The Dhandho investor

The Dhandho Investor is written by Mohnish Pabrai who manages Pabrai funds. He has been successful. At the start, he acknowledges, three gurus- Warren Buffet, Charlie Munger and his father, Om Pabrai for giving him investment wisdom.

Dhandho= endeavour to create wealth while taking minimal or no risk

Stories illustrating the Dhandho framework.

Marwari formula: Dividends received over three years=Original principal. Original principal shall not decrease over three years

The Dhandho framework:

1. Focus on buying an existing business.

2. 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 don’t like to lose money. Capitalism is pretty brutal. We look for mundane products that everyone needs.”-Warren Buffet.

3. 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.- Warren Buffet

I will tell you how to become rich. Close the doors.Be fearful when others are greedy. Be greedy when others are fearful.-Warren Buffet.

The very best time to buy a business is when its near-term future prospects are murky and the business is hated and unloved. In such circumstances, the odds are high that an investor can pick up assets at steep discounts to their underlying value.

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 Buffet.
I don’t want an easy business for competitors. I want a business with a moat around it. I want a very valuable castle in the middle and then I want the duke who is incharge of that castle to be very honest and hardworking and able. Then I want a moat around that castle. The moat can be various things: The moat around our auto insurance business, GEICO, is low cost.-Warren Buffet

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.

6. Focus on arbitrage.

  • Because my mother isn’t here tonight, I’ll even confess to you that I’ve been an arbitrageur.-Warren Buffet.

The arbitrage may be anything- a close shop, low cost, innovative product, etc.

 7. Buy businesses at a big discount to their intrinsic value.

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

8. Look for low risk, high uncertainty businesses.

9. It is better to be a copy-cat rather than to be an innovator.

INVEST IN EXISTING BUSINESS

Evidence shows that common stocks are the best assets to own. Think of them as an ownership stake in an existing business rather than a piece of paper whose price keeps changing.

The advantage of owning stocks is because you have an ownership stake in a business without needing to manage it. The stock has a price- which might be fair value, below value or over value.

If you stop to think about it, a pari-mutuel system is a market. Everybody goes there and bets and the odds change based on what’s bet. That’s what happens in the stock market.-Charlie Munger.

If you buy a stock when it is undervalued, then you have a fairly good chance of making money.

You do not have to have a lot of money to buy a stock, as opposed to buying a business. You have a great, if not unlimited choice. The costs of transaction are probably the lowest of all transactional costs.

INVEST IN SIMPLE BUSINESSES

Before we buy a business we should know its intrinsic value so that we can decide what price to buy it at:

John Burr Williams was the first to define intrinsic value in his The Theory of Investment Value published in1938. According to Williams, the intrinsic value of any business is determined by the cash inflows and outflows—discounted at an appropriate interest rate—that can be expected to occur during the remaining life of the business. The definition is painfully simple.

Only invest in businesses that are simple—ones where conservative assumptions about future cash flows are easy to figure out. Simplicity lies in the eye of the beholder-

“Our life is frittered away by detail . . . simplify, simplify.”- Thoreau

Einstein noted that the five ascending levels of intellect were, “Smart, Intelligent, Brilliant, Genius, Simple.”

The thesis should be simple. The calculations should be simple. If you need to make a lot of predictions or calculations to buy an investment, you should pass it. This is because-

The psychological warfare with our brains really gets heated after we buy a stock. The most potent weapon in your arsenal to fight these powerful forces is to buy painfully simple businesses with painfully simple theses for why you’re likely to make a great deal of money and unlikely to lose much.

INVEST IN DISTRESSED BUSINESSES IN DISTRESSED INDUSTRIES

Buffet’s replies to the efficient market theory:

I’d be a bum on the street with a tin cup if the markets were always efficient. Investing in a market where people believe in efficiency is like playing bridge with someone who has been told it doesn’t do any good to look at the cards.

It has been helpful to me to have tens of thousands [of students] turned out of business schools taught that it didn’t do any good to think.

Current finance classes can help you do average.

Observing correctly that the market was frequently efficient, [academics and Wall Street pros] went on to conclude incorrectly that it was always efficient. The difference between these propositions is night and day.

When humans, as a group, are extremely fearful, the pricing of the underlying assets are likely to fall below intrinsic value; extreme greed is likely to lead to exuberant pricing.

Sources to get a list of distressed businesses:

 1. Negative headline news about businesses

2. Lost the most value over the last 13 weeks

3. Stocks with low P/E, P/B and highest dividend yield.

4. Reading “The Little Book that beats the market”

5. Tracking stocks bought by top value managers

INVEST IN BUSINESSES WITH DURABLE MOATS

Moat from the financial statement= high Return on Invested Capital.

However moats are not for ever:

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. Over the very long term, history shows that the chances of any business surviving in a manner agreeable to a company’s owners are slim at best.- Charlie Munger.

So-

We are best 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).

FEW BETS, BIG BETS, INFREQUENT BETS

The Kelly formula= Edge/Odds=Fraction of the bank roll you should bet at any one time

An example:

Let’s say somebody offers you the following odds if you bet $ 1. Your bankroll is $10,000.

  •  80% chance of winning $21
  • 10% chance of winning $7.5
  • 10% chance of winning $0

So edge= 80% x 21 + 10% x 7.5 + 10% x -1( because we have lost our money)=16.8+0.75-0.1=17.45

Odds= Maximum money that we can win= 21

So edge/odds=17.45/21 x10,000= 8309. So you can bet $8309 on the bet.

