📚 The Dhandho Investor by Mohnish Pabrai 📖

About Mohnish Pabrai
He is famous for winning his bid with Guy Spier for a charity lunch with Buffett for USD 650,100 in 2007. Pabrai has high regard for Warren Buffett and admits that his investment style and investment fund (Pabrai Investment Funds) are copied from Buffett and others. 

Dhandho (pronounced dhun-doe) is a Gujarati word. Dhan comes from the Sanskrit root word Dhana meaning wealth. Dhan-dho, literally translated, means “endeavours that create wealth.” For the book, Pabrai uses the word more narrowly to describe the low-risk, high-return approach: “Heads, I win; tails, I don’t lose much!” illustrated with several businesses (motels), his business and how he had invested.

The book surrounds the keystone story of Manilal Chaudhari and his motel business — how he created a low-risk, high-return approach + few bets, big bets, infrequent bets to the business and allow it to scale.

The Dhandho Framework with its 9 principles

1. Focus on buying an existing business

An existing business with a well-defined business model and one with a long history of operations that he could analyse is much less risky than doing a startup.

2. Buy simple businesses in industries with an ultra-slow rate of change

We see change as an enemy of investments … so we look for the absence of change. We don’t like to lose money. Capitalism is pretty brutal. We look for mundane products that everyone needs.

Warren Buffett

Simple businesses are those where conservative assumptions about future cash flows are easy to figure out.

3. Buy distressed businesses in distressed industries

In such circumstances, the odds are high that an investor can pick assets at steep discounts to their underlying value.

Markets are not fully efficient because humans control their auction-driven pricing mechanism. Humans are subject to vacillating between extreme fear and extreme greed. When humans, as a group, are extremely fearful, the pricing of the underlying assets is likely to fall below intrinsic value; extreme greed is likely to lead to exuberant pricing.

Never count on making a good sale. Have the purchase price be so attractive that even a mediocre sale gives good results.

Warren Buffett

The entrance strategy is actually more important than the exit strategy.

Eddie Lampert

I will tell you how to become rich. Close the doors.

Be fearful when others are greedy. Be greedy when others are fearful.

Warren Buffett

4. Buy businesses with a durable competitive advantage — the moat

The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather 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 Buffett

However, most businesses with durable moats do not last forever.

5. Bet heavily when the odds are overwhelmingly in your favour

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 you three to one. You’re looking for a mispriced gamble. That’s what investing is. And you have to know enough to know whether the gamble is mispriced. That’s value investing.

Charlie Munger

We might invest up to 40% of our net worth in a single security under conditions coupling an extremely high probability that our facts and reasoning are correct with a very low probability that anything could drastically change the underlying value of the investment.

We are obviously only going to go to 40% in very rare situations – this rarity, of course, is what makes it necessary that we concentrate so heavily when we see such an opportunity. We probably have had only five or six situations in the nine-year history of the Partnership where we have exceeded 25%. Any such situations are going to have to promise very significantly superior performance relative to the Dow compared to other opportunities available at the time. They are also going to have to possess such superior qualitative and/or quantitative factors that the chance of serious permanent loss is minimal (anything can happen on a short-term quotational basis which partially explains the greater risk of widened year to-year variation in results). In selecting the limit to which I will go in any one investment, I attempt to reduce to a tiny figure the probability that the single investment (or group, if there is intercorrelation) can produce a result for our total portfolio that would be more than ten percentage points poorer than the Dow.

Warren Buffett

Kelly Formula (aka Kelly Criterion)
The Kelly Criterion is a mathematical formula created by John L. Kelly, Jr., which relates to the long-term growth of capital. Kelly developed the formula while working at the AT&T Bell Laboratory. The Kelly Formula helps determine what percentage of capital should be used in each bet/investment to maximize that bet’s long-term growth.

Kelly % = W – [ (1 – W)/R ]

The inputs are as follows:

  • Kelly % = per cent of investor’s capital to make on each investment or bet
  • W = historical win percentage of the investment strategy
  • R = investors historical win/loss percentage

6. Focus on arbitrage

Arbitrage is classically defined as an attempt to profit by exploiting price differences in identical or similar financial instruments. Anytime you are playing an arbitrage game, you end up getting something for nothing.

Arbitrage can be in the form of a business idea where it exists somewhere else and proves to satisfy an important need.

7. Buy businesses at big discounts to their underlying intrinsic value

If you buy an asset at a steep discount to its underlying value, even if the future unfolds worse than expected, the odds of a permanent loss of capital are low — minimising downside risk before ever looking at upside potential.

. . . the function of the margin of safety is, in essence, that of rendering unnecessary an accurate estimate of the future.

