen. We are likely to see big increases in per capita incomes in the third world

over the coming decades.

The typical hammer-wielding Wall Street analyst is fixated on the next few quarters, not the

next half century when trying to figure out any given company. No Wall Street analyst's mental

model of Coke in 1988 was comprised of the latticework that Munger and Buffett fixated upon.

Individual investors will do well if they only made investments within their circle of competence

based on an independent latticework of mental models. When all your mental models all

converge at about the same intrinsic value for a given business, and that value is well above

the price of the business, back up the truck. 

I'd recommend reading Robert Hagstrom's outstanding book, Latticework - which I referenced

for this article.

Chapter 16: The Demise of a Prized American TreasurePerspective: The Demise of a Prized American TreasureHewlett Packard and Compaq represent the pinnacle of entrepreneurship and free enterprise, yet both companies could not possibly be more different. As startling as it may sound, HP was not created with a profit motive. When Bill Hewlett and David Packard setup shop in that famed Palo Alto garage in 1938, their mission was not to make a lot of money and get rich.

They set out to create a company where they could exercise their creative and entrepreneurial

energies to build innovative products in their fields of interest and make meaningful

contributions to society at large. It did not stop there. They wanted to attract like-minded souls

and create a passionate, dedicated team that fostered intense individual creativity. Finally,

they wanted to be part of a company that was deeply committed to community involvement at

all levels.

Like Konosuke Matsushita, they recognized that profits were necessary to fulfill all the other

objectives of the company. Profitability was treated as the best single measure of their

contribution to society and the ultimate source of corporate strength. They clearly laid out a

profit maximization goal — but only to the extent that it was consistent with all the other

objectives of the company. 

Hewlett and Packard were intensely focused on achieving these lofty and counter-intuitive

goals. They created a world-class company, which has met every objective they laid out, and

then some. While they became rich in the process, neither fixated on personal wealth or

extravagant lifestyles. Both gave away 90 plus percent of their multi-billion dollar estates to

their respective charitable foundations.

Compaq, on the other hand, was a Ben Rosen venture-backed well-funded startup that had a

straight profit maximization objective. They wanted to build IBM PC-clones, scale up quickly

and get to over $100 million in revenues in the first year. Compaq achieved these monetary

goals and became the first company in history to have over $100 million in revenues in its first

year.

Compaq has been a success in its own right. However, unlike HP, the DNA structure of Compaq

is not that of an innovator. To put it bluntly, it is a profit maximizing focused PC-clone maker

that has never delivered any meaningful innovations, nor has it been able to do anything but

PC hardware. HP, on the other hand, has delivered a plethora of innovations in a diverse range

of disciplines. Compaq’s original DNA programming is diametrically opposed to the HP way.

Blending these two disparate cultures is trying to mix oil and water, and guaranteed to fail.

Ben Rosen is as sharp as they come. The only reason Compaq is being sold is because he

believes that he has indeed extracted every ounce of profit out of it that he possibly could, and

continuing independently will lead to eventual demise.

So why is Carly Fiorina hell-bent on pursuing this merger? The biggest mistake HP made was in

hiring an individual as its CEO who fundamentally does not subscribe to the HP way. The

founders were not money motivated. Fiorina needed an outrageous $75 million package to

sign on as CEO. That should have been the first clue to the board that she was the wrong

choice. Secondly, unfortunately, many Fortune 500 CEOs measure their success by their rank

on the Fortune 500. The ranking system is based on company revenues. If the list were based

on the 500 companies with the largest free cash flows and then ordered by the average

percent increase in per share free cash flow over the last five years, we’d see radically

different CEO behavior.

The only thing the merger accomplishes in the near term is a substantially higher Fortune 500

ranking — which is precisely what a high-ego, low HP-way ethos CEO would want. The new HP,

in the long run, will only be a small shadow of its present glory.

Another way to examine the merger is doing an intrinsic value analysis. At HP’s present stock

price, HP is paying about $21 billion for Compaq. It appears to me that virtually all of Compaq’s

assets are required to maintain its marker position and cash flow. What is the future of

Compaq? With revenues dropping from $42 billion to $33 billion is a year and profits dropping

from $1.7 billion to $170 million, it’s not a rosy picture. Figuring out Compaq’s future is murky.

I do see a business model and cost structure that’s vastly inferior to Dell. My most optimistic

assessment of Compaq’s intrinsic value is well under $10 billion. Adding in a Ben Graham

margin of safety, I would not want to pay more than $5 billion for the company. HP is paying

four to seven times optimistic valuation — and paying it with HP stock that, at present prices,

is well under its intrinsic value. It’s a very bad deal for HP stockholders and a blessing for

Compaq shareholders.

Mohnish Pabrai is the Managing Partner of Pabrai Investment Funds. He can be reached at

mohnish@corp.siliconindia.com

Chapter 18: All You Need is Love!All You Need is Love!When one charts the stock performance of Southwest Airlines, Dell or Walmart over the last five years, the results are very impressive. Dell is up nearly 600 percent while Walmart is up 400 percent and Southwest is up more than 300 percent. All three have trounced the S&P 500, which has gone up a modest 50 percent in the same period (see Figure 1).

All three companies compete in very challenging industries where it’s tough to earn a double-

digit return on equity, yet they’ve outperformed the S&P 500 average on the order of six to 12

times. Let’s take a look at Dell. Selling PCs is a very tough business. You’re essentially selling a

commodity, and price is a big driver. Yet Dell has consistently outperformed its industry peers,

Gateway and Compaq, which have both lagged the S&P 500 over the last five years and netted

investors a negative return over the same period (see Figure 2).

The contrast in performance between retailers Walmart, Sears and K-Mart is especially stark.

