I am a huge fan of Mohnish Pabrai and his investment philosophy. I wanted to retain and remind myself of his lessons from his book ‘Dhandho Investor’. The post is about major ideas discussed in the book that stood out to me. I would be happy to share the scanned copy of the book with anyone who wants to read. Just leave an email in the comments section below.
Mohnish describes Dhandho as endeavors that create wealth while taking virtually no risk. He encourages us to participate in coin tosses (bets) only where “Heads, I win; tails, I don’t lose much!” can be applied. What that means is, the probability of losing money is minimal. Remember Buffet’s first rule? ‘never lose money’. He then provides examples where investors can reward high return by following “Few Bets, Big Bets, Infrequent Bets”. Per Charlie Munger, the wise ones bet heavily when the world offers them that opportunity. They bet big when they have the odds. And the rest of the time, they don’t. It’s just that simple. Mohnish refers to Marwari business people who, even with only a fifth-grade education, simply expect all their invested capital to be returned in the form of dividends in no more than three years. They expect that, after having gotten their money back, their principal investment continues to be worth at least what they invested in it. This is some good stuff which is not necessarily taught in business schools.
The future performance of selected Dhando businesses may be very uncertain. However, such entrepreneurs (Patels) had thought through the range of possibilities and drew comfort from the fact that very little capital was invested and/or the odds of a permanent loss of capital were extremely low. Both are highly desirable characteristics in an investment. Minimizing downside risk while maximizing the upside is a powerful concept. Chances of a company going bankrupt or default should be less as compared to increase its operations.
Invest in simple businesses
Mohnish presses the thought to invest in painfully simple businesses where conservative assumptions about future cash flows are easy to figure out. Einstein noted five ascending levels of intellect, “Smart, Intelligent, Brilliant, Genius, Simple.” For Einstein, simplicity was the highest level of intellect.
Different types of businesses
- High risk, low uncertainty – These could be well-run banks, airline leasing companies, utilities etc. Although they have a certain risk, there is consistency of future cash flows. Avoiding risk is important.
- High risk, high uncertainty – These are airlines, commodities, housing finance companies or poor lenders. Such businesses have a lot of competition and at the same time need a lot of debt that could be difficult to service in the future. It’s better to stay away from such businesses.
- Low risk, and low uncertainty – Such businesses are loved by Wall Street, and stock prices of these securities show some of the highest trading multiples. Some examples are American Express, ADP, Paychex, Procter & Gamble, and Costco etc. They have predictable cash flows and favorable economics that allows them to command above-average returns. Their stock prices rarely get to bargain basement prices. When uncertainty does cloud their future, as it did for American Express in the 1960s, their stock price will dutifully tank. Identifying these companies and buying them at bargain prices can reward shareholders.
- Low risk, high uncertainty – This combination gives us our most sought-after coin-toss odds. ‘Heads, I win; tails, I don’t lose much!’ Mohnish provides an example of Stewart enterprises where they had a debt that market thought was not serviceable. Thus, the stock price was trading below its book value. Mr.Market forgot to check the value of land parcels they held that they could easily sell and service the debt. Not surprisingly enough, the debt was refinanced and serviced in 2 years and stock price soared.
Mohnish lays out following Dhandho framework to filter through different businesses.
- Focus on buying existing business. Well-defined business models that have a long history of operations easy to analyze.
- Buy simple businesses in industries with an ultra-slow rate of change. “We see change as the enemy of investments. So we look for the absence of change. We look for mundane products that everyone needs.” Warren Buffet
- Buy distressed businesses in distressed industries. – “Never count on making a good sale. Have the purchase price be so attractive that even a mediocre sale gives good results.” Eddie Lampe
- Buy businesses with a durable competitive advantage. The key to investing is determining the competitive advantage of any given company and above all, the durability of that advantage. The products and services that have wide, sustainable moats around them are the ones that deliver rewards to investors. – Warren Buffet
- Bet heavily when the odds are overwhelmingly in your favor. “To us, investing is the equivalent of going out and betting against the pari-mutuel system. We look for the horse with one chance in two of winning which pays us three to one. We’re looking for a mispriced gamble. That’s what investing is. And we have to know enough to know whether the gamble is mispriced. That’s value investing” Charlie Munger
- Focus on Arbitrage. Arbitrage is classically defined as an attempt to profit by exploiting price differences in identical or similar financial instruments. For example, if gold is trading in London at $550 per ounce and in New York at $560 per ounce, assuming low frictional costs, an arbitrageur can buy gold in London and immediately sell it in New York, pocketing the difference. Over time, all arbitrage spreads narrow and disappears. However, this arbitrage allows an enterprise to build their brand and loyal customers that offer sustaining profits. A great example is the Motel business of Patels where the moment they take over a motel, the operating costs drop. With the low-cost structure, they offer a very competitive average nightly rate that leads to higher occupancy and higher profits.
- Buy businesses at big discounts to their underlying intrinsic value. If we buy an asset at a steep discount to its underlying value, the odds of a permanent loss of capital are low even if the future unfolds worse than expected.
- Look for low-risk, high-uncertainty businesses. – Dhandho entrepreneurs first focus on minimizing downside risk. Low-risk situations, by definition have low downside. The high uncertainty can be dealt with by conservatively handicapping the range of possible outcomes.
- It’s better to be a copycat than an innovator. Lifting an existing idea and scaling carries far lower risk and decent to great rewards.