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.-Charlie Munger.

Practical lesson: If you can find the intrinsic value of a business today and the value in 2-3 years time and can buy it at a deep discount to value you will profit.

You can ask: When will the market value it appropriately: Read this-

Fulbright: One other question and I will desist. When you find a special situation and you decide, just for illustration, that you can buy for $10 and it’s worth $30, andyou take a position, and then you cannot realize it until a lot of other people decide it is worth $30, how is that process brought about—by advertising, or what happens?
What causes a cheap stock to find its value?
Graham: That is one of the mysteries of our business and it is a mystery to me as well as to everybody else. But we know from experience that eventually the market catches up with value.

If you invest in any under- or overpriced business,it will eventually trade around its intrinsic value—leading to an appropriate profit or loss.

Listen to what Buffet says:

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 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 partnerships wherewe have exceeded 25%. Any such situations are going to have to promise very significant superior performance.. . . They are also going to have to possess such superior qualitative and/or quantitative factors that the chance of serious permanent loss is minimal. . . . 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 can produce a result for our portfolio that would be more than 10 percentage points poorer than the Dow.

For complex bet-sizing go here: http://www.cisiova.com/betsizing.aspMohnish himself bets around 10% of assets on each bet.

FOCUS ON ARBITRAGE

Arbitrage means exploiting differences in value. These can be cost related or moat related.

We like to own castles with large moats filled with sharks and crocodiles that can fend off marauders—the millions of people with capital that want to take our capital. We think in terms of moats that are impossible to cross, and tell our managers to widen their moat every   year, even if profits do not increase every year. We think almost all of our businesses have big and widening moats.-Warren Buffet

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.-Warren Buffet

MARGIN OF SAFETY

The Intelligent Investor is still the best book on investing.

It has the only three ideas you really need:

1) Chapter 8—The Mr. Market analogy. Make the stock market serve you. The C section of the Wall Street Journal is my business broker—it quotes me prices every day that I can take or leave, and there are no called strikes.

2) A stock is a piece of a business. Never forget that you are buying a business which has an underlying value based on how much cash goes in and out.

3) Chapter 20—Margin of Safety. Make sure that you are buying a business for way less than you think it is conservatively worth.

Two realities to realise:

1. The bigger the discount to intrinsic value, the lower the risk.
2. The bigger the discount to intrinsic value, the higher the return.

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.

Very few people have adopted our approach. . . . Maybe two percent of people will come into our corner of the tent, and the rest of the ninety-eight percent will believe what they’ve been told (e.g., that markets are totally efficient).- Warren Buffett

The gap between intrinsic value and actual price closes in 18 months-3 years.

INVEST IN LOW-RISK HIGH UNCERTAINTY BUSINESSES

Heads, I win, Tails, I don’t lose much

INVEST IN COPYCATS RATHER THAN INNOVATORS

Do not take advice from many people. Think for yourself.

THE ART OF SELLING

When to buy?

1. Is it a business I understand very well—squarelywithin my circle of competence?
2. 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?
3. Is the business priced at a large discount to its intrinsic value today and in two to three years? Over 50 percent?
4. Would I be willing to invest a large part of my net worth into this business?
5. Is the downside minimal?
6. Does the business have a moat?
7. Is it run by able and honest managers?

When to sell?

Rule number 1:Any stock that you buy cannot be sold at a loss within two to three years of buying it unless you can say with a high degree of certainty that current intrinsic value is less than the current price the market is offering.
Rule number 2: Take a loss after 3 years.
Rule number 3: Sell when the stock’s value is more than 90% of the inrinsic value.

Some quotes:

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 very many of them.

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

This idea (of focused value investing) has zero currency in academic circles. Investment managers don’t feel they will make enough money this way. It’s so foreign to them.

Billy Rose used to say that if you have a harem of a hundred girls, you never get to know any of them very well. The trick is to know a lot about what you own, and you don’t own that many things.

TO INDEX OR NOT TO INDEX

Some variations:

  • Index fund dollar cost
  • Greenblatt’s strategy
  • Small-cap Greenblatt’s strategy
  • 52 week lows
  • 13 week maximum loss
  • Low P/E
  • Low P/B
  • High dividend yield
  • Business newspapers and magazines

INVESTING LESSONS FROM A GREAT WARRIOR

Focus is important.

Analyse a company that jumps up at you completely.

You give but little when you give of your possessions. It is when you give of yourself that you truly give. For what are your possessions but things you keep and guard for fear you may need them tomorrow? . . . There are those who give little of the much they have—and they give it for recognition and their hidden desire makes their gift unwholesome. And there are those who give and know not pain in giving, nor do they seek joy, nor give with mindfulness of virtue. . . . Through the hands of such as these God speaks, and from behind their eyes He smiles upon the earth. You often say, “I would give but only to the deserving.”. . . Surely he who is worthy to receive his days and his nights is worthy of all else from you. And he who has deserved to drink from the ocean of life deserves to fill his cup from your little stream. See first that you yourself deserve to be a giver, and an instrument of giving. For in truth it is life that gives onto life—while you, who deem yourself a giver, are but a witness.-Kahlil Gibran

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