Retailing is a tough way to make a buck, and among the most transparent of industries. Trade

secrets are virtually non-existent. Competitors can uncover Walmart’s strategy just by walking

through its stores. All the data one would care to know — pricing, product lines, merchandising

strategy — is displayed on the shelves. Yet, while K-Mart has decimated all shareholder value

with its recent bankruptcy filing and Sears is simply treading water, Walmart has delivered

spectacular returns to shareholders (see Figure 3).

Warren Buffett jokes that if he ever gets the urge to buy an airline stock, he dials an 800

number to reach Airlines Anonymous to talk him out of his delusion. After living through the

gyrations of his US Air investment, he learnt his lesson and will probably never buy an airline

stock again. The basic economics of the business are very bad. You have organized labor that

believes a pilot making $300,000 is underpaid and can choke off your entire revenue stream

with a strike. Add to that the high fixed costs of airplanes and finally, pricing that is determined

by the moves of your dumbest competitor, who’s only trying to recover marginal costs. The

combination can be lethal!

Not only have Delta and United not earned a dime for their shareholders in the last five years,

they’ve proceeded to lose some of the principal as well. But Southwest has more than tripled

investors’ original stakes in the same period. Indeed, Mr. Buffett should note that had an

investor invested an equal amount in Berkshire Hathaway and Southwest Airlines in 1990, he

would have made a stunning 15 times his original investment with Berkshire Hathaway, but

Southwest would have given him more than 29 times his original investment. So much for all

airlines being a crappy investment! (See Figure 4).

How does one explain the wide difference in performance between Southwest, Dell and

Walmart and their respective competitors? There is no discernible difference in the direct-sales

strategies of Dell and Gateway. Nor is there a difference in the discount- retailing model of

Walmart and K-Mart. United’s Shuttle operation in California was an exact replica of

Southwest’s model of going point to point, turning planes around rapidly and flying only Boeing

737s, except that United lost tens of millions of dollars in the endeavor and eventually folded

not only California’s, but its entire U.S. Shuttle operation!

The difference between Southwest, Dell and Walmart and their competitors lies in their

leadership. The CEOs of these three companies are fairly similar to their counterparts in

capability and intellect. But they possess other qualities that give their companies a

competitive advantage. 

I recently read three unrelated books that provide deep insights into how fundamental

differences in business leadership styles, unrelated to competency, can become big drivers for

dramatic performance differences between companies: Power vs. Force by David

Hawkins, Matsushita Leadership by John Kotter and Good to Great by Jim Collins. All three are

exceptional and provide many of the answers.

It is impossible for me to capture these three books in a few paragraphs. I’d strongly

recommend that the reader delve into all three. To summarize, it turns out that shareholder

value can be significantly enhanced by certain traits in a company’s leader. Companies, even

in challenging industries, will do far better than their competitors if, in addition to competence,

the CEO possesses the following traits:

No ego. A singular focus on truth. Truthful CEOs do not send “messages” to shareholders,

employees or customers. They speak core truths that they deeply believe in. None would ever

even think of “delivering a tailored message.” This is a very critical characteristic, and the

definition of truth is very broad and deep. They are deeply in love with their companies and

their stakeholders. Their primary motivation comes from this dear love. The company is their

temple.

This combination of lack of ego, love, truth and capability is potent. Leaders who possess these

rare traits will deliver astounding results. If a CEO, tries to fake it, it does not work.

Stakeholders can see through the fake eventually and react appropriately.

When corporate boards look for CEOs, they often look for charisma and marquee names ¾

turning to high-ego leaders like Al Dunlap or Carly Fiorina. High-ego CEOs may, at best, do well

during their terms, but their companies inevitably fall apart after they leave. On the other

hand, Walmart’s Sam Walton, Southwest’s Herb Kelleher and Berkshire Hathaway’s Buffett

have built companies that will endure and perform well for decades beyond their tenures. As

Buffett says of Berkshire Hathaway, “It’s been lovingly created.” Kelleher expressed his feeling

for Southwest through the company’s quirky ticker symbol, “LUV”. 

A good way to gauge CEO ego, or lack thereof, is to assess the extent to which CEOs promote

themselves, versus their companies. In the case of Southwest, there is no bio of Herb Kelleher

on the entire Southwest Web site. He’s a business legend who has no interest in talking about

himself. Contrast that with the bios of Delta and United CEOs posted on their companies’ Web

sites. Interestingly, the United CEO’s bio does not even talk much about United! Judging from

their Web sites and business press, both Michael Dell and Gateway’s former leader, Ted Waitt,

are very high-ego CEOs. Gateway fell apart after Waitt left. The data suggests a not-so-rosy

picture for Dell post-Michael. 

Investors can identify CEOs with the right combination of value-driving personality traits — lack

of ego, truthfulness and love for their business — by assiduously mining the wide array of data

that on public companies that is available from the business press, Web sites, earnings

conference calls and annual reports. Try characterizing the personality traits of the CEOs of the

companies in your portfolio. If you can buy a great company well below its intrinsic value, and

it’s run by a very low-ego, totally truthful, high-capability CEO who is deeply in love with his

business, back up the truck. Otherwise, keep on driving and read those three books.Mohnish

Pabrai is the Managing Partner of Pabrai Investment Funds. He can be reached at

mohnish@corp.siliconindia.com

Chapter 19: Risk vs. UncertaintyRisk Vs. UncertaintyWall Street loves consistency and certainty about the future prospects of any business, and will usually over-reward for certainty. Just look at the market valuation of Automatic Data Processing (ADP) or its cousin Paychex (PAYX). ADP trades at a lofty trailing P/E of more than 40 while PAYX has a P/E of 49! ADP has a record of meeting or beating Street expectations and consistently rising dividends and earnings for more than 40 years. There are very few businesses that can claim a record of no major blimps in their operations for such a long period of time.