Stock Markets & an opportunity for the retail investor
Mohnish reminds the reader that an ownership stake in a few businesses is the best path to building wealth. This path does not require any heavy lifting. There are plenty of bargain buying opportunities without any minimum capital requirements. Plus, there are almost 50,000 stocks to choose from globally at low frictional costs. Thus, buying stakes in a few publicly traded existing business is no brainer
We should not forget that markets are not fully efficient because humans control its auction-driven pricing mechanism. Humans are subject to vacillation between extreme fear and extreme greed. When humans, as a group are extremely fearful, the pricing of underlying assets is likely to fall below its intrinsic value; extreme greed is likely to lead to exuberant pricing. Human psychology affects the buying and selling of fractions of businesses on the stock market much more than the buying and selling of entire businesses. Understanding the critical gap between market being mostly and fully efficient is an opportunity for value investors to higher reward. The psychological warfare with our brains really gets heated after we buy a stock and it goes down. The most potent weapon in our arsenal to fight these powerful forces is to buy painfully simple businesses with a simple thesis for why we’re likely to make a great deal of money and unlikely to lose much. Thus, always write a thesis to help yourself remind of your assumptions.
How to practice Dhandho?
The Dhandho investor only invests in simple, well-understood businesses. That requirement alone likely eliminates 99 percent of possible investment alternatives. Now, like Arjuna, we must be down to only reading up on simple, well-understood businesses. We must remain squarely in our circle of competence and not even be aware of all the noise outside the circle. Within the circle, read pertinent books, publications, company reports, industry periodicals, and so on. Every once in a while something about a business will jump out. If there appears to be some meat left on the bone and you sense that the business might be underpriced compared to its intrinsic value, it is time to hone in. At that point, we need to become ultra-focused like Arjuna. All we should see is this one business. Shut everything else down. Nothing else shall exist on the planet for you. Drill down and see if it truly is an exceptional investment opportunity. Ask yourself if it fits in as a Dhandho buy. Most times it won’t be as cheap as we’d like or something will bother us. Take a pass. In that case, go back to scanning for business within your circle of competence. Again, when something jumps out, focus intently on it until it’s either rejected as an investment or passes all the Dhandho filters.
Do not make the fatal mistake of looking at five businesses at once. Learn all you can about the business that jumps out for whatever reason and fixate solely on it. Once you’re at the finish line with your analysis, only then look at the broader circle of competence
It’s important to have these answered before making an investment decision.
- Is it a business I understand very well within my circle of competence?
- Do I know the intrinsic value of the business today and, with a high degree of confidence, how it is likely to change over the next few years?
- Is the business priced at a large discount to its intrinsic value today and in two to three years? Over 50 percent?
- Would I be willing to invest a large part of my net worth into this business?
- Is the downside minimal?
- Does the business have a moat?Is it run by able and honest managers?
‘The intelligent investor’ written by Benjamin Graham is by far the best book on investing per Mohnish. Concepts such as Mr. Market & Margin of safety are very enlightening. We should make sure we are buying a business for way less than we think it is conservatively worth. Ben Graham says when we buy an asset for substantially less than what it’s worth, we reduce the downside risk. Graham’s genius was that he fixated on these two joint realities:
- The bigger the discount to intrinsic value, the lower the risk.
- The bigger the discount to intrinsic value, the higher the return
if we invest in any under or overpriced securities, it will eventually trade around its intrinsic value, leading to an appropriate profit or loss. Thus, if we can determine the intrinsic value of a given business two to three years out and can acquire a stake at a deep discount to its value, profits are all but assured. Even fortune 500 company has a life expectancy of just 40 to 50 years. Of the fifty most important stocks on the NYSE in 1911, today only one, General Electric, remains in business. That’s how powerful the forces of competitive destruction are. For intrinsic value calculation, we are better off never calculating a discounted cash flow stream for longer than 10 years or expecting a sale in year 10 to be at anything greater than 15 times cash flows at that time plus any excess capital in the business.
A critical rule of chakravyuh traversal is that any stock that we buy cannot be sold at a loss within two to three years unless we can say with a high degree of certainty that current intrinsic value is less than the current price the market is offering. The gap between existing stock price and intrinsic value is likely to close in 2-3 years. After three years, if the investment is still underwater, the cause is virtually always a misjudgment on the intrinsic value of the business or its critical value drivers. The only time a stock can be sold at a loss within two to three years is when both following conditions are satisfied:
- We can estimate its present and future intrinsic value, two to three years out, with a very high degree of certainty.
- The price offered is higher than present or future estimated intrinsic value.
Kelly Formula ( Do Not Use)
The book speaks about Fortune’s Kelly formula written by William Pound-stone in his book to figure out how much of our bankroll should we bet. Recently – Mohnish has made a statement in one of his lectures that this formula is not applicable to investment decisions and thus should be discarded. Instead, he suggests making 5 to 10% bet on every convicted idea.
Mohnish explicitly asks us to read daily business headlines. He is a voracious reader and has adopted this habit from Warren and Charlie. He also talks about Value investors club (www.valueinvestorsclub.com) by Joel Greenblatt. Members of this group have to share at least 2 investment ideas every year. The quality of these ideas is decent as they are peer rated. we can access the same data with a 2 months delay as a guest. Subscribe to the major business publications—Fortune, Forbes, the Wall Street Journal, Barron’s, and Business Week. The more we read up on the different companies, people, and industries in these publications, the better we’ll get at securities analysis.