Book: The Dhandho Investor by Mohnish Pabrai
Mohnish Pabrai defines himself as a shameless copycat of Warren Buffett: he buys with a great margin of safety a concentrated portfolio of businesses in his circle of competence, with widening moats, low risk of loss, incertain but high potential outcome, able and honest management, and usually during a temporary crisis in the acquired businesses, their industry, or their country.
I can’t agree more with the value investing philosophy.
Mohnish Pabrai’s background
- He’s born in 1964 in India and moved in the 1980s to the US for college.
- He’s originally a network engineer, worked a couple of years in international sales for a US IT company, and then founded in 1991 an IT service company, TransTech, providing Indian network engineers to US companies during the tech brain shortage of the ’90s. He grew that company to 165 people and $20M annual revenue.
- He started investing in 1995 after reading Peter Lynch One Up on Wall Street, sold TransTech for $6M, and launched his fund Pabrai Fund in 1999.
- This book was published in April 2007, therefore, most of its philosophy is about surviving the internet bubble, avoiding overvalued tech stocks, and building a defensive portfolio.
Low risk, high potential outcome, high uncertainty
- The main idea behind the “Dhandho” philosophy is to take low-risk, high potential outcomes, high uncertainty bets.
- He gives the example of the Indian immigrants in the US buying motels in the 1970s for very little, and who didn’t take a big risk because they could take a job in case of failure. How much profit could generate these motels was uncertain, but they had a high potential since these immigrants had very little expenses because they were living in these motels and used their families as low-cost staff.
- In his own words “heads I win, tails I don’t lose much”.
- He uses a similar strategy with his fund. He invests in companies:
- with a low risk of losing capital, usually following the Buffett-Graham method of picking businesses that are sold for less than the value of their assets (low risk).
- having a great potential future in 10-20-30 years, with a widening moat. The moat is the growing competitive advantage that protects them against their competitors (high potential outcome)
- but clouded with temporary uncertainty, either within the company, its industry, or the country, because most investors prefer to stay away from short-term uncertainties, hence selling at discount compared to their long-term intrinsic value. (high uncertainty)
- He gives several examples :
- Stewart funeral homes. A conglomerate of many independent funeral homes. These are very stable businesses that remain mostly unaffected by any economic crisis, and fully independent from each other, which means they can be sold individually if necessary, and without a loss even in difficult times. This conglomerate was at some point sold for significantly less than the sums of its subsidiaries because it faced a risk of default on some part of its bond. That would have been dangerous for a regular company, but easy to fix in this case by selling some assets.
- Level 3. A fiber cable company. Their bond sold for 18 cents on the dollar during the internet bubble because Wall Street wrongly assumed that all internet stocks were rotten and also wrongly assumed that this company’s Capex was fixed. Also Wall Street didn’t care that the CEO was honest, being a Warren Buffett’s friend, and didn’t trust what he said about his company.
- Frontline oil tankers. The oil tankers market is like a commercial real estate market: during good times the operators become euphoric and order too many tankers, and when bad time comes, while the ordered oil tankers just finished construction, they have too much of them, which leads to market over-saturation and prices for oil transport collapse. But Frontline had only modern double hull oil tankers, the least affected type of tankers in bad times, with debt lien only on individual ships. They could sell 3 of these ships every year in the worst time (out of 200), making the company very hard to bankrupt in hard times, and, in good times (during shortages of oil tankers were oil tanker rents skyrocket), the best-positioned company to rent their ships at crazy prices.
Margin of safety
- In a Warren Buffett – Benjamin Graham style value investing, he focuses only on businesses sold at a significant discount of their intrinsic value. As Buffett says: Be fearful when others are greedy. Be greedy when others are fearful.
- He calculates the intrinsic value with the DCF (Discounted Cash Flow) method over a 10 year period, and with 10-15 free cash flows residual value. He uses “mediocre sales” as inputs for projections.
- Even if DCF is a great tool in value investing, it’s still prone to wide inaccuracies because it multiplies the inaccuracy of the input, the future cash flow 10 years ahead, itself relying mostly on future sales. Estimating future sales 10 years ahead is, at best, a very incertain exercise, because so much can change in the world in between. Therefore, DCF can only have decent reliability with quite predictable businesses, and even in the best context it still requires a fat margin of safety.
