Sunday, January 29, 2017

Book Review #28: The Dhandho Investor: Author: Mohnish Pabrai

Let me start off with a confession. I always thought the word was 'Dhandha'. 'Gujaratis do Dhandha from childhood there even 5 year old children know how to do Dhandha and rake in money', I was told. In my mind 'Dhandha' in Gujarati meant 'Small Business'. 

After reading this book, I realize two things.

One, the word is 'Dhandho'. Two, the word means 'Endeavors that create wealth'

Good....

Now that we got it out of the way...

The word 'Dhan' stands for wealth. Dhandho as practiced by business communities in India, like Gujaratis', is characterized by 'low risk, high return' approach to building wealth. The focus is on minimizing risk while maximizing (can this word be far behind?) rewards

About Mohnish Pabrai. A renowned investor. Runs the Pabrai Investment Funds. The fund has returned 13% annualized since its inception in 1999. He closely follows the Value Investing approach and admits to copying Graham and Buffets investment model. 

The book, 'Dhandho Investor', starts off by introducing Dhandho through a series of stories about people (mostly Gujaratis) who practice the concept. There is the Patel community in the US, minuscule population-wise, but owns more than half of motels in the country and pays about $725 Million in taxes. The early patels saw an opportunity in buying motels that were driven down due to recession created by oil embargo of the 70's. 

Other examples like that of Manilal who brought distressed assets during recession created by 9/11 or that of Sir Richard Branson whose Virgin group is a typical example of Dhandho approach. Or that of Lakshmi Mittal, Indian Steel Tycoon, who buy distressed steel mills across the globe and turn them around. All these investors stress the fundamental Dhandho approach, 'Invest in Low Risk, high return investments' or colloquially 'heads I win big, tails I don't lose much'.

Starting from Chapter 5, author lays down the 9 principles that from the basis of Dhandho Framework. A chapter is devoted to each principle. 

1. Focus on buying an existing business: The easiest way to make money is to invest in stocks of publicly traded companies. Stock markets allow you to identify potential investments with little effort, provide bargain buying opportunities, require ultra-low capital requirement, deliver ultra-large selection and  has ultra-low frictional costs. Investing in established publicly traded companies is the Dhandho way.

2. Invest in simple businesses: According to Einstein, five ascending levels of intellect are 'Smart, Intelligent, Brilliant, Genius, Simple'. From the perspective of Dhandho, a business is simple if conservative assumptions about future cash flows are easy to figure out. Write down your investment thesis. If it takes more than a paragraph it may not be a simple business. 
Once he identifies future cash flows, Pabrai extensively uses Discounted Cash Flow (DCF) method for business valuation.

3. Invest in distressed companies in distressed industries: Look out for distressed companies in the stock market. Some of the criteria could be '52 Week Low', 'Low PE' etc. The industries and business should be simple to understand. Currently in Indian Stock Market, real estate is one such industry. One could identify solid companies in the sector and invest in them for significant returns in one or two years.

4. Invest in businesses with durable moats: Moats are durable competitive advantages that a company possess. Moat allows it to have a long period of higher profitability. One way to identify a company with a moat is high / increasing returns on invested capital. Once caveat while evaluating a company with a durable moat. Moats are never long lasting, so it is important to have a time horizon of 10 years while analyzing the company.

5. Few bets, big bets, infrequent bets: The essence of this chapter is the Kelly Formula that tells the proportion of funds that one should invest in an opportunity. The formula is 
Proportion that one should bet each time = Edge / Odds
Suppose in a coin toss you win $2 for each 'Heads' and lose $1 for each 'Tails'
Edge = 0.5 X 2 + 0.5  X -1= 0.5
Odds are what you gets for a win, in this example Odds = 2
Therefore, as per Kelly Formula, the proportion that you should invest = 0.5 / 2 =0.25= 25%
As per Mr.Pabrai, making small, frequent transactions is a sure fire way to lose money in Stock Market.
Dhandho investor waits for the right opportunity to appear and then invests big. Example given of Warrent Buffett who invested 40% of his portfolio in American Express when it was hit by Salad Oil Crisis

6. Focus on Arbitrage: In simple terms Arbitrage means buying in a market where prices are low and selling the same item (almost immediately) in another market where prices are high (Or the reverse). Arbitrage will help the investor to get decent upside with virtually zero risk. Different types of arbitrages are Commodity Arbitrage, Stock Arbitrage, Currency Arbitrage, Merger Arbitrage etc.
Dhandho arbitrage is a low risk, high uncertainty arbitrage. Author give example of Compulink, which in the initial years of computer boom created an arbitrage for itself by selling cables of non-standard lengths. 

