Circle of Competence

I’m not sure if anyone has read this month’s issue of SmartMoney. I like the magazine, I find it is well written, and while it is aimed at the general public (i.e. lots of retirement advice and such in there) occasionally there is very interesting article or stock pick to investigate.

This month’s issue, as I mentioned, has a 3 page article about Mohnish Pabrai entitled: “Looking Up to Buffett.” No shock here; Mohnish has said many times in the past he is merely a “shameless cloner” of Buffett. The article is a typical piece on a money manager; fawning over his success, reveling in the simplicity of his approach, asking him for a stock pick. I’m a huge fan of Pabrai myself, so in this case it doesn’t bother me; I think he deserves a ton of respect, and he has the record and approach to back it up.

Now, if you follow Mohnish at all, you know he bet big (to the tune of 10% of his fund at the time, $40-$50mm) on a now-bankrupt mortgage lender in 2006, Delta Financial Corp (DFCLG). Not only did he bet big, he added to his stake late in 2007, arranging $10mm in convertible financing for the company along with Angelo, Gordon’s $60mm in financing. The company went under shortly after, caught in the tidal wave of a securitization market slammed shut. Headline story: One of the most highly respected value investors out there bet big and lost over $50mm.

The most important part of the SM article, in my opinion, is where SM asks Mohnish about DFC:

SM: “How do you deal with a Delta Financial, professionally and personally?”

MP: “Investing is a game of probability. Sometimes when you make favorable bets, you still lose them. Even a blue chip could go to zero tomorrow. With Delta Financial, the company didn’t have enough financial strength- that was probably a mistake on my part. I think of it as a favorable starting blackjack hand where unfavorable cards showed up afterward.”

SM: “If you could do it over, would you have done the same thing?”

MP: “It was a good bet.”

There are a number of lessons here that we as investors can take away. The first one, the most obvious one, is to take your losses and move on. It doesn’t sound to me, from the tone of the article and his words, that he thinks about DFC much. Clearly he studied the reasons he lost the bet and learned from them, but he’s not hung up on a bad choice.

The second big lesson here is the importance of thinking probabilistically about investments. Buffett+Munger have said in the past that investing is a simple game of probabilities, and if you get ‘em right, you’ll be successful over the long term. It’s just intelligent, informed, rational, betting. Finding mis priced bets, squarely in your circle of competence, is the key to beating the market.

Myself, I almost made the same bet Mohnish did. There were lots of good reasons it could have worked out, the stock was undeniably cheap, and you had a vote of confidence from a very successful investor (Pabrai). In the end, I couldn’t get comfortable. I had the tremendous benefit of having lost my whole investment in American Home Mortgage earlier in the year, a nice slap in the face that showed me one area that was squarely outside my circle of competence.

As Pabrai points out, investing intelligently doesn’t mean every bet will go well. The pari-mutuel nature of the market is such that even when you get a fat pitch, you still might swing and miss. Get used to it.

Disclosure: None