A Wealth Creation Journal

Key takeaway of Pabrai’s latest talk at Google

Here’s the link to Pabrai’s third talk at Google [Youtube].

Pabrai’s book The Dhandho Investor is worthwhile too.

I will be upfront: I’ll provide the reader with one key thing to remember, but also one Q&A answer to forget.

The Best Idea Fund

Charlie Munger coined a problem at his dinner party: Capital Group (large LA based fund manager) created The Best Ideas fund. This fund would collect one favorite stock per analyst in the fund. Munger mentioned that this fund underperformed the market significantly and asked guests as to why this might be.

The answer was

  • consistency bias: the idea that managers had spent the most research time on was typically their “best idea”. Human beings tend to selectively filter new information that confirms the first thing they belief to be true based on something they read or listened to.
  • the specialist problem: specialist analysts get biased toward their sector benchmarks. They do not select the best stock, but the best stock in the sector.
    • TC Comment: this compounds the insider view bias that Kahneman discovered. Man is naturally taking too much of an insider view already in general, and not enough benchmarking ideas to the outsider view, or base rates.

Why I think Pabrai’s thought on the general market valuation was confusing at best

In the Q&A Pabrai says (minute 57):

If interest rates stay low, for an extended period of time, then present valuations may be a bargain. [..] And of course we won’t know that, til we get to ’20 – ’24. And so, markets are discounting mechanisms, if markets had a crystal ball to tell us where interest rates were at 2020 or beyond, you could get to [the valuation] accordingly.

Of course we won’t know how interest rates for maturity X will change in the future, this is self-evident. What Pabrai seems to forget is that we do know what the expected future interest rate is for maturity X at future time T by backing out forward rates from the current term curve.

In short, I found it a bit stunning that Pabrai forgets to mention that we can use the market discounting mechanism today to find the market’s implied future interest rate for maturity X at future time T. The market does provide us with a crystal ball that gives us the expected interest rates in the future, or the ‘central scenario’, if you will.

It looks like Pabrai is not familiar with the elementary concept of forward rates (and neither is the Google audience!). For those that want to familiarize themselves with the concept, feel free to visit Wikipedia: forward rates, or take a Yale Introduction to Finance course by Robert Shiller: ‘Forward and Future Rates’.

TC

2 Comments

  1. MC

    I would just add a few point on this talk.

    Here are the things I liked about talk:
    1. I do agree that having scanned a wider investment universe is useful to avoid the bias that one simply end up investing in ideas that one spends most time on.
    2. Awareness of consistency bias and other human biases are critical to sound investment decision making process
    3. Ability to say no quickly

    Here are things I found debatable:
    1. He mentioned about the art of being unreasonable. And that he wants to buy great companies cheap i.e. have the cake and eat it at the same time. Of course we all want it but the problem is that if it is that cheap it is probably not that great. My point being that for obviously great company to be cheap, there is, more often than not an obviously, a big problem at the obviously great company. Hence you need special insight to detect if that the big problem is really big and/or relevant. Special insight means a lot of in-depth research and due diligence. Which means focusing only on opportunities that offer huge upside does not mean that you can have a more effective investment process. Another way to look at it is that if you immediately like an idea after 10 seconds, you are probably under the influence of the impulsive System 1 thinking.

    2. He mentioned that “Growth is always better”. This is self-contradictory

    So far I think Monish’s best insight is uncertainty does equal to risk!

    • pembridgecap

      “So far I think Monish’s best insight is uncertainty does equal to risk!”
      You mean if there is huge uncertainty of valuation from an event, but that the downside is largely priced in and hence largely positive assymetry uncertainty? (Dhando) I fully agree that is something useful he highlights, and I’ve come to recognize over the years that the market really does not like upside uncertainty as much as it should. A recent debatable example is tech businesses like AMZN, Alphabet where it is difficult to account for positive optionality (or assymetry if you like), and just because it is hard to quantify it is largely discarded.

      In retrospect I think the talk wasn’t that interesting and was full of platitudes.

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