7. Margin of Safety: It is an observed fact that in investing all discounts to intrinsic value will eventually close and the value of asset will move closer to its intrinsic value. Margin of safety simply means that tone should invest in any business when it is available at a significant discount to its intrinsic value. Higher the margin of safety, lower the downside risk and higher the returns. The concept of MOS turns the traditional linkage between risk and return (higher the return, higher the risk) on its head. Higher the MOS, lower the downside risk and higher the eventual return. 
Finally, when do you find assets at significant discount to their intrinsic value? This normally happens at times of extreme distress. For example, real estate sector in India is one such opportunity now. One can find solid small and mid cap stocks at significant discount to intrinsic value.

8. Invest in Low-risk, high uncertainty opportunities: This is a very interesting concept that clashes with some of the points mentioned in the book. The author turns the traditional equality between risk and uncertainty on its head. Traditionally, high uncertainty can lead to higher risk. Markets do not like either risk or uncertainty. At times of high uncertainty, Mr.Market can push the valuation of assets to significant discount to intrinsic value that the downside risk is very low. However, due to uncertainty market will give a lot of time for the investor to enter at the lower levels. As the uncertainty slowly fades, the valuation catches up with the intrinsic value.
Mr.Pabrai gives the examples of three companies that met this criteria. More than the math, what fascinates me was the details into which he goes before making any investments. he reads a lot, gains knowledge and then waits patiently for the opportunities to present themselves. For instance, his understanding of shipping industry is quite good, despite him being from a different industry.

9. Invest in copy cats rather than innovators: Existing businesses have proven market / business / revenue / profit models and hence by nature they are low risk. Innovators are higher risk and do not meet Dhandho criteria of 'Low risk, high uncertainty'.

Starting from Chapter 5, each chapter till chapter 14 elaborates each Dhandho principle mentioned above. Chapters 15 through 17 are more philosophical in nature. Through an example of Abhimanyu and Chakravyuha (from Mahabharata) author illustrates the importance of timely exit from an investment. With reference to selling stocks, author makes the following points.

a) It is very important to buy at a steep discount to intrinsic value
b) Once you buy you should give the investment about 2 to 3 years for the uncertainty to fade and market value to catch up with intrinsic value
c) As soon as market value comes to within 10% of intrinsic value, you should start exiting
d) As soon as the market value crosses the intrinsic value, you should fully exit
e) If, within the holding period of three years, there is a significant return, you should exit (I did not follow this advice on Freshtrop Fruits, Kaya and Waterbase where I had made significant profit in the first year as volatility was playing out)
f) If, at the end of three years, you are running a loss, you should exit. 

While the author do not encourage one to sell at a loss, there are two rules to be followed when selling at a loss.

a) If we are able to estimate the present value and future intrinsic value with very high degree of accuracy, and
b) Price offered is higher than the present value or the future estimated intrinsic value

One chapter is dedicated to index investing. There are some interesting ideas presented on identifying a set of stocks and rule based investing. Investor will find them useful.

One of the drawbacks of the book is Over-generalization. For example, at some point while discussing arbitrage, the discussion shifts to Moat and arbitrage is conflated with Moat, which is nothing but a durable competitive advantage, which is called USP in Marketing. By author's definition, any USP is an arbitrage opportunity, which to my mind is not correct.

Some ideas clash with the general theme of the book. One such is the suggestion to invest in low-risk, high uncertainty business. How do you evaluate the cash flow of company that is going through high levels of uncertainty?

With a lot of cliches, mash up of widely available ideas, vague explanation of 'Dhandho' and over generalization of every known value investing concepts to fit with 'Dhandho' (for example, Margin of Safety, Moat, DCF Valuation), this book adds little value to an aspiring investor. The three areas that adds value - Kelly Formula, art of selling and the experience of the author - are cursorily covered. 

I will give this book a rating of 3 / 5

Initially, when I was planning to buy this book, it was selling at about 1000 bucks. I did not buy it at that time. I waited for the prices to come down to 250 before making the Buy Call.

That is value investing, I guess....

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