Tuesday, 24 April 2012

The Dhandho Investor: Heads I win, Tails I Don't Lose Much

Recently, I finished reading veteran value investor Mohnish Pabrai's highly acclaimed  book Dhandho Investor: The Low Risk Value Method to High Returns. Mr.Pabrai started managing money in 1999 with Pabrai Investment Fund and has generated compounded annual returns of close to 18% net of all expenses for 12 years. Thus, he has vastly outperformed the S&P and DJIA. 

Dhandho Investor is a thoroughly enjoyable read as Mr.Pabrai very succinctly illustrates how age-old approach of Gujarati and Marwari community to doing business deeply ingrains value investing philosophy. The book starts with how the first Patel family migrated from Africa to USA, decided to enter into motel business which is relatively simple to understand and operate (Investing in existing business, Investing in simple business). Motel industry was going through a tumultuous phase (Invest in distressed industries/businesses) and motels were available at dirt cheap rates for buying presenting enough margin of safety. Moreover, the value proposition on the table was so good that bet will result in to multi-fold returns on success while the downside was capped (Heads I win, tails, I don't lose much). So, Mr. Patel decided to take a plunge and put up entire chunk of saving to finance owner's equity, while rest of the money is lent by banks (Few Bets, Big Bets). Once he is successful in his venture, his relatives also follow same model and copy his strategy, which turn out to be a great success for them as well. 

Key elements of Dhandho framework as outlined in the book are as below. 

  • One should invest in existing businesses with long history of operations that has established business model. This will allow investor to analyze the past performance of the business, its profitability and cyclical nature of business. It is much safer to invest in existing operating business than investing in a start-up.
  • One should invest in business that is simple to understand and operate. Mr.Pabrai suggests that even though, methodology for arriving at intrinsic value is quite simple, it is not easy to arrive at intrinsic value of business. With an example, he illustrates that even for a simple business, intrinsic value will have range of estimates depending upon assumptions taken to arrive at intrinsic value. If the business is not simple and is fast changing, estimation of intrinsic value will have far more diverse range and prone to sharp change in intrinsic value. He suggests staying with businesses that are very slow changing as one can, with reasonable certainty, predict future cash flow for next 8-10 years.
  • According to Mr. Pabrai, investors must continuously scan  businesses and industries under distress. This is essential for getting into great businesses at bargain price, as many a times, market only factors near term negatives in the industry or business while losing focus on long term drivers of the value creation. In general, market does not like uncertainty and hence perceives lack of certainty as risk thus bringing down the price of the stock well below its long term intrinsic value. Thus a business/industry in distress may provide a good entry point for an investor
  • Investors shall make investment choices that exposes him to situations where loss on downside is minimal while potential upside is multi-fold. He call this strategy  "heads I win, tails I don't lose much". Typically these opportunities are surrounded by high uncertainty but low risk and clearly reflects mis-pricing by the market. If investor creates a portfolio comprising of handful of such businesses, he will be able to obtain very high returns with minimal risk. A key to identify such opportunities is to find businesses which are surrounded by uncertainty/fear and understand various possible outcomes and assign probabilities to such outcomes for such businesses(which requires primary understanding of the business and industry.) including probability of permanent loss of capital. 
  • When investors identify a bet where odds are overwhelmingly in his favor, one must bet big as opportunities which passes all criteria of Dhandho framework ( simple, existing business having strong moat, available at substantial discount to intrinsic value and exposing one to very high potential upside) are very rare. This strategy is essential for maximizing one's returns. In other words, he suggests that developing a focused portfolio comprising of small number of stocks is the best approach to maximizing returns from value investing. He suggests "Few Bets, Big Bets, Infrequent Bets". 
  • As a disciple of Mr.Buffet, Mr. Pabrai stresses importance of "moat" or "sustainable competitive advantage" and "margin of safety" as central thesis of investment. 
  • As a value investor, I have struggled to understand how long one should hold onto a business, in case if the price does not approach intrinsic value (as perceived by investor) even after a year or two. He suggest, from his experience, 3 years is reasonable time frame. In his experience, most of the market anomalies are taken care of in around 3 years. Hence if in 3 years, price does not approach intrinsic value, it is better to get out of investment as opportunity cost of holding onto such investment may be very high. He also gives rationale behind time frame of 3 years. He very interestingly points out that as value investor, buying a right business is like penetrating a "chakravyuh", however if one does not have exit strategy (i.e. to sell) in place, result may be sub-optimal. 
  • Finally, he has an opinion on crucial question for individual investors on whether to invest in index fund or run an actively managed portfolio. Mr.Pabrai, suggests that he would prefer passive investment in stocks selected based on "magic formula" designed by Joel Greenblatt rather than investing in index fund. I am not too sure if that is the right approach as I have not delved into how exactly "magic formula" works. 
In all, Dhandho Investor is worth every penny due to Mr.Pabrai's grasp of the subject, fresh perspective that he brings to central ideas of value investing , crystal clear thought process (no ambiguity at all!) and writing style that truly caters to individual investors. 

Strongly Recommended!

3 comments:

  1. Hi Dhwanil,
    Yes. Its a good book.
    But for Warren Buffett, I personally like 2 books

    1 - New Buffettology - Mary Buffett and David Clark
    2 - Buffett and Beyond - Prem Jain.

    To know WB, these two books are sufficient.

    Regards,
    Vikas

    ReplyDelete
    Replies
    1. Hi Vikas,

      I have read the one by Mary Buffet and liked it.

      Thanks for your suggestion.

      Best Regards
      Dhwanil Desai

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    2. Buffett himself doesn't like the Buffettology book, btw.

      Delete