- Hence, the amount of discount, the “margin of safety” is in most of his examples when the market value is in the order of one-fifth of the intrinsic value. For example, he illustrates this with Warren Buffett buying the Washington Post in 1973 for $100M when most analysts publicly valued the company $500M.
- Like Warren Buffett, he looks for “fat pitches”: companies that are an absolute no-brainer to buy when comparing the market valuation and the intrinsic value, because of very high margin of safety.
Stable and simple businesses in his circle of competence
- First, because of how he estimate intrinsic value (with the DCF method), he needs a stable, simple, and predictable business in input to avoid having an excessive uncertainty in valuation.
- Then, to improve the reliability of these calculations, it’s imperative for him to stick to industries he knows very well and where he can make decently reliable predictions of future sales.
- Therefore, like Warren Buffett, he passes on 99% of the opportunities just because they are not right in his circle of competence.
- Missing a good opportunity costs way less than losing capital.
- Consequently, he stays with a fairly concentrated portfolio, with less than 15 companies, sometimes as low as only 3 companies. Like Warren Buffett, he thinks that diversification is a protection against ignorance, but not the safest way to build a portfolio. Concentration allows knowing much deeply the companies in your portfolio and mitigating more efficiently the risks with the appropriate expertise.
- At the time of this book, he was focusing on industries with a slow rate of change, like the railroad, hospitality, steel production, etc. Anything that probably won’t be deeply disrupted in the next decades. That being said, he slowly moved away from that rule in the following decade after publishing this book. In 2021 he was trying to find the next Amazon, but still in a conservative, prudent way.
- Mohnish Pabrai extensively quotes Warren Buffett on that aspect.
- 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 Buffett
- The relationship with clients and the knowledge of their business and systems is the deeply hidden moat in IT services. That being said, it’s difficult to assess from an outside investor perspective.
- 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 in charge 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 Buffett
- High return on invested capital (ROIC) is a telltale of moats.
- We 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 Buffett
- For this reason, his whole strategy is long-term, and he avoids selling in the first 3 years, only doing so if something changed in the underlying intrinsic value, and only if it’s significant, permanent, and with a high degree of confidence. When in doubt, he avoids selling.
Sources of investments ideas
- Scandals and crises. He finds great companies at a decent price usually during difficult times. Either:
- The company is facing a temporary scandal. Ex: in 1962, American Express was the victim of the salad oil scandal, lending money against non-existent assets, and its share plummeted while the core of the business remained solid.
- The industry is going through a temporary downturn. Ex: cyclical sectors like cars, housing, finances, etc.
- The country is in crisis: Ex: Turkey 2018-2022 crisis
- The world economy is in crisis. Ex: 2008 financial crisis
- Newspapers. He looks for negative events like company scandals, CEO sent to prison or resignation, market crisis, war events (like Pearl Harbor), major terrorist events (like 9/11), presidents resign or assassination, anything having a significant impact on a company, an industry, or a country, in newspapers like Fortune, Forbes, Wall Street Journal, Barron’s, BusinessWeek, etc. He also monitors in these newspapers if any other known value investor publicly invests in any company to get inspiration.
- 13F reports. He monitors the quarterly 13F fillings (US-based filling for investors owning more than $100M of public US stocks) of known value investors, like Warren Buffett, Peter Lynch, Bill Ackman, etc. Since many opportunities in value investing stay open for months, some good ideas are still valid even after a couple of months of delays of these fillings.
- Stock screeners. On websites like Value Line, Barron’s, NYSE, he looks for stocks having either dividend yield above 10-12%, P/E between 3 and 6, P/B below 2, stocks at 52 weeks low, etc. It’s just a starting point before the deep investigation of their intrinsic value.
- Events and mastermind. He also spends time in events like the Value Investing Congress, or the annual Berkshire Hataway shareholders meeting, as a way to network and gather investment ideas with like-minded peers.
- That being said, like many value investors, when it comes to discussing investment ideas, he avoids making any commentary on any current investments. As Warren Buffett said: Despite our policy of candor, we will discuss our activities in marketable securities only to the extent legally required. Good investment ideas are rare, valuable, and subject to competitive appropriation just as good product or business acquisition ideas are.