In the second half of the Q&A session after his lecture at the Fall 2020 Value Investing Course at Peking University's Guanghua School of Management, Mohnish Pabrai answered more questions on his "Spawning" framework. This article focuses on the questions and answers regarding his experiences and lessons from mistakes.
Question 6: Is it possible for non-founder-led companies to become "Spawners?" And how do you avoid the "hammer-and-nail syndrome?"
Most "Spawners" are indeed founder-led. The founder has the DNA. The founder is typically young or relatively young and still running the company with the same DNA. If it is transitioned to another generation, then you have to determine if you have enough data to make the judgment of whether the next generation can inherit the DNA. In some cases, the next generation can be better than the previous generation.
For example, in India, one of the largest companies is Reliance Industries (BOM:500325, Financial). The second generation is running it. The second generation is better than the founder. The son is better than the father. But it takes some time to understand that's the case. If there's a transition that has taken place to professional management who acts like agents, and the "spawning" took place when there was a founder, it's a red flag. You have to have enough data on the professional manager.
For instance, when a business like Amazon (AMZN, Financial) were to transition to the next leader, we need to ask the question "has the 'Spawning DNA' been so deeply entrenched into the business that the next leader has the DNA as well?" We have to see if that is actually the case.
With regards to not falling for the "hammer-and-nail" syndrome, you have to make sure you're not fooling yourself, because you are the easiest person to fool. If we take a step back, one of the things Charlie Munger (Trades, Portfolio) had told Pabrai was that it's always good to have somebody to bounce your investment ideas off of. Munger said sometimes he would discuss his ideas with somebody other than Warren Buffett (Trades, Portfolio).
The person you discuss your ideas with should be a peer. It cannot be an employee-employer relationship because there is a hierarchy, which makes a candid sharing of perspectives harder. But if you can share your ideas with a peer who can be honest and candid with you, that is one way to avoid the "hammer-and-nail syndrome."
Question 7: How do you know this "Spawner and Non-Spawner" framework is not an example of "hammer-and-nail problem?"
If we look at a lot of businesses and decide that we want to start separating them into "Spawners" and "Non-Spawners," it's not really possible, as these are not binary results. There are some companies that are complete "Non-Spawners." On the other hand, there are companies that are extreme "Spawners." And then throughout the continuum you will find companies that have a strong "Spawning DNA" and then others that would have a weak "Spawning DNA." It would be more like a continuum and not a binary switch if you looked at different businesses. As long as you can identify where you want to be on the continuum, for instance, towards the strong "Spawning DNA" end of the continuum, you will be able to separate them.
The other thing is that just like in baseball, there are no called strike. So it's ok to miss a "Spawner." It is problematic to think a business is a "Spawner" when it's not. It should be obvious that a company has strong "Spawning DNA."
Pabrai hypothesized that if he had a portfolio of ten carefully-selected "Spawners," he would set it and not touch it for a long time. Pabrai thinks the odds are good that if you've done your selections properly, three or four of these companies may turn out to be really good, and that's all you need. If you get a few that are really good, it will make up for all the all the mistakes that you can come up with. If you just identify a few that give you very strong returns, as long as you don't lose much money on the others, you'll be okay.
The "Spawner" approach can tolerate being wrong on some of the businesses because business is difficult. Trying to forecast future of a business is difficult no matter what. We may be wrong on some of these "Spawners" and that's perfectly fine. We don't need to be right on all of them.
Nick Sleep, for example, was absolutely right on one business – Amazon. He first bought Amazon shares at $30, then he bought at $100, and then he bought a $200. He even bought at $300 a share. It didn't matter. There were about a dozen companies in his portfolio. This was the only one that mattered.
Question 8: If the past 10 years had been a bear market, would you have had a different thinking on the framework? And how do you deal with short-term suffering caused by price decline?
The bear market might make it easier to buy those kinds of businesses because no one's interested in them. There's a saying that goes like this: "If wealth is lost, nothing is lost. If health is lost, something is lost. If character is lost, everything is lost." You're not buying a stock, you're buying a business.
Before you buy the business, you need to understand what that business does, and what that business is worth. Then you're not going to get distressed. In fact, you should be happy when the price goes down because you can buy more. It is in the nature of auction-driven markets that we are going to see these swings both ways. And we can take advantage of those swings.
Question 9: Any thoughts on why Berkshire has sold its Costco (COST, Financial) position? Can you also comment on your Seritage (SRG, Financial) position?
The Costco sale was a complete surprise to Pabrai because from his observations, there are few companies that Munger loves more than Costco.
Seritage is a "Non-Spawner," but the price was down a lot earlier this year, so that's why Pabrai loaded up.
Question 10: Do you think you can become the investor that you are today without your previous entrepreneurial and operating experiences? And do you think physical location is important in understanding a business? For instance, for someone who lives in the U.S they may understand U.S companies better. But on the other hand, Charlie Munger (Trades, Portfolio) has invested in China even without being fully present there.
It's a very big advantage if you have run a business before. It helps you identify "Spawners." With regards to where to invest, you have to have very high conviction. Any time you're making investments, you have to have very high conviction. You cannot be concerned that you don't understand something. So the thing about investing is that the size of the circle of competence is irrelevant. What is more relevant is that we stay within the circle.
Question 11: What is your biggest mistake in investing and what influences does it have on you?
The investments that Pabrai said give him the most trouble are companies with leverage. Pabrai had many investments over the last 26 years that did not work well. A good number of them are companies which had too much debt.
Read more here:
- Mohnish Pabrai Shares Insights on Identifying 10 to 100-Baggers - Part 2
- Mohnish Pabrai Shares Insights on Identifying 10 to 100-Baggers - Part 1
- Li Lu Explains the Case for China - Part 8
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