Book Review: What Makes a Dhando Investor? Part III

Mohnish Pabrai is an Indian-American businessman and investor. For a number of years, he turned heads with the performance of Pabrai Investment Funds since its inception in 1999. Pabrai has high regard for Warren Buffett and admits that his investment style is copied from Buffett and others. We're exploring the topics in his book about value investing.

Chapter 11: Dhando Arbitrage

Pabrai advises investors to "fixate on arbitrage", especially those situations where downside risk is eliminated, even if upside potential is limited. He discusses the following types of arbitrage, with particular emphasis on the last one:

1. Traditional: Buying gold on one exchange and selling it for a higher price on another

2. Correlated: Buying shares of a Class B stock while shorting the Class A if there's a price/value discrepancy

3. Merger: Buying a company about to be bought-out by another. It's important to note that this type of arbitrage is generally not risk-free.

4. Dhandho Arbitrage

Dhadho arbitrage is the central theme of this chapter. Dhandho arbitrage allows businesses to earn above normal profits for a limited time, before competitors or substitutes enter and destroy these higher returns. An enduring Dhadho arbitrage is what Buffett would call a moat.

Pabrai goes on to describe the Dhandho arbitrage spreads of several businesses. Some have spreads of just a few months, while others have spreads that span decades. While Pabrai argues that the "Dhadho arbitrage spreads" of all businesses will eventually be eroded, two important factors can allow investors to earn excellent returns in the interim: the size of the spread (or moat), and its duration.

To that end, Pabrai describes a couple of businesses owned by Warren Buffett that no longer have moats, Blue Chip Stamps and World Book. Nevertheless, the "aribitrage spread" earned by these companies over the years has made Buffett a lot of money - for example, Buffett's purchase of See's Candy was partially bought by money earned from Blue Chip. Pabrai advises investors looking for superior returns to invest in companies with wide and durable Dhandho arbitrage spreads.

Chapter 12: Margin of safety

This chapter stresses the importance of only purchasing investments with a healthy margin of safety. Once again, Pabrai quotes Buffett to back up this point:

Make sure that you are buying a business for way less than you think it is conservatively worth.

Pabrai also refers to the writings of Ben Graham in The Intelligent Investor (which we've summarized here) by pointing out that Graham discussed the following joint benefits of employing a margin of safety: lower downside risk, and higher upside potential.

The entrepreneurs described at the beginning of Pabrai's book had likely never read the writings of Graham. Nevertheless, it is clear to Pabrai that their decisions were always taken with the idea of risk minimization in mind. Business schools, on the other hand, teach that reward comes from risk, and do a great disservice to their students, Pabrai argues.

The idea that higher rewards can only be achieved through higher risk is a common argument made by those who believe that the market is efficient, and therefore that it does no good to look for low-risk, high-reward situations. On this topic, Pabrai quotes Buffett again:

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?

Chapter 13: Uncertainty is not risk

The theme of this chapter is that high uncertainty does not equal high risk. Wall Street will often shun companies with uncertain outlooks, but this is exactly what allows value investors to swoop in and make outsized profits. Pabrai walks the reader through three examples of Pabrai fund purchases, and how excellent returns were realized.

Stewart Enterprises (STEI) was an over-leveraged funeral home operator that traded at a 50% discount to its tangible book value. Wall Street punished the stock because its debt was coming due; but in Pabrai's estimation, the chances of bankruptcy were slim. The company was earnings and cash flow positive, and was comprised of several businesses. Stewart was able to sell off businesses that were not cash positive and thus pay off its debt without hurting cash flows.

Despite the fact that Level 3 had cash of $2.1 billion, some of its debt was selling for under 20 cents on the dollar, as the company was cash flow negative and the industry outlook was uncertain. Careful analysis of management's plan, however, indicated that cap ex would not be spent unless revenues justified expansion. This meant that the company's cash reserve could continue to meet interest payments for another three years. Due to the low bond price, the investor could recover his initial investment in interest payments alone!

Frontline (FRO), a shipping company, sold at a massive discount to the scrap value of its ships in 2002. Furthermore, Pabrai argues it had enough liquidity to last several months at the depressed shipping prices that prevailed in the market at the time. Needless to say, the company outlasted the downturn and Pabrai was rewarded for his investment.

While all of the above companies were in different industries and with different surrounding circumstances, each investment represented an investment in a highly uncertain but still low-risk position. Due to Wall Street's opposition to high uncertainty, value investors can profit by finding investments that fall within this group.

Chapter 14: Don't look for innovators

Many companies are devoted to innovating of some sort, and many investors are looking to find the next big innovation that will generate superior returns on investment. Pabrai argues, however, that investors should focus not on companies that innovate but rather on companies that excel at copying and scaling.

Pabrai goes through a couple of case studies to illustrate his point. Ray Kroc purchased McDonald's (MCD) restaurant from a pair of brothers. He didn't invent the concept, but saw its potential and expanded it. Furthermore, many of the menu items and processes that made McDonald's into the restaurant we see now did not come from corporate headquarters, but rather from its franchisees and other restaurants. McDonald's is successful because it has been able to scale up the innovations of others.

Microsoft (MSFT) is another company Pabrai describes as a non-innovator that is excellent at scaling up the successful innovations of others. Microsoft's own inventions have often failed, but when it has taken a competitor's existing idea and applied Microsoft's know-how is when it has been at its most successful. It took the idea of the computer mouse and graphical user interface from Apple (AAPL), Excel from Lotus, Word from Word Perfect, networking from Novell (NOVL), Internet Explorer from Netscape, XBOX from Playstation and the list goes on. In these cases, Microsoft waited for a product/service to demonstrate a certain acceptance by customers, and then went after this now proven market.

