Mohnish Pabrai puts forth a quick read for novice and expert value investors in The Dhandho Investor. Value investing is more than just buying something cheaply, it involves understanding the nature of a business and the markets in which that business operates as well as the intelligent allocation of risk capital at the portfolio level.
Pabrai is a successful investor who understands the major lessons for long term terminal wealth maximization. He is quick to credit those whom he has learned from and comes across as a helpful and supportive teacher.
Pabrai clearly articulates the keys to value investing for maximum terminal wealth:
- Understand a business and its operating market dynamics, cycles and position
- Think about moats as margins that contract or expand over time or due to catalysts
- Understand intrinsic value and work back from this figure
- Come up with a few outcome scenarios and probability weight their likelihoods
- At the portfolio level focus your portfolio bets according to a fractional Kelly betting / allocation mentality. Only risk a little to gain a lot. Understanding how and why the odds are stacked against you is the first lesson to overcoming them.
- Exhibit patience
Many value investors stop at step 4 and never contemplate the nature of change inherent in item 2 or the dynamics and importance of item 5 about bet allocation. Pabrai presents his thoughts clearly on these items.
A few interesting notes in the book include reference to company longevity. For example companies have finite lives something glossed over in CAPM etc. Pabrai mentions the book The living company by Arie de Guess and how the average major corporation is shrinking with age as Schumpterian innovation goes into overdrive. Innovative competitive environments are antithetical to value investing as they represent moat uncertainty.
With regards to patience, Pabrai offers an extract from a table of major events seen below.
It speaks highly to the virtues of patience in light of responding to acute news events which may not be economically chronic. As a Portfolio manager and not a trader, he discusses waiting 1-3 years for ideas to work. Again the antithesis of having an emotional Cramer moment a la CNBC.
DJIA declines and subsequent performance after crisis events (click here to see paper). You may be surprised at the resilience in markets after an acute news shock.
Pabrai also gives acknowledgment to Joel Greenblatt’s useful book and approach from The little Book that Beats the Market. Greenblatt's book offers a helpful approach to portfolio design via a basic ranking system.
The Dhandho approach is to risk little in order to gain a lot over a period of time and focus on long term wealth maximization. Pabrai comes across as level headed and as a person with a significant future ahead of him creating and contributing value in many areas.
Discipline and patience are vital.
I have found in my research of Mutual and Hedge funds that most investors under perform both the mutual and hedge funds they invest in. Here is a paper on the phenomenon. Think about that for a moment, even after the work of selecting a great vehicle, the average investor manages to extract below average returns from that investment vehicle.
If the average actively managed fund underperforms the index by 2% and the investor underperforms the fund by 2% and equities return 8% over the long run in real terms, an individual is left with 4% before taxes which in an active portfolio may be short term capital gains weighted. If the individual switches often in "less than a year" to the next HOT thing, they are in trouble.
The stream is swift and you are going up and into it, plan carefully and thoroughly.