The primary business of both companies is the boring and cumbersome task of outsourced

payroll processing. Even with the enormous growth both have enjoyed over the years, they

have a very small percentage of the entire market for payroll processing. It is a highly

fragmented industry with very high switching costs and big barriers to entry. 

Due to the lofty valuation of companies like ADP, returns to investors who decide to buy the

stock in 2002 and hold it for five years will probably be lackluster. More importantly, there is

no Ben Graham margin of safety when buying these stocks. Were there to be a single missed

quarter, the stock would tank. It would only take one bad quarter to see a 50 plus percent

decline in market cap. In the case of ADP, the disrupter may be a Web-based payroll processor

with its entire back office in Bangalore, with customers just printing emailed checks at their

site. Such an entity could potentially charge 80 percent less than ADP and still be quite

profitable.

A missed quarter seems very unlikely for ADP or PAYX, but one can look at any number of

companies that at one point looked invincible and subsequently really left a lot of investors

hurting. A good example is Tellabs (TLAB) (Note: The author was an employee of Tellabs from

‘86-‘91). Tellabs was a wonderful company with an exceptional founder and CEO, Mike Birck

and a terrific management team and corporate culture. The company really started to hit its

stride in the early 1990s with the release of its flagship product, the TITAN 5500. The TITAN

5500 was an optical cross-connect that helped voice and data service providers groom and

manage their T1, T3 and OC-X pipes. The product was superior to all others on the market and

rapidly gained customer acceptance at a number of blue chip companies including MCI, Sprint,

the various RBOCs, various cellular, paging and data service providers. Through the 1990s,

Tellabs enjoyed rapid sales growth and was one of the top 10 stocks in all performance from

1991-1999. Sales increased tenfold from under $200 million to more than $2 billion and

profitability increased more than twenty fold over that period. 

An expert looking at the networking space as late as 1999 could only forecast continued good

times ahead for Tellabs. Tellabs had a market cap of more than $30 billion in 1999 against

revenues of about $2 billion. Today the company has a market cap of $6 billion — with more

than $3 billion in cash and hard assets! Investing in Tellabs in 1999 again had no Ben Graham

margin of safety and was a highly risky investment. In addition, being a technology business,

Tellabs is more prone to getting disrupted. The experts who saw nothing but good times ahead

in 1999 would today not be able to assure us that there will even be a Tellabs in 10 years.

The dichotomy is that seemingly low uncertainty businesses are not necessarily low risk for the

investor. ADP and Paychex are high-risk investments at today’s prices — just as Tellabs was in

1999.

The flip side is that when the future in uncertain, Wall Street punishes the company and

usually the punishment is really rigorous! Stewart Enterprises (STEI), also mentioned as an

example in a previous column, is the second largest company in the “death care” industry

worldwide. Stewart has about $700 million in annual revenues and owns about 700 cemeteries

and funeral homes in nine countries, with the bulk of them in the United States. 

As shown in Figure 2, Stewart was trading at about $2 per share for several months during Q3

and Q4 of 2000. Its historical high was about $28 per share (achieved in 1999). At the time,

Stewart had a book value of $8.50 per share. It was thus trading at less than one quarter of

book value. 

At the time, Stewart’s free cash flow was about $0.72 cents per share. The stock was trading

at less than three times cash flow! It was also trading at about one quarter of annual revenue.

Like ADP, Stewart has a highly predictable revenue stream. We don’t know who will die in

Boise, Idaho in 2006, but any number of life insurance actuaries can tell you with a fair degree

of accuracy how many will die in Boise in 2006 — or for that matter any year for the next 10

years. Why was Wall Street pricing Stewart at three times cash flow and ADP at more than 40

times cash flow?

The reason was that Stewart is a leveraged company with a lot of debt. About $500 Million of

that debt was coming due in 2002 and there was no clear answer in July 2000 as to how the

company was going to pay it. Wall Street assumed the company may have to declare

bankruptcy when it defaulted on its debt and tanked the stock to under $2 per share (from $28

per share).

When I looked at Stewart, I envisioned three possible scenarios for Stewart over the next 24

months:

Each individual funeral home is a distinct stand-alone business. Stewart was a roll-up that had

bought hundreds of family-owned funeral homes. It had kept the same name etc. Most

customers did not know that ownership had even changed hands. Thus, to raise cash, Stewart

could elect to sell some of their “stores.” Presumably, many of the previous owners might buy

them back. The company had typically paid eight or more times cash flow for each home. They

should be able to sell these for at least five to eight times cash flow. Thus 50 to 100 homes

might be sold to take care of the debt.

Stewart’s lenders or bankers could look at the company’s solid cash flow and predictable

business model and extend the loan maturities.

Stewart goes into bankruptcy. In a bankruptcy reorganization like Stewart, the judge would

order that some of the stores be sold and cash proceeds be used to repay defaulted debt. In a

distress sale, these stores should still go for at least five to seven times cash flow due to

competition among buyers. more than 100 stores get sold and the company emerges clean

from bankruptcy.

Even under scenario three, the stock was mispriced at $2 per share. Once one of the above

scenarios unfolded, I thought that the uncertainty would go away and the stock would go to 10

times cash flow or $7 to $8 per share. The Pabrai Investment Funds bought Stewart at about

$2 per share in Q3 and Q4 of 2000 with the intent of exiting at anything more than $4 per

share within two years.

In Q4 2000, the company announced its intent to sell some international funeral homes and in

Q1 2001 had definitive buyers. The stock was at $4 per share by the end of Q1 2001, for a 100

percent gain in less than nine months. The funds exited their entire position at about $4 per

share. Subsequently, Stewart has been trading between $6 and $8 per share.

