Pabrai investment funds were started by the information technology entrepreneur Mohnish Pabrai in the internet bubble of year 1999 with a seed capital of 1 million dollars only. Since then, by virtue of an annualized return of 18% till last quarter of 2010 (compared to returns of less than 1% for the S&P 50 index and 3% of Dow Jones index for the same time period) and the continuous infusion of money from many dedicated investors, the current assets under management stand slightly above 300 million dollars today.

While a fund with such a track record for a decade could have rather easily ballooned into a couple of billion dollars, Pabrai has purposefully kept the fund size relatively small so he does not run into the problems of his mentor and guide Warren Buffet where high minimum investment requirements preclude many under-valued opportunities.

Indeed, Pabrai gets his returns from a deeply value-oriented philosophy, focusing on a concentrated portfolio of stocks comprising the classic combination of a margin of safety on the investment side and a recognizable moat on the business side, which he vicariously learned from the likes of Warren Buffet and Charles Munger. He combines this bookish learning with his experience as an entrepreneur and, more importantly, infuses it with the historical DNA that empowered business success in the United States of his Dhando people. The latter, a people from the state of Gujarat (that any given year doubles the GDP of the host country India, last reported at 8%), have efficiently created a business model of motel ownership in the United States. In his book “The Dhandho Investor: The Low – Risk Value Method to High Returns”, he analyzes the reasons for the success of the” motel model”. First, the typical immigrant family invested in the motel because they could live there (thereby save on business expenses) and they simply relied on the historical cash flow to support the mortgage. Second, if the business actually failed, the chances of failing again with the same cautious approach were extremely minimal, 1 in 99, according to his incidental analysis.

In addition to sharing a deeply value-oriented philosophy with Warren Buffet, Pabrai has also imitated Buffet’s compensation structure when Buffet launched his initial hedge fund in the fifties. In stark contrast to the 2-20 model pursued by most hedge funds today, he has a structure that is more deeply aligned with his investors: He does not charge any management fees, but only an incentive fee of 25% after having met an annual hurdle of 6% for his investors. To further align his interest with his investors, he invests all his and immediate family’s investible capital in his own funds, thereby following the adverbial advice of eating one’s own cooking.

It is worth noting that despite his impressive annualized record and a fierce commitment to aligning his interest with investors, his journey was not without turbulence. His fund plunged more than the indices in the years of 2007 and 2008, and made him question his method of a highly concentrated fund with no or little cash allocation and no reference to a model against which one can check the possible erroneous movements one is about to make. This led him to three changes accordingly.

First, a movement from 10-10 model to a 2-5-10 model. In the 10-10 model, a manager holds 10 stock positions and hence has roughly an equivalent of 10% of his entire fund allocated to each position. In the 2-5-10 model, a manager allocates only 2% of his funds to positions that he finds reasonably undervalued, up to 5% of his funds to opportunities that are exceptional, and up to 10% of his funds to prospects that present themselves once in a while. In that manner, the fund is diversified into a more reasonable spread beyond 10 positions at any given time (e.g. currently his fund holds 27 positions with varying degrees of exposure to each position between a minimum of 2% to a maximum of 10%).

Second, he realized and now exercises the discipline of holding around 10% or more in cash in order to avail of opportunities when the markets crash as they did in 2008. Additionally, the need to find more investments as per the new diversification model prompts a fund to hold some cash as at any given moment it is hard to find so many undervalued investment opportunities.

Third, he became cognizant that even the greatest investors make erroneous judgments and that he (especially in a volatile market) was no exception, so a system of checklist has to be established to catch the mistakes (as humanly as possible) before they occur. For this he approached the system of checklist created by the aviation industry where a plane crash is analyzed into the smallest of details so that the same does not recur. Currently, he has a checklist of 80 variables, ranging from debt-to-equity ratio to free-cash-flow availability, that he subjects any investment idea through before including it in his portfolio. While the possible investment does not have to pass all the variables a priori and absolutely, it enables him and his team of analysts to question and understand the projected “failure” of the potential investment as per any of the parameters.

Manager Background:

Prior to founding his hedge fund, Pabrai started an IT consulting business named TransTech. The company, which was started with a seed capital of 100 thousand dollars was sold to Kurt Salmon for a price of 20 million in 2000. He gained his IT background while employed by the network communications company Tellabs, from 1986 to 1991.

In June of 2007 he won a charity lunch with Warren Buffet by bidding over half a million dollars.

QUOTES

“Investing is a peculiar business. The larger one gets, the worse one is likely to do. So this is a field where the individual investor has a huge leg up on the professionals and large investors. So, not only can The Dhandho Investor approach be applied by small investors, they are likely to get much better results from its application than I can get or multi-billion dollar funds can get. Temperament and passion are the keys.”

“And it’s all about participating in coin tosses where: Heads I win; tails, I don’t lose too much.”

“Charlie Munger says all intelligent investing is value investing. The term value investing is redundant. There is just one way to invest – buy assets for less than they are worth and sell them at full price. It is not “my approach.” I lifted it from Graham, Munger and Buffett. Beyond that, one should stick to one’s circle of competence, read a lot and be very patient.”

“As long as humans vacillate between fear and greed, there will be mispriced assets. Some will be priced too low and some will be priced too high. Mr. Buffett has been talking up the virtues of value investing for 50+ years and it has made very few folks adopt that approach.”