Pabrai: The Dhandho Investor

TLDR

This book presents a value investing framework based on the principles of Indian immigrants who achieved business success in the US. This book advocates for investing with a margin of safety, focusing on areas of competence, creating a concentrated portfolio, and embracing contrarianism and patience. It emphasizes the importance of independent thinking and provides case studies of successful investments made by the author as well as a few others. Overall, it offers a practical approach to value investing suitable for both novice and experienced investors.

The Author

Mohnish Pabrai is an Indian-American investor, philanthropist, and author who has made a name for himself as a successful investor and business owner. Pabrai is the founder and managing partner of Pabrai Investment Funds, a hedge fund that has delivered impressive returns for its investors. He is also the author of several books on investing, including "The Dhandho Investor" and "Mosaic: Perspectives on Investing."

Pabrai gained attention in the investment community for his successful investment in the auto industry, where he purchased a significant stake in the struggling auto parts maker, Delphi Automotive, and made a substantial profit when the company's shares rebounded. He has also made successful investments in other companies, including Goldman Sachs and Horsehead Holding. Pabrai has also achieved very impressive returns in the stock market over the years. Pabrai Investment Funds, the hedge fund he founded and manages, has reportedly delivered annualized returns of more than 28% since its inception in 2000, outperforming the S&P 500 by a wide margin. Comparatively, his investment fund had a return of 517% from 2000 - 2013 versus the S&P 500 return of merely 43%.

Pabrai's investment approach, which focuses on identifying undervalued companies with a margin of safety, has proven to be highly effective over the years, earning him a reputation as one of the most successful value investors in the business. Even though he has built a reputation in the value investing community, he attributes a lot of his success to the teachings of Benjamin Graham and Warren Buffett. He is a frequent speaker at investment conferences and business schools and is highly respected for his knowledge and insights on investing.

Despite his fund being closed to new investors, an alternative to having him oversee your finances is to acquire knowledge on how he invests. He provides a complete account of his approach in his book, The Dhando Investor. If you desire to gain insights that will aid you in transforming a modest sum of money into a substantial fortune, with minimal risk, then continue reading below!

The Dhando Framework

1. Buy an existing business
2. Choose simple, stable industries
3. Invest in distressed businesses
4. Invest in businesses with a competitive edge
5. Bet big when the odds are in your favor
6. Look for arbitrage opportunities
7. Buy at discounts to intrinsic value
8. Focus on low-risk, high-uncertainty businesses
9. Imitate instead of innovate

The Dhandho Investor book presents ways to achieve high returns with minimal risk. The book takes inspiration from the Patel family's successful investment approach, which involves taking calculated risks with significant upside potential and limited downside risk. Mohnish Pabrai adapted this approach into his investment philosophy, which is detailed in the book. The book is aimed at individual investors, and Pabrai explains how to apply the Dhandho investor philosophy to the stock market. The book's motto is "Heads I win, tails I don't lose much," emphasizing the importance of minimizing risk while maximizing returns.

The Book

1. Buy an existing business

According to Pabrai, investing in an existing business with a proven and stable history is less risky than starting a new and untested business. He recommends investing only in companies with a solid business model, which can be achieved by buying stocks of publicly traded companies. This is the easiest way to become a business owner without actually running the business yourself. When you purchase a stock, you acquire an ownership stake in the business without doing any heavy lifting. Stocks have historically performed better than other main asset classes, making them a wise investment choice. This approach is more accessible than buying an entire business, making it easy to get started. To summarize the first principle of Dhando investing, one should focus on purchasing existing businesses through the stock market.

2. Choose simple, stable industries

The second principle of Dhando investing is to buy simple businesses with slow changes in the industry. This strategy is similar to Warren Buffett's investment approach of investing in businesses that can be run by even a fool. Pabrai advises avoiding complicated businesses, such as IT and banking, that require high levels of expertise to operate and have undergone significant changes in the past two decades. The reason for this is that to determine whether an investment is a good deal or not, one needs to know the intrinsic value of a business. In order to assess the intrinsic value, an investor must add up all the cash flows that will occur during the life of the business, then discount it appropriately to present value. The discounted cash flow (DCF) analysis is the best way to assess these investment opportunities, but estimating future cash flows is not an easy task. Therefore, Dhando investors invest only in simple businesses with relatively predictable and stable cash flows that can be estimated with relative confidence. Examples of such businesses are motels, Coca-Cola, and Bed Bath & Beyond. By avoiding complicated companies, Dhando investors can focus on businesses with more reliable intrinsic values. The goal is to find simple businesses that everybody needs, as Warren Buffett says, "change [is] the enemy of investments."

3. Invest in distressed businesses

Pabrai advocates buying stocks below their intrinsic value to find great investment opportunities. To do this, one can look for distressed companies, like how Papa Patel bought a motel during the 1970s recession at a discounted price. The same approach can be taken with the stock market, as stock prices can be very volatile and driven by news headlines, creating dislocations between a stock's price and its underlying value. By buying stocks at a distressed price, investors can take advantage of fear in the market. This aligns with Warren Buffett's quote: "Be fearful when others are greedy. Be greedy when others are fearful."