Stewart had high uncertainty about its future course in Q3 2000. However, there was very low

risk in terms of shareholder return or the company’s future. Wall Street could not distinguish

between risk and uncertainty and got confused between the two. Savvy investors like Buffett

and Graham have been taking advantage of this handicap that Mr. Market possesses for

decades with spectacular results. Occasionally, you’ll see a company like Stewart which shows

three interesting characteristics — Low Risk, High Uncertainty and High Return Possibilities.

The combination of these three attributes at the same time in the same company makes for

some very satisfying investing returns. Take advantage of Wall Street’s handicap!

Mohnish Pabrai is the Managing Partner of The Pabrai Investment Funds. He can be reached at

mohnish@corp.siliconindia.com.

Chapter 20: Is it Time to Buy Infosys?Is it time to buy Infosys?I’ve been a long-time admirer of Infosys and its outstanding management, specifically N. R. Narayana Murthy and Nandan Nilekani. The corporate culture, talent pool, world-class client base and deep management strength are formidable. These are big barriers that allow Infosys to have a near-permanent lock on its current clients and to be very well positioned to get new ones. Hewitt named it the best company to work for in all of India, while the Far East Economic Review rated Infosys the number one company in India.

However, over the last few months, as revenues and earnings have continued to grow at a

triple digit rate, the stock has plummeted from $375 to $48. Market capitalization has fallen

from about $25 billion to $3.2 billion in the last 18 months — a drop of over 87 percent! Might

it be time to start buying Infosys? Can Infosys go any lower than it already has? 

Before investors call their brokers to buy Infosys, they should ask themselves: What is Infosys

really worth? What annualized rate of return can be expected if the stock were bought today?

To answer these questions, one needs to understand how to calculate intrinsic value. The

intrinsic value of any business is the sum of free cash flow it will generate from now to eternity,

discounted to present value using a reasonable interest rate. (John Burr Williams, Ben Graham,

Warren Buffett, et al.) For further insight into intrinsic value please see the article entitled

“Intrinsic Value” in the July 2001 issue of siliconindia.

So, it’s fairly simple. If one can project the future cash flow that Infosys will generate, then its

intrinsic value can be easily derived. Infosys had revenue and net income of $131 million and

$39 million respectively for the quarter ended June 30th. While the company has grown at an

annualized rate of more than 65 percent for the last seven years, it projects just 30 percent

growth in the coming year.

High-growth companies appear to have growth engines that will continue to propel them

unabated for decades to come. However history has taught us that even one-time market-

dominating, rapidly-growing companies eventually mature to sedate or even negative growth

levels. In the early 1970s, Xerox was a high-growth, high-P/E, high-flying stock that investors

loved (one of the “nifty-fifty”). Investors were right in their assessment that photocopying was

in its infancy and Xerox dominated copiers with strong patent protection and a big

technological lead. Xerox’s stock price in the early 1970s was a historical high for the

company. That price was never met or exceeded after 30 years of growth. A buyer of early

1970s Xerox shares would have found that, while document duplication has gone through an

unprecedented growth curve in the last 30 years, Xerox has come to the brink of bankruptcy.

For more recent examples, one can look at the growth rate projected for Oracle, Cisco and Dell

five years ago and compare it to their projected growth rate for the next five years.

If Infosys grew 50 percent annually over the next 10 years, it would have a head count of

400,000 in 2011. That is a larger headcount than IBM, Cisco and Microsoft — combined. Clearly

the 50 percent annualized is way off. I’d propose that it might be reasonable (even optimistic)

to assume the company grows 30 percent next year (as management has guided) followed by

20-percent growth for the next three years, followed by 15 percent growth for the next three

years followed by 10 percent growth in years eight through ten. Further, let’s assume that the

company is sold in 2011 for its cash on hand plus 10 times its 2011 earnings.

I don’t think I’d be too far off in speculating that the average siliconindia reader is not

interested in making investments in companies like Infosys to earn a five or ten percent

annualized rate of return. Presumably, the reader is looking for 15-20 percent annually (or

more). We now have all the data necessary to figure out if shares of Infosys ought to be bought

at $48. Table 1 shows the present value of all the future cash flow Infosys will generate under

the aforementioned assumptions.

Infosys has 66.1 million shares outstanding at present. The company has an excellent stock

option program for its employees. Assuming a 3 percent annual dilution in shares outstanding

leads to 88.8 million shares outstanding in 2011. This yields a price of $38 per share. In other

words, if all of our assumptions came true, an investor buying Infosys today at $38 per share

can expect a 20 percent annualized rate of return over the next 10 years.

Ben Graham suggested a substantial margin of safety when investing in any common stock.

We don’t know what the future holds. To get downside protection, Infosys should be bought at

a minimum 50 percent discount (margin of safety) to intrinsic value or $19 per share. If one

desired a 15 percent annualized rate of return, then one could buy Infosys for up to $29 per

share with a 50 percent margin of safety. Conversely, if one were (like me) looking for a 30

percent annualized rate of return with a 50 percent margin of safety, Infosys should be bought

at no more than $10 per share — a fifth of its present price. Buying the stock at $48 with a 50

percent margin of safety would yield the investor an annualized return of just 3.9 percent.

Intrinsic value is a simple concept, but very difficult to precisely calculate for most companies.

The best that one can do is to make conservative assumptions and then add a significant

margin of safety. The message of this article is not to suggest the price at which Infosys should

be bought or sold, but rather to give the reader a simple toolset to evaluate whether to invest

in any given publicly-traded company. To start, investors must have a good idea of the rate of

return they’d like from a given stock. They should know the company well enough to assess its

future prospects. In growing companies, one needs to remember that no tree grows to the sky.

