Book Review: What Makes a Dhando Investor? Part II

by: Saj Karsan

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 6: Common stocks are best

Of all of the asset classes that investors have the option in which to invest, Pabrai argues that common stocks have proven to offer the best returns. While investors also have the option of buying (and selling) individual businesses, Pabrai offers the following advantages of the stock market:

  1. With an entire business, you have to run it, or find someone who can. To be successful, this requires an enormous amount of dedication.

  2. In the stock market, you're buying a business that is already staffed, yet you still get to share in the earnings.

  3. With whole businesses, often the sellers know a lot more about the business than the buyers, and furthermore the prices offered are not usually as attractive as they can be in the stock market.

  4. Buying an entire business requires a large investment. In the stock market, however, you can start with just a tiny amount of capital, and add to that capital over the years - a tremendous advantage.

  5. The selection offered to buyers of private businesses does not compare to that offered by the stock market. With a few brokerage accounts, the investor has the option to purchase from 100,000 companies worldwide. On the other hand, how many private businesses are for sale within a 25 mile radius of the investor?

  6. In the purchase of a private business, transaction costs can add a good 5 to 10% to the price of the transaction. The frictional costs in the stock market, however, even for an extremely active investor, are extraordinarily low.

As long as investors follow the "Dhandho" approach to investing (as described in the previous and subsequent chapters), the stock market offers the best potential for realizing excellent returns on investment.

Chapter 7: Simplicity

Now that Pabrai has established that the best place to look for returns is in the stock market, he turns his attention to discussing why investors should restrict their investments to simple and predictable companies.

A stock will sell on the market for a particular value. The investor must compare this selling price to the actual worth of the underlying business. The worth of the underlying business is determined based on the business' future cash inflows and outflows.

To demonstrate this, Pabrai takes the reader through a quick valuation of Bed, Bath & Beyond (NASDAQ:BBBY) in 2006. While the stock sells with a market value of about $11 billion, the estimate of the worth of the underlying business conducted by Pabrai reveals the company is probably worth between $8 billion and $20 billion. As such, this investment should not excite the reader much.

By changing the expected estimates of the cash inflows and outflows of a business, however, its valuation can change dramatically. It is for this reason that it is of utmost importance to stick to simple and easy-to-understand businesses. If a business' future can be predicted, an investor can calculate its intrinsic value with more accuracy. In turn, this allows the investor to know that he is buying a company at a discount.

Chapter 8: Distressed investing

In this chapter, Pabrai extolls the virtues of investing in distressed businesses in distressed industries. While he believes the market is mostly efficient, he believes that investors paying close attention can find the situations where it is not. When a business (or its industry) is distressed, it can often sell at large discounts to its intrinsic value due to the fear that is prevalent in the market. It is precisely this phenomenon that offers investors the opportunity to buy stocks at large discounts.

For those who believe the market is always efficient, Pabrai offers the following Warren Buffett quotes:

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.

Pabrai discusses several ways for investors to find distressed industries/businesses. For one thing, business headlines are often filled with negative news and outlooks for particular businesses and industries. Examples include Tyco's (NYSE:TEL) stock during the Kozlowski scandal, Martha Stewart's stock (Pending:MSO) following her prison sentence, and H&R Block's (NYSE:HRB) stock following Elliot Spitzer's investigations.

Another useful place to find distress is Value Line's weekly summary of the stocks that have lost the most value. It also publishes a list of the stocks with the lowest P/E and P/B values. Pabrai also recommends looking at 13-F disclosures to see what other value investors are buying, and using Value Investor's Club. Pabrai also recommends that investors read Greenblatt's The Little Book That Beats The Market for help in this area.

From the above sources, a plethora of troubled industries and businesses can be identified. From this group, Pabrai recommends investors eliminate those businesses which are not simple to understand or which fall outside the investor's circle of competence. For the remaining stocks, the Dhandho framework (as discussed in the rest of the book) should be followed to determine which of these stocks should be purchased.

Chapter 9: Durable moats

While no moat can last forever, Pabrai suggests readers invest in businesses with competitive advantages that can last for several years. There is an endless list of businesses with durable moats, and Pabrai goes on to name some including: Chipotle (NYSE:CMG), American Express (NYSE:AXP), Coca-Cola (NYSE:KO), H&R Block (HRB), Citigroup (NYSE:C), BMW (BAMXY.PK), Harley-Davidson (NYSE:HOG), and WD-40 (NASDAQ:WDFC).

Pabrai also lists a few companies with no moat at all: Delta Airlines (NYSEMKT:SAL), General Motors (OTC:MTLQQ), Cooper Tires (NYSE:CTB), Encyclopedia Britannica, and Gateway Computers (GTW).

Sometimes the moat is not so clear. The example of Tesoro Corporation (TSO), an oil refiner, is highlighted. While Tesoro has no control over the price of its supplies (crude oil) or the price of its principal product (gasoline), it does have an advantage: refineries on the west coast. While the number of refineries has declined over the years, Tesoro holds a growing advantage due to environmental regulations for gasoline products that are specific to the West Coast.

While a business' moat is often hidden, whether a company has one is usually clear from its financial statements: good businesses generate high returns on invested capital. For example, if opening a Chipotle store costs $700,000 and it generates $250,000 per year in free cash flow, in Pabrai's words "it's a damn good business."

While some moats are more durable than others (e.g. American Express was founded 150 years ago, and still has a strong moat.), it's important to note that all moats erode over time. As noted by Charlie Munger,

Of the fifty most important stocks on the NYSE in 1911, today only one, General Electric, remains in business...

Even seemingly invincible businesses today such as eBay (NASDAQ:EBAY), Google (NASDAQ:GOOG), Microsoft (NASDAQ:MSFT), Toyota (NYSE:TM) and American Express will all eventually decline and then disappear. Pabrai notes the results of Arie de Geus' study that showed the average life of a Fortune 500 company is just 40 to 50 years (and it takes about 25 to 30 years from inception for the typical company to get to the Fortune 500, meaning the typical company ceases to exist after spending less than 20 years on the list). The implication of this is that discounted cash flow estimates into the future should be kept to relatively short timeframes.

Chapter 10: Few, but big bets

The basic idea underlying this chapter is that when opportunities exist, it's important to bet big. Pabrai is not an advocate of investing frequently, with amounts of money that won't significantly move the needle. Instead, he suggests disproportionate amounts should be invested when the odds are significantly in one's favour.

To calculate how much an investor should bet on a given opportunity, Pabrai suggests using the Kelly Formula, which he discusses in detail. A major weakness of using this formula, however, is that it requires the payout and odds to be known in advance. This knowledge is available in gambling games (where the Kelly Formula is perhaps more relevant), but stock returns are not calculated with assurance so easily. To better understand how investor's should think about how much to invest in a particular opportunity and why, Pabrai recommends William Poundstone's book, Fortune Formula.

Though the motel-buying Patels described in earlier chapters of the book had likely never heard of the Kelly Formula, Pabrai argues that they nevertheless recognized the fundamental concept behind it, and that's why they were so successful: When a great opportunity presents itself, bet big. Pabrai also analyzes the statements and writings of Warren Buffett and Charlie Munger and concludes that they employ the very same credo. Said Charlie Munger in a speech at the USC business school:

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.

And wrote Warren Buffett in his partnership letters from 1964 to 1967:

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.

In light of the above, Pabrai finds it puzzling that the average mutual fund holds 77 positions, and that the top 10 holdings represent just 25% of assets. Dhandho, on the other hand, as Pabrai describes it, is

about making few bets, big bets, infrequent bets.

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