Pabrai Funds is also a copy of Warren Buffett's funds to a large extent. From the fee structure, to the philosophy on identifying good investments, to the reporting scheme, to the investor profiles, to the personnel structure, Pabrai has tried to emulate the partnerships of Buffett's past.

Too many investors make the mistake of looking for innovators in the public equity markets. Instead, Pabrai advises to focus on companies run by people who have repeatedly shown they can lift and scale existing ideas.

Chapter 15: When to sell a stock

In the investment world, there is much discussion devoted to determining when to buy a stock. Comparatively very little time is spent on when to sell. Indeed, the first fourteen chapters of this book provided information with a leaning towards buying. This chapter discusses the process investors should go through to determine whether to sell.

First of all, Pabrai advises that investors have their selling plan for a stock in place before they buy. Without a plan in place, once an investor has purchased, he will then be subject to the psychological strains of stock ownership that can cause irrational behaviour; a plan can help avert a poor decision.

Once a stock is purchased (presumably at a discount to intrinsic value), Pabrai advises holding it for at least two years. While he admits this number is rather arbitrary and that he has no empirical data to back it up, he argues that a few months is not long enough for a business' value to have changed significantly (and therefore intrinsic value could not have fallen by such a large amount), and 5-6 years is too long to have money tied up due to opportunity costs. The only times Pabrai believes an investor should sell within two years are if:

1) One can estimate the business' intrinsic value 2 years out with a high degree of certainty, and

2) The price offered is higher than that estimated value

Note that in cases where the future has become uncertain since the stock purchase, Pabrai advises investors to hold on (as rule 1 above is not met), as he believes the clouds of uncertainty tend to clear over the course of several months. To illustrate this point, Pabrai takes the reader through an example of a theoretical gas station whose future cash flows become uncertain, as well as a real example he encountered in his fund.

Furthermore, if after three years a security has not reached intrinsic value, Pabrai argues that the investor is likely wrong about his valuation or intrinsic value has likely fallen. On the other hand, should the stock rise to within 10% of intrinsic value, Pabrai recommends investors strongly consider selling. Should the stock price rise above intrinsic value, Pabrai recommends immediate sale (with the only exception being tax considerations, if neccessary).

Chapter 16: Finding the right money manager

Pabrai admits that the returns from investing in stock indexes will be better than returns generated by most active managers. In the aggregate, active managers are the market, and therefore after including frictional costs, active managers in the aggregate will always be outperformed by the market.

However, Pabrai argues that Dhandho investors will always outperform the market, and therefore he suggests that individual investors (who don't have the time or the inclination to invest in a Dhandho manner themselves) find such a manager.

For those interested in finding the investments themselves, Pabrai recommends 10 places where "50 cent dollars" (i.e. investments worth one dollar but selling for 50 cents) can be found:

1. magicformulainvesting.com : stocks are ranked by P/E and ROIC. Pabrai recommends this as a terrific screening process

2. valueinvestorsclub.com : contains the stock ideas of other value investors

3. Value Line's bottoms list : stocks that have lost the most value in the last week, stocks with the lowest P/E's etc

4. 52-week low lists

5. Outstanding Investor Digest and Value Investor Insight : both contain interviews with great value investors who offer up some ideas every once in a while

6. Portfolio Reports : This publication lists the buying activity of some of North America's top money managers

7. Guru Focus : A site dedicated to tracking the buying and selling of some of the world's top value investors

8. Super Investor Insight : tracks the 13-F filings of the top money managers

9. Major business publications (e.g. Wall Street Journal, BusinessWeek, etc.)

10. Attend the Value Investing Congress

By using the above resources, you are bound to find a few good ideas. Considering the value investor does not need many ideas to succeed, Pabrai argues that these resources are invaluable.

Chapter 17: Focus on your circle of competence

In this, the final chapter, Pabrai begins with a fable that illustrates the importance of focusing on companies within one's circle of competence. Investors can pick and choose from hundreds of thousands of companies (both public and private), real estate, currencies, mutual funds, options, hedge funds, treasuries, commodities and other investments. If the investor were to try his hand at all of them, he is not likely to do well. But by focusing on simple, easy-to-understand businesses, the investor increases his odds.

To that end, Pabrai advises investors to look only for opportunities that meet this criteria. Once an opportunity appears, study it closely, vet it, and make sure it's trading at a discount. "Do not make the fatal mistake of looking at five businesses at once," Pabrai argues. One should fixate on one company at a time, and only when the analysis is complete is one ready to look at other companies within the circle of competence.

While the book has been aimed at teaching readers how to maximize their wealth, Pabrai argues that there is more to life than money. A life focused only on increasing material wealth is not fully rewarding. Pabrai concludes the book by urging those who find success in Dhandho investing to give some of their wealth to those who are not so fortunate.

Read: Book Review: What Makes a Dhando Investor? Part I, Part II

Comments

[Anthony B:]

Wow, feel like I don't even need to read the book. Although I'll definitely put it on my book "watch list."

Very useful stuff, helps me validate some of the strategies I've been using.

Thanks for the in-depth review!

Oct 12 06:33 PM

[rrtzmd:]

...who cares what Pabrai thinks?...as I recall his results have been quite a bit short of even average...something like a half dozen of the stocks he owned ended up bankrupt, didn't they?...and he gets a glorious "D+" rating from thestreet.com...so, pardon me if I pass on
"Dhandro" whatchamacallit...

Oct 15 04:44 PM