Be conservative on future growth prospects. Finally, add a substantial margin of safety.

But, one might argue, what about the value of all the intangibles of great management, brand,

client base, etc.? What about the value of the terrific talent Murthy and his team bring to the

table? The answer is simple. All the intangibles are very relevant, but they are the reason the

company will do so well in the future. I would not be optimistic that a second- or third-tier IT

services firm in India will even be around 10 years from now. American Express, Boeing and

IBM all have exceptional brands and intangibles. These intangibles are very relevant to

shareholders and they do lead to sustainable competitive advantages that finally trickle down

to cash flow that the company generates. All of Infosys’ intangibles are fully appreciated and

have been implicitly factored into its future cash flow projections. If a competitive advantage

does not eventually translate into cash flow then it is not a competitive advantage that’s

relevant to investors.

It might be an interesting exercise for the reader to calculate the intrinsic value and future

return expectations of all the stocks in their portfolios. The results will probably be surprising.

Investors would be well served to look for great businesses within their circle of competence

and then calculate intrinsic values for those businesses based on their annualized return

expectations. The data would call to take a pass on most companies. Occasionally, however,

Mr. Market will throw out a fat pitch. You know what to do then.

Mohnish Pabrai is the managing partner of Pabrai Investment Funds. He can be reached at

mohnish@corp.siliconindia.com 

Chapter 21: When Mr. Market Gets Depressed, Back up the Truck!When Mr. Market Gets Depressed, Back Up the TruckAfter closing in the aftermath of the Sept. 11 tragedy, stocks plummeted the following week — with the Dow over 14 percent! As one would expect of a rational market, companies like American Airlines, Smith & Wollensky Restaurants, and The Four Seasons Hotels all took major hits to their pre-Sept. 11 market caps. However another important event took place. Federal Reserve Board Chairman Alan Greenspan reduced interest rates by another 0.5 percent, bringing the prime rate to a seven-year low. 

As amazing as it sounds, there is a set of businesses for which both the WTC tragedy and

Greenspan’s rate cut are positive events. Under the rational/efficient market hypothesis, these

stocks should have gone up when the market reopened on the 17th, because it is pretty clear

that their future profitability just got better. Is that what happened?

Let’s examine a few of these publicly-traded companies. Stewart Enterprises (STEI) is the

second largest company in the “deathcare” industry worldwide. Stewart has about $700

million in annual revenues and owns about 700 cemeteries and funeral homes in nine

countries, with the bulk of them in the United States. With $325 million in debt tied to the

prime lending rate, Greenspan’s action will increase Stewart’s earnings by about two cents

annually.

As a result of the events of Sept. 11, their revenue or operating profit are not expected to

decline at all (they may have increased). Thus, net-net STEI should have had a price increase

of at least $0.20 over its Sept. 10 close. Stewart closed at $7.15 on Sept. 10 and at $5.85 on

Sept. 24. In percentage terms, the Dow was down 14 percent during the week, while Stewart

was down more than 18 percent! Nearly every single Dow stock is going to report significantly

lower earnings as a result, while Stewart will be reporting higher earnings, yet it lost nearly a

fifth of its market cap. How much sense does this make?

Let’s move from the morbid subject of death to the relatively more uplifting subject of medical

diagnostic services. Radiologix (RGX) is a company that develops and manages radiology and

medical imaging centers. RGX operates 124 centers in 18 states. The company has about $250

million in annual revenue and a market cap of $121 million ($6.20 a share) as of Sept. 10. In

addition the company has $160 million of debt that is tied to the Fed discount rate and LIBOR.

The 0.5 percent drop in interest rates had the impact of increasing EPS by about $0.05

annually and should have led to a $0.30-0.60 increase in the share price. On Sept. 24, after a

steady decline throughout the week, RGX ended at $5.25 — a decline of more than 15 percent!

I cannot find a correlation between the events of Sept. 11 and the intrinsic value of RGX. Why

did RGX lose 15 percent of its market value in the week following Sept. 11, when it should

have increased five to 10 percent?

From death and MRIs, let’s move to the more colorful world of retail. Liquidation World is an

impressive operation based in Calgary, Alberta, Canada. From its start in 1987 through 2000,

sales have grown from less than C$1 million to C$165 million, with no decline in sales in any

single year. Since 1992, net profit has grown every single year and they have about 90 stores

(up from one in 1987). The company specializes in buying merchandise from other retailers

and e-tailers that have obsolete or excess inventory, bankruptcy or distressed situations,

receiverships, closeouts, etc. They go in and buy great stuff at pennies on the dollar and then

put it in their outlets and do what Sam Walton preached: Stack it High and Let it Fly! You get

the picture.

When Silicon Valley was reeling from its dot-com bust and all the e-tailers were going under,

Liquidation World had many teams working overtime in California and all over the U.S. getting

the best stuff from these e-tailers at super-distressed prices. All of those VC losses were their

gain!

On Sept. 10, LIQWF was changing hands at around $6 a share. In the wake of the tragedy, it

dropped to $5.30 — a 12 percent decline. LIQWF’s prospects for picking up excess inventory,

etc., only improved after the tragedy as several retailers are driven to the brink of bankruptcy

with declining sales and consumer confidence. In addition, most of its outlets are in Canada.

Canadians feel significantly less threatened and traumatized than the general U.S. population

by the events of Sept. 11. So, the best that I can tell, Liquidation’s prospects and profitability

only improved. Why did it lose 12 percent of its already modest value?

The public equities markets are mostly efficient, but not fully efficient. Events like Sept. 11

tend to widen the efficiency gap – as shown by our three examples. In times like these, Mr.