Benjamin Graham

Read the section below on “Margin of safety: Low risk, high return” for elaboration

8. Look for low-risk, high-uncertainty businesses

Low-risk situations, by definition, have low downsides. The high uncertainty can be dealt with by conservatively handicapping the range of possible outcomes.

Heads, I win; tails, I don’t lose much!

Read the section below on “Low-risk, high-uncertainty businesses” for elaboration

9. It’s better to be a copycat than an innovator

Innovation is a crapshoot, but copying, lifting and scaling an existing and proven business idea carries a lower risk and decent to great rewards.

Examples:
McDonald’s where its burgers and business concepts are copied from franchisees, Burger King or elsewhere.

Microsoft (a) bought its rights from Seattle Computer for $50,000 which later become MS-DOS and IBM-DOS, (b) saw Apple’s Macintosh mockup where they incorporated a graphical user interface and the mouse, (c) lifted the features of Lotus 1-2-3 and VisiCalc for Excel, (d) lifted many features of Word Perfect for Word, (e) acquired a software company that developed PowerPoint, (f) modelled most of Netware’s and Unix’s networking features and bundled them into Windows NT, etc.

In seeking to make investments in the public equity markets, ignore the innovators. Always seek out businesses run by people who have demonstrated their ability to repeatedly lift and scale.

Margin of safety: Low risk, high returns

Note: This is an expansion of the 7th principle in his The Dhandho Framework.

When we buy an asset for substantially less than what it’s worth, we reduce downside risk.

Minimising downside risk while maximising the upside is a powerful concept. It is during times of extreme distress(9/11 and the Cuban missile crisis) and pessimism that rationality goes out of the windrow and prices of certain assets go well below their underlying value.

The bigger the discount to intrinsic value, (a) the lower the risk and (b) the higher the return.

The lower the risk, the higher the rewards
Low-risk, high returns

To many (i.e. conventional wisdom), risks correlate with returns — low risk, low returns; high risk, high returns.

Warren Buffett’s observations with his purchase of Washington Post stock in 1973:

We bought all of our WPC holdings in mid-1973 at a price of not more than one-fourth of the then per-share business value of the enterprise. Calculating the price/value ratio required no unusual insights. Most security analysts, media brokers, and media executives would have estimated WPC’s intrinsic business value at $400 to $500 million just as we did. And its $100 million stock market valuation was published daily for all to see. Our advantage, rather, was attitude: we had learned from Ben Graham that the key to successful investing was the purchase of shares in good businesses when market prices were at a large discount from underlying business values.

Most institutional investors in the early 1970s, on the other hand, regarded business value as of only minor relevance when they were deciding the prices at which they would buy or sell. This now seems hard to believe. However, these institutions were then under the spell of academics at prestigious business schools who were preaching a newly-fashioned theory: the stock market was totally efficient, and therefore calculations of business value – and even thought, itself – were of no importance in investment activities. (We are enormously indebted to those academics: what could be more advantageous in an intellectual contest – whether it be bridge, chess, or stock selection than to have opponents who have been taught that thinking is a waste of energy?)

….. Through 1973 and 1974, WPC continued to do fine as a business, and intrinsic value grew. Nevertheless, by yearend 1974 our WPC holding showed a loss of about 25%, with market value at $8 million against our cost of $10.6 million. What we had thought ridiculously cheap a year earlier had become a good bit cheaper as the market, in its infinite wisdom, marked WPC stock down to well below 20 cents on the dollar of intrinsic value.

Warren Buffett, 1985 Letter to Shareholders of Berkshire Hathaway

Most institutional investors in the early 1970s, on the other hand, regarded business value as of only minor relevance when they were deciding the prices at which they would buy or sell. This now seems hard to believe. However, these institutions were then under the spell of academics at prestigious business schools who were preaching a newly-fashioned theory: the stock market was totally efficient, and therefore calculations of business value – and even thought, itself – were of no importance in investment activities. (We are enormously indebted to those academics: what could be more advantageous in an intellectual contest – whether it be bridge, chess, or stock selection than to have opponents who have been taught that thinking is a waste of energy?)

Warren Buffett, 1985 Letter to Shareholders of Berkshire Hathaway

Be fixated on a large margin of safety and go to great lengths to seek out low-risk, high-return bets; this is truly fortune’s formula.

Low-risk, high-uncertainty businesses

Note: This is an expansion of the 8th principle in his The Dhandho Framework.

Uncertainty means the future performance/business outcome of the business can be very wide.

A low-risk business where very little capital was invested and/or the odds of a permanent loss of capital were extremely low.

