Saturday, September 26, 2009

The Dhandho Investor: Chapter 15

Mohnish Pabrai is an Indian-American businessman and investor. For a number of years, he turned heads with the performance of Pabrai Investment Funds since its inception in 1999. Pabrai has high regards for Warren Buffett and admits that his investment style is copied from Buffett and others. Over the next few weeks, we'll be exploring the topics in his book about value investing.

In the investment world, there is much discussion devoted to determining when to buy a stock. Comparatively very little time is spent on when to sell. Indeed, the first fourteen chapters of this book provided information with a leaning towards buying. This chapter discusses the process investors should go through to determine whether to sell.

First of all, Pabrai advises that investors have their selling plan for a stock in place before they buy. Without a plan in place, once an investor has purchased, he will then be subject to the psychological strains of stock ownership that can cause irrational behaviour; a plan can help avert a poor decision.

Once a stock is purchased (presumably at a discount to intrinsic value), Pabrai advises holding it for at least two years. While he admits this number is rather arbitrary and that he has no empirical data to back it up, he argues that a few months is not long enough for a business' value to have changed significantly (and therefore intrinsic value could not have fallen by such a large amount), and 5-6 years is too long to have money tied up due to opportunity costs. The only times Pabrai believes an investor should sell within two years are if:

1) One can estimate the business' intrinsic value 2 years out with a high degree of certainty, and
2) The price offered is higher than that estimated value

Note that in cases where the future has become uncertain since the stock purchase, Pabrai advises investors to hold on (as rule 1 above is not met), as he believes the clouds of uncertainty tend to clear over the course of several months. To illustrate this point, Pabrai takes the reader through an example of a theoretical gas station whose future cash flows become uncertain, as well as a real example he encountered in his fund.

Furthermore, if after three years a security has not reached intrinsic value, Pabrai argues that the investor is likely wrong about his valuation or intrinsic value has likely fallen. On the other hand, should the stock rise to within 10% of intrinsic value, Pabrai recommends investors strongly consider selling. Should the stock price rise above intrinsic value, Pabrai recommends immediate sale (with the only exception being tax considerations, if neccessary).

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