4. Invest in businesses with a competitive edge

Pabrai recommends investing in businesses with a competitive advantage, or a "moat," which protects them from competitors. He uses the example of Patel's Motel business, where the family members provide services such as room service, reducing the cost of employees and rent. This allowed them to rent out motel rooms at a cheaper price and gain a competitive advantage. To determine if a business has a moat, investors should look at the financial statements and identify businesses with a high return on capital. Companies such as American Express, Coca-Cola, Harley Davidson, and Google are examples of businesses with moats, which can come from factors such as brand name, cost advantage, and economies of scale. Having a moat is important in free-market capitalism, where competition can be ruthless and businesses without a competitive advantage will struggle to compete and may not survive.

5. Bet big when the odds are in your favor

To be a successful Dhando investor, one should bet heavily when the odds are overwhelmingly in their favor. The Patel family provides an example of how this principle works. They purchased bankrupt motels for low prices and borrowed the rest to make high returns on their investment with low risk. Similarly, if an investor finds a company with a strong moat and a simple business model, under temporary distress, and with a stock price below its intrinsic value, they should bet heavily on it. Pabrai recommends using the Kelly Formula, a mathematical formula that can help calculate how much money to stake on an investment opportunity based on the odds of success. Investing with a probabilistic mindset and betting big in high-probability situations is the key to successful Dhando investing.

6. Look for arbitrage opportunities

The book emphasizes the potential for arbitrage to drive business growth, citing examples such as GEICO's direct sales model that allows for a 15% reduction in operating expenses, which can be passed on to customers. While traditional arbitrage involves exploiting price discrepancies to make riskless profits, Dhando-style arbitrage involves creating an advantage over competitors, as seen in the Patel motel's low overhead costs that enabled them to offer cheaper room rates. Other companies like Wal-Mart and Home Depot have similarly leveraged unique advantages to outperform competitors. This "arbitrage spread" is essentially a moat, and Mohnish encourages investors to capitalize on such opportunities when they arise.

7. Buy at discounts to intrinsic value

To ensure a safe investment, Pabrai advises always having a margin of safety when buying assets. This can be achieved by purchasing an asset significantly below its intrinsic value and expected future cash flow. By doing so, investors can earn great returns over time while also minimizing their potential losses. To illustrate this point, the book cites the example of buying a gas station for $500k when its intrinsic value was $768k, creating a margin of safety. The Dhando investing philosophy emphasizes the importance of buying companies at a steep discount to their underlying value due to the future's inherent uncertainty. By investing with a margin of safety, one is protected from the unpredictable nature of the future. Benjamin Graham coined the phrase "The function of the margin of safety is, in essence, that of rendering unnecessary an accurate estimate of the future."

8. Focus on low-risk, high-uncertainty businesses

The Dhando investing framework emphasizes the importance of seeking out low-risk, high-uncertainty business opportunities. This combination of factors allows for a conservative investment with the potential for a significant payoff. In contrast, high-risk, high-uncertainty investments are akin to gambling, while low-risk, low-uncertainty opportunities offer limited potential for gains. The Patel motel exemplifies the ideal low-risk, high-uncertainty business, as the only risk was the $5k down payment, while the potential for upside was substantial. By seeking out opportunities with low-risk and high-uncertainty, investors can maximize their chances of success within the Dhando framework.

9. Imitate instead of innovate

Pabrai states that copying a proven idea is often more reliable than attempting innovation. This is because innovators face high levels of risk, while copycats can simply replicate an existing idea with minimal effort and cost. The Patel family's success in the motel industry is a prime example of this principle in action. Similarly, companies such as McDonald's and Microsoft were copycats, not innovators. McDonald's founder modeled his restaurant after a successful hamburger stand, and Microsoft licensed its flagship product from another company. The Dhando philosophy focuses on minimizing risk and primarily investing in proven ideas with a history of success. Investors can remember this easily through the Dhando tagline of "heads I win, tails I don’t lose much."

Conclusion

"The Dhandho Investor" offers valuable insights into the principles of value investing that can benefit every type of investor. Mohnish Pabrai's approach of identifying businesses with a moat, investing in low-risk high-reward opportunities, buying at a significant discount to intrinsic value, and replicating proven business models has proven to be successful. By focusing on a few well-researched investments and adopting a long-term approach like him, investors can benefit from compound interest and avoid over-diversification, allowing investors to build their net worth substantially. The book's casual writing style and relatable examples make it an engaging and accessible read. Overall, this book is one of the best all-around value investing books available, as it provides a clear understanding of the principles of value investing, combined with practical advice and real-world examples. With the knowledge gained from this book, investors can apply these principles to their investment strategies and potentially achieve greater success in their investment endeavors.