I was fortunate enough to interview value investor Mohnish Pabrai at his office in California last month. Pabrai is a great investor to talk to not only because of his success, but also because of his experiences. In 2007 he paid $650,000 to have dinner with Warren Buffett (the proceeds went to charity), and he followed up with several dinners with Charlie Munger.
Most of what anyone would want to know about Buffett and Munger is public information and repeated ad nauseam. So when Pabrai said "I don't think Charlie's talked about this publicly" and proceeded to cite three rules that could create investment results "vastly better than the rest," I listened up.
Ready? Here are Charlie Munger's three secret rules for investment success.
1. Follow the great investors
Munger's first rule is to "carefully look at what the other great investors have done," Pabrai told me. "So, in fact, Charlie was endorsing copying off the 13-Fs, right?"
The 13-F is a regulatory disclosure that requires all large investors to publicly disclose what they're investing in -- a legally mandated fly on the wall that gives us a look into great investors' minds.
You can search for investors' 13-F filings here. They're an incredible resource. Using the search tool, you can see that Pabrai's investment fund owned shares of Berkshire Hathaway (NYSE:BRK-B), Bank of America (NYSE:BAC), Citigroup (NYSE:C), and Goldman Sachs (among others) at the end of 2011. Or that David Einhorn's hedge fund owned puts on Chipotle Mexican Grill (NYSE:CMG) at the end of September.
Pabrai says most of his investment ideas come from other great investors -- though I think he's being modest. "God bless the SEC for their 13-F requirements," he said. "In fact, Nov. 14 was the last time when the 13-Fs came out, and you know, I'm like a pig in [expletive]. It's just great because there's so much to look at. That keeps me busy for a few weeks, and then the next 13-Fs come out."
2. Look at the cannibals
Munger's second rule is to pay close attention to cannibal companies. "What he meant by 'look at the cannibals,'" Mohnish said, "is, look carefully at the businesses that are buying back huge amounts of their stock."
Take IBM (NYSE:IBM). It has repurchased $107 billion of its own stock in the past decade, reducing its shares outstanding by more than a third. As value investor Bill Miller noted two years ago: "IBM is the only one of the megacap stocks that were popular in the late 1990s to go to an all-time high. The reason for that is, IBM has an absolutely unequal record in capital allocation."
AutoZone (NYSE:AZO) is another good example. This $12 billion company has repurchased $11.7 billion of its stock in the past decade, reducing shares outstanding by more than 60%. That's helped push shares to a 412% gain since 2002.
Many, maybe most, companies have a poor track record of buybacks, gorging on their stock when it's expensive and backing away when it's cheap. But those that get it right can create tremendous value for shareholders.
3. Carefully study spinoffs
Munger's last rule is to focus on spinoffs. "Of course, you know Joel Greenblatt has a whole book on spinoffs: You Can Be a Stock Market Genius," Pabrai reminded me.
Successful investing is about finding situations of mispricing, or companies selling below their true worth. And spinoffs, when a company divests one of its divisions, are a great place to dig for those situations.
My colleague David Meier wrote about spinoffs several years ago:
One reason companies spin off certain businesses is to get rid of redheaded stepchildren. That way, the unloved or "bad" business can stop taking time and resources away from the crown jewel. But, as Greenblatt points out, sometimes that is exactly what the bad boy needs in order to straighten his life out.
Another reason spinoffs can create mispricing is that shareholders of the new company might be forced to sell, either for tax reasons or because they are institutional investors prohibited from owning a company with certain characteristics. When Kraft decided to spin off its snack division, it warned shareholders (emphasis mine):
Kraft ParentCo shareholders receiving shares of our common stock in the Distribution generally may sell those shares immediately in the public market. Although we have no actual knowledge of any plan or intention of any significant shareholder to sell our common stock following the Spin-Off, it is possible that some Kraft ParentCo shareholders, including some of our larger shareholders, will sell our common stock received in the Distribution if, for reasons such as our business profile or market capitalization as an independent company, we do not fit their investment objectives, or -- in the case of index funds -- we are not a participant in the index in which they are investing.
I'm not an expert on spinoffs, but I'd highly recommend Greenblatt's book if you're interested in learning more.
I'll leave you with a classic Munger quote:
This is really crucial: Warren is one of the best learning machines on this earth. The turtles who outrun the hares are learning machines. If you stop learning in this world, the world rushes right by you.