Market gets severely depressed and can only think about doom, gloom and uncertainty.

Investors who use times likes these to make investments in a few great businesses and make

these investments meaningful portions of their portfolio for the long haul can take advantage

of these inefficiencies. With his occasional mood swings, Mr. Market offers a wide array of

great businesses on “clearance sale” for a few weeks every few years. This is a good time to

take advantage of Mr. Market.

Disclaimer: The companies mentioned in this article are not being highlighted as stock tips or

“buys.” They may or may not be bargains at current prices. The Pabrai Investment Funds may

have present or past long positions in some of the securities mentioned. 

Mohnish Pabrai is the managing partner of The Pabrai Investment Funds. He can be reached at

mohnish@corp.siliconindia.com. 

Chapter 22: Entrepreneurs Aren't Risk Takers - They're Arbitrageurs!Entrepreneurs Aren't Risk Takers - They're Arbitrageurs!Last year, former Harvard professor Amar Bhide wrote “The Origin and Evolution of New Businesses,” a book based on hundreds of interviews with Inc. 500 CEOs about the elusive beast known as entrepreneurship. His conclusions are counter-intuitive and should be required reading for would-be entrepreneurs and investors looking at everything from startups to public equity markets.

Bhide’s research showed that virtually all startups fall into two categories: marginal startups

(e.g., hair salons, lawn care, etc.) and promising startups (e.g., Microsoft, HP, etc.). Marginal

startups have low uncertainty, low investment requirements and low likely profit. Promising

startups have high uncertainty, low investment requirements and low likely profit. However,

both types have two things in common: they are low risk and arbitrage oriented. This is

contrary to the myth that entrepreneurs are risk takers. When Gates dropped out of Harvard

and started Microsoft, his opportunity cost was very low. He was not worth much in the job

market. But, had Microsoft failed, he could have simply returned to Harvard to finish his

degree. He faced uncertainty and ambiguity, but not risk (see figure 1).

Risk Reward Equation

Consider the example of a skilled hairdresser who notices that there are no salons within a 24-

mile radius of her town. She scrounges up her savings and opens a little salon with very basic

infrastructure. Her risk of failure is quite low because people need to get their hair cut and they

are driving at least 24 miles.

Because of the compelling proposition, she soon gets a steady and growing clientele. She has

virtually no risk because, if the venture fails, she simply goes back to working at another salon.

The upside is better than working at another salon, but it’s unlikely that she’ll end up on the

Forbes 400 as a result. Essentially, she’s engaged in arbitrage. The arbitrage “spread” is the

24 miles between her and the next salon. As she gets busy, another venturesome hairdresser

leaves her job and opens a salon 12 miles away. Then another opens three miles away, and so

on. Eventually, the market becomes efficient and net changes in salon chairs match population

changes.

When Gates and Allen launched Microsoft in 1975, their only product was an 8080 BASIC

compiler that ran only on an Altair computer. At the time, they were the only ones serving this

small niche. Similarly, HP started with an audio oscillator for which there was very limited

demand. Both companies essentially were acting as arbitrageurs in their respective markets.

They were collecting the “spread” until other entrants show up. Neither had a grand plan to

get them to where they are today. They simply were trying to be resourceful and survive.

Arbitrage by definition is low risk and typically a return slightly higher than the risk. If gold is

quoted in London at $275/ounce and $280/ounce in Frankfurt, arbitrage players quickly jump

in buying in London and selling in Frankfurt till the spread eventually equals transaction costs.

But an astute investor — whether looking to invest in Microsoft in 1975 or in our salon when it

still enjoys the 24-mile advantage — is not usually looking for an arbitrage spread. Buffett

succinctly says: “The key to investing is … determining the competitive advantage of any

given company and the durability of that advantage.” Our salon has a wonderful competitive

advantage when it starts, but that advantage is not durable. Hence it would make a poor

investment. Similarly, the barriers to entry for others to create a BASIC compiler for the Altair

were essentially nonexistent (see figure 2).

The good news for entrepreneurs and investors is that the arbitrage spread can occasionally

last for years. Given enough time, some durable barriers to entry may be created such as

brand, scale or a loyal customer base. Nonetheless, Bhide’s research clearly shows that the

business model of the overwhelming number of startups is straight arbitrage. Any sustainable

competitive advantage is nonexistent at the time of startup.

Both Microsoft and HP would have failed Buffett’s durable competitive advantage test in their

early days. To scale, both jumped from one niche to the next without much planning or

analysis. Any one wrong jump would have done them in.

Who Fails? 

Most companies, however, are unable to keep successfully jumping from one arbitrage

opportunity to the next and thus wither away. The ones that choose not to jump (like our

salon) remain small. U. S. government data indicates that 60 percent of the million annual

startups fail in the first six years. More importantly, the overwhelming number of survivors

remain small.

Durable competitive advantage is usually the result of unpredictable and rare random events,

like IBM’s call to Microsoft to sell them a PC operating system when Microsoft had never built

an operating system before and did not have one to sell. These events have no pattern and

cannot be forecast when a startup is being formed. They happen to a very small minority.

Once a startup has acquired a durable competitive advantage, and investors get an

opportunity to buy in well below intrinsic value, backup the truck.

Because entrepreneurs are arbitrageurs, they constantly watch companies with durable

advantages. They then try to find a way to carve off a piece of that advantage for themselves.

Durable competitive advantage is an anomaly and quite rare. When the Coca Cola Company

started it had a unique product that delivered high value to its customers. The drink was wildly

popular.Concocting Coca Cola was not rocket science and soon enough numerous other

“colas” emerged. These new arbitrage players offered lower prices or entered markets that

Coke had not yet entered. In time, hundreds of “cola companies” with names similar to Coca

Cola had popped up. Most folks would ask for Coca Cola and vendors would freely serve any

other brand they were selling. Coke was in a fix until its brilliant lawyers sued all the

competitors and their vendors — driving them out of business. Pepsi, based in Canada,

escaped and today is Coca Cola’s primary competitor.