Wall Street could not distinguish between risk and uncertainty and it got confused between the two. Savvy investors like Buffett and Graham have been taking advantage of Mr Market’s handicap for decades with spectacular results. Take advantage of Wall Street’s handicap by seeking out low-risk, high-uncertainty bets.

Fear and greed are very much fundamental to the human psyche. When extreme fear sets in, there is likely to be irrational behaviour. In that situation, the stock resembles a theatre that is filled to capacity. Someone sees some smoke and yells “Fire, Fire!”. There is a mad rush for the exits. In the theatre called the stock market, you can only exit if someone else buys your seat as each share has to be sold and held by someone else. If there is a mass rush to leave the burning theatre, what price do you think these seats would go for? The trick is to only buy seats in those theatres where there is a mass exodus and you know that there is no real fire, or it’s already well on its way to being put out. Read voraciously and wait patiently and from time to time these amazing bets will present themselves.

Value investing is fundamentally contrarian in nature. The best opportunities like in investing in businesses that have been hit hard by negativity.

Abhimanyu’s Dilemma – The Art of Selling

Selling a stock is a more difficult decision than buying one. Pabrai described the decision to enter, traverse and finally exit a Chakravyuh battel formation as akin to figuring out when to buy, hold and sell a given stock.

Chakravyuha battle formation

To enter or not to enter — that is the question

  1. Is it a business I understand very well — squarely within my circle of competence?
  2. Do I know the intrinsic value of the business and with a high degree of confidence, how it is likely to change over the next few years?
  3. Is the business priced at a large discount to its intrinsic value today and in two to three years? Over 50 per cent?
  4. Would I be willing to invest a large part of my new work into this business?
  5. Is the downside minimal?
  6. Does the business have a moat?
  7. Is it run by able and honest managers?

Traversing the rings

When the lion roars, our brains tell us to start running. We don’t process; we just run. When stock prices drop dramatically, the fear that sets in is similar to hearing the lion roar. Our first instinct is to sell the turkey, purge the memory of ever having owned it, and run away. This is one of the primary reasons why most investors do worse than the stock market indexes. They are enthusiastic about buying stocks that have been rising, and they are keen to sell positions that have undergone large drops. To counterbalance our messed-up brains, we have to put rational Chakravyuh traversal rules in place to promote rational behaviour.

The key to being a successful investor is to buy assets consistently below what they are worth and to fixate on absolutely minimizing permanent realised losses.

A critical rule of Chakravyuh traversal is that any stock that you buy cannot be sold at a loss within two to three years of buying unless you can say with a high degree of certainty that the current intrinsic value is less than the current price of the market is offering. Markets are mostly efficient and in most instances, an undervalued asset will move up and trade around (or even above) its intrinsic value once the clouds have lifted. Most clouds of uncertainty will dissipate in two to three years.

The three-year rule also allows us to exit a position where we are simply wrong in our perception of intrinsic value. If we always wait for convergence to intrinsic value, we may have an endless wait. There is a very real cost to waiting. It is the opportunity cost of investing those assets elsewhere.

Example: Universal Stainless & Alloy Products

Exiting the Chakravyuh

Having successfully traversed the rings, the exit from the spiral is very simple. Within three years of buying, there is likely to be a convergence between intrinsic value and price; leading to a handsome annualised return. Anytime this gap narrows to under 10 per cent, feel free to sell the position and exit. You must sell once the market price exceeds the intrinsic value.

How many simultaneous Chakravyuh battles?

A lot of great fortunes in the world have been made by owning a single wonderful business. If you understand the business, you do not need to own many of them.

Warren Buffett

Really outstanding investment opportunities are rare enough that you should really have a go at it when it comes around and put a huge position of your wealth into it. I’ve said in the past you should think of investment as though you have a punch card of 20 holes in it. You have to think really hard about each one and in face 20 (in a lifetime) is way more than you need to do extremely well as an investor.

Warren Buffett

The mantra always is “few bets, big bets, infrequent bets” — all placed when the odds are overwhelmingly in your favour. We have the luxury of choosing just a handful of Chakravyuhs from over 30,000 over an investing lifetime spanning several decades. Entering these carefully selected Chakravyuhs at times when the soldiers are asleep all but guarantees successful traversals and big rewards.

Focus – Arjuna and the fish eye: Investing lessons from a great warrior

The story of Arjuna and the Fish Eye

There are well over a hundred thousand publicly traded companies on many exchanges around the world. There are hundreds of thousands of privately held businesses around the globe that are also available to be bought and sold. Also, there are fixed-income securities, currencies, commodities, real estate, hedge funds, treasuries etc.

The Dhandho investor investors only invest in simple, well-understood businesses; 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. Shut everything else out. Nothing else exists on the planet. Drill down and see if it truly is an exceptional investment opportunity.