Mosaic: Perspectives on Investing
by Mohnish Pabrai

May 2006

Sloppy in places, but overall worthwhile

This book was given to me by a friend who saw Mohnish Pabrai speak at a value investor's conference. Pabrai has roughly $300 million under management as of this writing, yet works with only a single secretary / assistant, reads a lot, and takes naps a lot, resting in the conviction of his concentrated, long-term positions.

In this Pabrai is a living counterpoint to one of his favorite Pascal quotes, "All man's miseries derive from not being able to sit in a quiet room alone." That is the type of observation that either resonates deeply or not at all. For me it definitely does.

I think Pabrai has much to offer by way of example, and I appreciate the nuggets of wisdom in this slim tome. However, I was disappointed by a few glaring instances of sloppy thinking here and there. For someone who vigorously highlights a commitment to latticework and the use of multidisciplinary thinking, some of the assertions in Mosaic were a bit breezy, with one or two real howlers thrown in. I do not highlight them because they indelibly mar the book, but because they were so surprising in an otherwise thoughtful text.

For example: in an essay on the folly of shorting, Pabrai does not just make known his distaste for shorting, he argues that shorting stocks makes no sense under any circumstance whatsoever. This is an extreme view that is defeated by simple evidence—that evidence being the number of successful funds who have made their shorting activity a consistent profit center, with track records to prove it. Not only have numerous long / short managers navigated the short side successfully, a bonus for profit-oriented shorts is a volatility damping effect on the portfolio, as short positions help offset hurting longs in market declines.

There is a strong empirical disconnect here; if shorting is a bad idea and doesn't work, then why has it worked well for a statistically significant number of practitioners over a statistically meaningful period of time? And how is it useful to say stocks return 8-10% a year "on average" without acknowledging the fact that future returns hinge greatly on present valuations, that industries or even whole sectors can go into multi-year decline as the rest of the market rises, and that stocks have seen flat to negative returns in the past, inflation adjusted, for years or even decades at a time?

On a more puzzling note, an example Pabrai gives to show why shorting is dangerous makes little sense. He starts with a hypothetical overvalued company at $1 billion market cap and 100 million shares outstanding, then goes on to show how the shorts could get "hosed" (his term) if the company chose to do a secondary offering of 500 million additional shares, adding the offering cash to its books to raise intrinsic value.

The reason this example is ludicrous is because it blithely assumes the successful absorption of a huge offering at the going market price, even as the total number of shares balloons by five hundred percent! If a company out there really tried to flood the market with five additional shares for each one currently outstanding—without compelling reason to do so—it would be an absolute field day for the shorts, as new supply would overwhelm existing market demand. (Not to mention the obvious question, if small overvalued companies could raise their intrinsic values simply by slinging new shares for quick cash, why don't they do it more often? Because unjustified secondaries don't fly, that's why.) This example showed a glaring lack of regard for simple supply and demand mechanics, and some other elements of the "don't short" argument were hastily put together and borderline superstitious.

I also had a bone to pick with the assertion that entrepreneurs are not risk takers. It's possible that they are arbitrageurs and risk takers simultaneously… but to suggest that entrepreneurs are not risk takers at all is over the top. Pabrai says that Bill Gates "faced uncertainty and ambiguity, but not risk," because Gates had the comfort of knowing he could go back to Harvard if Microsoft failed. Speaking later of a fictional hairdresser with plans to start a new hair salon, Pabrai says she has "virtually no risk" because "if the venture fails, she can simply go back to working at another salon."

No risk? Not quite. Starting an enterprise with your own credit on the line, and making it run on blood, sweat, and tears, is typically a high-risk proposition no matter what one's fallback options are. There is a massive time and energy cost to factor in, not to mention financial cost, emotional cost, and family cost. Yes, Bill Gates had Harvard as a fallback. But what if Microsoft had fizzled out after four grueling years of 90 hour weeks? Four years of life thrown away, and possible bankruptcy to boot, is somehow no big deal?

The example of the riskless hair salon is even more detached from reality; Gates at least had an idea what he was getting into. Pabrai should read "The E Myth" by Michael Gerber: small mom and pop type businesses are notorious for tearing would be entrepreneurs apart, because the myriad challenges of running a small business are so often underestimated. Even if the fictional hairdresser can go back to another salon, she might do so with destroyed finances, destroyed relationships, and an ulcer on top. The risk of sailing out into the open seas is real.

Moving on, this paragraph bowled me over, especially since it came in reference to a 'circle of competence' test: "Most readers use Intel and Microsoft products directly on a daily basis. Most of us use Cisco's products indirectly each time we go on the Internet or a network within the workplace. It's fair to say that most readers understand these three businesses quite well."

Quite well? How many people know the first thing about the logistics of the semiconductor business, just because there is an Intel chip hidden in their PC? How many understand the even more complex guts of the router / internet backbone business (I'm not even sure what the proper terminology is) just because they use Cisco's products inadvertently to surf the web? Understanding the deeper dynamics of a company like Intel, let alone Cisco, is far outside the circle of competence for most non-tech savvy investors, regardless of the ubiquity of INTC and CSCO products—which is a great example of why Warren Buffett, Pabrai's hero, doesn't mess with technology!

The missteps are all the more head-scratching considering that Pabrai runs a hedge fund, so he should know about share price mechanics; he founded a successful company, so he should know about the risk-laden aspects of entrepreneurialism; and he worked in the tech industry for years, so he should know the average joe has little knowledge of what goes on under the hood.

Let me close by saying I really did like this book, and Pabrai's personal success as a man doing what he loves (not to mention the excellent success of the Pabrai Funds) is both motivating and inspiring. The book gave me a sense of looking at the world through a traditional value investor's eyes, not to mention an interesting idea or two, and that made it a more than worthwhile read. My stringent criticism comes in part because I too am a mental model / latticework junkie, as Pabrai is, and I feel that us multidisciplinary guys should appreciate being held to the highest standards. Iron sharpening iron and such.