Thus, the Coca Colas and the Microsofts of the world are under constant attack by thousands

of entrepreneurs trying to make inroads.

In another fascinating book, “The Living Company,” Arie de Geus noted that the average life of

a Fortune 500 company is less than 50 years from birth to death. The Fortune 500 represents

the businesses that are able to take advantage of some aberration and build durable

competitive advantage. 

Investing in most startups is akin to gambling. The odds do not favor the investor. Hence it is

necessary invest in them at substantial discounts to intrinsic value with a Ben Graham “margin

of safety” to realize a good return within the first few years.

Mohnish Pabrai is managing partner of The Pabrai Investment Funds. Write to him at

mohnish@corp.siliconindia.com 

Chapter 23: The Investor's Dilemma - Mutual Funds or Stocks?The Investor's Dilemma: Mutual Funds or Stocks?Conventional investing wisdom says that one needs to concentrate investments when amassing wealth and diversify when preserving wealth. Most successful entrepreneurs at some point have 90+ percent of their wealth tied up in a single company. They are in wealth amassing mode and represent the extreme of asset concentration. Ironically, most entrepreneurs are quite comfortable with their non-diversified assets.

Young people with several decades until retirement mainly want to amass wealth, not preserve it. But how do you do that if you are not an entrepreneur? Charlie Munger points out that the first step to wealth is to spend less than you earn from the outset. As you generate savings, the most logical choices are to invest either in individual stocks or mutual funds or both.

Mutual funds has been one of the most rapidly growing industries for the last two decades. The number of funds has mushroomed to more than 8,000; assets under management have grown consistently to several trillion dollars over the years. This, despite the fact that six out of every seven funds lag the performance of the S&P 500 index over time. The industry is one of the only ones I know of where even if you perform poorly, you still continue to grow revenues and profit! 

If the objective is to amass wealth, then mutual funds are not the answer. Regulations do not permit funds to invest more than five percent of assets in a single stock. Thus, at a minimum, any fund has at least 20 stocks. In practice, virtually all mutual funds have hundreds of stocks with no single one being more than two to three percent of the portfolio. Any portfolio with hundreds of securities has a very high probability of under-performing the market and an infinitesimal probability of outperforming it. I find it difficult to find more than four to six winners in a year. I don’t know how a fund manager can find 200 winners. There is very good logic behind the 5 percent rule: it protects investors from big losses. The side effect is that it pretty much guarantees mediocrity.

The best way to sum up mutual fund investing is the following quote from Warren Buffett, taken from the 1996 Annual Report of Berkshire Hathaway:“…The best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat the net results delivered by the great majority of investment professionals.”

Since index funds are the way to go to preserve wealth, should one invest in a few stocks directly to build wealth? When Warren Buffett ran his Buffett Partnerships he rarely made an investment in his portfolio with less than five or 10 percent of assets. Once in the 1960s he invested 40 percent of the Buffett Partnership funds’ assets in a single stock: American Express. Buffett’s partner Charlie Munger has an even more extreme perspective. He feels that three to four stocks are all that are needed to have a stellar portfolio. It reminds me of a former CEO of Coca Cola, Woodrow Wilson. He was once asked by an analyst if it was a good time to sell Coca Cola stock. Wilson responded, “I don’t know. I’ve never sold any.” Till today, the Wilson Foundation has never diversified. Over 90 percent of its assets are in Coca Cola stock. Needless to say, its returns have trounced the overall market. Charlie strongly endorses

the Wilson Foundation’s perspective on non-diversification. The Buffett Foundation will inherit more than 99 percent of Buffett’s estate and it too will be 98+ percent concentrated in a single holding: Berkshire Hathaway.

So should investors build their own portfolios? I can’t resist another Buffett quote from the same annual report on the subject that sums it up succinctly:

“Should you choose … to construct your own portfolio, there are a few thoughts worth remembering. Intelligent investing is not complex, though that is far from saying that it’s easy. What an investor needs is the ability to correctly evaluate selected businesses. You don’t have to be an expert on every company or even many. You only have to be able to evaluate companies within your circle of competence. The size of the circle is not important; knowing its boundaries, however, is vital.”

The key point in Buffett’s quote is that while intelligent investing is simple, it’s far from easy. Over the last five years, 90+ percent of funds have lagged the S&P 500. The Odean and Barber study (done at the University of California at Davis) covering 78,000 individual investors showed that, on average, individual investors also lagged the market. My own experience with individual investors concurs with the results of the study. Most individuals would do better with index funds.

Investors who take the time to study and then only invest in a few outstanding businesses that they think are available well below their intrinsic value (see siliconindia article on intrinsic value in the July 2001 issue) and then hold those great businesses for a long time will come out ahead on their journey to wealth. However, there are only a few of us who have the discipline, analytics and patience to follow this approach.

To sum up, most managed mutual funds will lag the market. Index funds are a good way to preserve your wealth but not make you rich. And individual stock picking is a loser’s game for most investors. To make matters worse, Buffett predicts that the U.S. stock market will only deliver a four to six percent annualized rate of return over the next 10-15 years. I agree with Buffett’s thesis. So the next decade will be a disappointing one for most investors.

