Q&A At The Pabrai Investment Funds Annual Meeting 2014

Question & Answers

Question: Why did you invest in Chesapeake Energy (CHK) and what were your reasons to exit?

Answer: Historically, based on an energy equivalent basis, crude oil and natural gas prices should have a 6 to 1 ratio. However, in recent years the price of oil typically had traded 8-12x that of natural gas due to a combination of rising domestic production from unconventional shale gas and regulation of natural gas export from U.S depressing price levels and fear premium for the global crude oil prices.

Chesapeake Energy‘s stock price had hit a low under the leadership of Aubrey McClendon due to unsustainable expansion and spending. McClendon ran into financial and ethical trouble and was ousted by the board of directors

Chesapeake Energy was going through a change in management with the appointment of Doug Lawler as CEO and election of Carl Icahn and Lou Simpson (Trades, Portfolio) to the board. Doug Lawler had started to bring spending discipline and focus the company on its core business.

My expectations and assumptions when I invested in Chesapeake Energy were:

• The core business had great underlying assets
• There are few shale formation in U.S and there is less possibility of discovering new shale formations
• In the long run, Natural Gas will do better and there is a high probability that 6:1 ratio between crude oil prices and natural gas are restored.
• The U.S govt will be lobbied by European countries to allow Natural Gas exports from U.S (though I was not counting on that)
• The new management will bring back spending discipline and profitability

Though I still believe in the long term prospects for Natural Gas and Chesapeake Energy, it did not meet all my expectations. When I found a better opportunity to invest capital, I decided to exit Chesapeake Energy.

Question: Are dividends an important part of your investment decisions?

Answer: Owners Earnings and the quality of the earnings are more important than dividends in my investment decision. One should look at the big picture instead of focusing on yield or dividends. If done right, share buybacks are more efficient and beneficial to shareholders than dividends.

Question: Why the change of heart on India?

Answer:

I had stayed away from India as most of the companies tend to be family owned and lots of them have governance issues, and we didn’t prefer to invest in family controlled businesses. However, we found a few opportunities this year which fit our criteria. One of them is the South Indian Bank.

Why South Indian Bank –

• Unlike the west or U.S, it’s hard to get a banking license in India
• 60% of the country still doesn't have a bank account
• The growing middle class is embracing banking and opening bank accounts
• It’s not a family owned business

Question: On re-entry into POSCO

Answer:

• Posco has derived its highly efficient manufacturing process for steel and iron from Nippon Steel, Japan in early 1960’s
• Even though Korea has no raw material for steel, due to highly reliable and low cost sea transportation, Posco has developed a strong competitive advantage
• Steel business is cyclical and almost all steel companies have losses at one time or another; however, Posco has never lost money
• Posco has strong support of the South Korean government.
• South Korean culture and work ethic is also a strong advantage

Question: How has your process of investment selection changed over time?

Answer:

• Over time I have realized it’s better to be a cloner than to think of original investment ideas.
• Using a checklist before making an investment keeps me safe from biases and overconfidence.

Question: Have you changed your philosophy of portfolio allocation from diversification to concentration over time?

Answer: My approach or philosophy depends on the availability of investment opportunities. in 2008-09 there were many opportunities and one could have a diversified portfolio with less than 2-3% allocated to each investment. In the current environment it’s hard to find many opportunities and I have changed my allocation to be lean towards concentration.

Question: How do you know if an investment is within your circle of competence and how far to the edge are you willing to go?

Answer: If a business is in your circle of competence, you should be able to think like the owner or CEO of the business, which would mean you are able to identify the key metrics or factors that really makes or breaks a business. I try to stay towards the center of my circle of competence and would rather not test the edges.

Question: How do you read annual reports of tech companies like Google?

Answer: I had read the S1 document which Larry Page had written about his vision for Google. It’s important to read the management discussions in the annual reports over the years to get the big picture and understand how the management has executed on its vision. Summarize your investment thesis in a single paragraph and monitor it. If you can’t do that then you can’t own the stock. Do not read the annual report blindly and read it by asking questions. Based on your research you should be able to extrapolate the range of outcomes for a business in the future.

Questions About Dhando Holdings

Question: Recommended Books / Publications on Insurance?

Answer:

• The Davis Dynasty: 50 Years of Successful Investing on Wall Street
• The Essays of Warren Buffett: Lessons for Corporate America, Third Edition
• Anatomy of a good insurance company in Berkshire Hathaway annual report 2004
• Yellow book filings of insurance companies

Question: What kind of companies will Dhandho invest in?

Answer: Dhandho will own relatively small and entrepreneurial companies.

Question:What is the difference between investing in public markets and investing in private companies ( i.e. Negotiated Vs Non-Negotiated )?

Answer: Public markets offer bargains for a shrewd investor due to many factors including unintelligent / uninformed investors and market forces. In private markets, you pay up for a quality business run by quality management; however, private acquisitions can be highly profitable in the long term if the acquirer can add value to the earning power or moat of the acquired business.

Question: How do you intend to setup right incentives at the Stone Trust Insurance?

Answer: Tim (Timothy W. Dietrich) is a great partner to have and will continue to lead Stone Trust. He works hard to be over reserved and profitable on underwriting. He need not work for a living, however he is passionate about his work and Stone Trust. I proposed a compensation to include 10% of under writing profits and it took him less than few seconds to agree. To conclude my philosophy about compensation is that “Humans work for a cause and something they believe in and not just for the love of money.”

Question: Will Pabrai Funds buy shares of Dhandho when it goes public?

Answer: When I invest capital for Pabrai funds, Dhandho Holdings will be one among the many opportunities available at that time. The decision to buy Dhandho will be based on the price and its valuation at that time.