To close on a somewhat positive note, I’d like to add that a few professional investors have consistently beaten the market following Buffett style of focused value investing closely. I’d recommend that the reader stick to index funds or investigate investing with managers like Marty Whitman (Third Avenue Value Fund), Bill Ruane (Sequoia Fund), Mason Hawkins & Stanley Cates (Longleaf Partners), Bill Nygren (Oakmark Fund) and Seth Klarman (Baupost Fund). They have all delivered results that have been vastly superior to the indices and have a focused investment style with limited securities in the portfolio.

Mohnish Pabrai is the Managing Partner of The Pabrai Investment Funds. He can be reached at mohnish@corp.siliconindia.com. 

Chapter 25: Intrinsic ValueValuation By Intrinsic Value“It’s a real tragedy when you buy a stock that’s overpriced; the company is a big success and you still don’t make any money.” Peter Lynch, “One Up on Wall Street,” New York, Penguin Books, 1989, p. 244.Microsoft shares recently have been trading at about $70, off more than 40 percent from a high of $119.93. They went as low as $40 a share in December 2000. Is Microsoft a buy at $70? Is it a compelling buy if it dips down to $40 again? What is Microsoft worth and what type of annualized return would one derive from buying the stock today?

Before we try to answer those questions for Microsoft, let’s consider another one:Let’s say a neighborhood gas station is put up for sale for $500,000. Further, let’s assume that the gas station can be sold for $250,000 after 10 years and free cash is expected to be $100,000 a year for the next ten years. Let’s say that we have an alternative risk-free investment that would give us a 10 percent annualized return on the money. Are we better off buying the gas station or taking our 10 percent risk-free return?

“Any business is worth the sum of free cash flow it will generate from now to eternity, discounted to present value using a reasonable risk-free interest rate” (John Burr Williams, Ben Graham, Warren Buffett, et al.)

Applying this notion of intrinsic value to the gas station yields a present value of $710,000. In other words, the gas station represents a better deal and a return substantially higher than 10 percent annually (Table 1).

The bigger the discount to intrinsic value, the more compelling the business becomes as a buy. All the great qualities of a business get fully reflected in its ability to earn cash in the future. Hence, regardless of the quality of the business, no business should be purchased above its intrinsic value. 

Microsoft is a wonderful business. It has several exceptional traits that are rare to find together in a single company. Some of these are its recurring revenue stream (from upgrades), ability to raise prices and reduce costs ahead of inflation, it’s near-monopoly in most of its markets, its strong installed base, brand, etc.

Microsoft’s Intrinsic ValueThe question an investor should ask when looking at Microsoft, or any other company, is not what the stock is priced at, but what the market capitalization of the company is. Like the gas station selling for $500,000, Microsoft is selling for $380 billion. Most investors fix on the stock price. Microsoft, however, through splits or reverse splits, can make its stock price whatever it wants it to be. Think of it as a business, just like you think of the gas station as a business.

Microsoft’s free cash flow is vastly different from reported net income. Like many technology companies, Microsoft issues stock options to virtually all employees. It has historically spent a large portion of its net income buying back stock to offset the dilution effect of options. The share buybacks annually are less than the options exercised each year. So the money used to buy back stock (less the amount received from employees when they exercise options) should be subtracted from net income to get closer to free cash flow. In effect, the money spent buying back stock might as well have been delivered in the form of checks to employees. The end result is the same.

In fiscal year 2000, Microsoft had net income of $9.4 billion, but spent about $4.9 billion buying back its stock. So ignoring other minor balance sheet items, free cash flow was around $4.5 billion. Let’s assume that Microsoft grows at 10 percent annually through 2005, and eight percent thereafter for the next few years. Let’s also assume that free cash flows are a healthy 25 percent of revenues after stock buy backs. Finally, let’s assume a sale of Microsoft in 2011 for a rich 15 times cash flow or almost 2 times its 2010 growth rate (Table 2).

Microsoft’s book value is about $41 billion. If I (generously) give them 100 percent credit for all of it being excess capital, the total intrinsic value of Microsoft is about $168 billion or $23 a share. The growth assumptions on Microsoft and the assumption that they will hit no road bumps or disrupters in the next 10 years are quite optimistic. If $23 a share is the correct intrinsic value, then value investors would want a Ben Graham/Warren Buffett “margin of safety” to justify the investment. This margin in a technology-centric business should be at least 40-50 percent.

So, at most, Microsoft may be a buy at under $13/share. It’s a far cry from the $70 a share it is currently trading at. It’s important to remember that investors who buy Microsoft at $23 a share will net a 10 percent return if there are no road bumps. Investors buying at $40, $50 or $70 a share will see a much lower return that starts to approach zero.

As Ben Graham succinctly put it, the stock market is a voting machine in the near term and a weighing machine in the long term. In the long run, all companies will trade around their intrinsic values. So, unless the fundamental business improves dramatically, we are bound to see a lack luster performance by Microsoft stock over the next decade — even though the company continues to grow and prosper.

Let’s do the math from another angle. Microsoft has a market cap of $235 billion. If someone

invested in Microsoft thinking it was a good long-term investment, they might be looking for at least a 15-20 percent annual rate of return from this blue chip tech company.

If a 20 percent annual return has to be realized over a five-year period, Microsoft needs to have a market cap north of $600 billion in 2005 (including employee option exercise dilution). To justify a valuation of $600 billion, Microsoft needs to be generating free cash flow in the range of $50-60 billion a year in 2005. How many companies in the United States have ever generated that type of cash flow? The answer is zero. It is very unrealistic that free cash flow will grow 10-fold in the next five years. Even GE does not generate that type of cash flow.

Investors would be well served to look for great businesses within their circle of competence and then calculate intrinsic values for those businesses. If they are being sold well above intrinsic value, just take a pass. On the other hand, if they are available at deep discounts to intrinsic value, back up the truck!

Mohnish Pabrai is the managing partner of The Pabrai Investment Funds.