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Heads, I win; tails, I don’t lose much!

By Alex of SnowBall Effect

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Hope everyone enjoyed a bit of a break during the holidays and I wish all of you an amazing 2018! On my side, as you might have noticed, I took a break and skipped two weeks of writing to explore Australia and New Zealand and spend some time with the family. These two countries are surprisingly different – although Aussies and Kiwis would tell you it’s obvious – and there’s much to love about both. One thing they have in common…? The important number of Chinese tourists and immigrants. Living and working in Hong Kong, the influence China has on other countries is always something I notice extremely quickly. Although both Australia and New Zealand are trying, in some ways, to resist Chinese people taking over by blocking some corporate M&A deals or imposing increasingly strict rules in relation to real estate, the two countries are clearly benefiting economically from the interest China has for the region. It’s noticeable in large cities such as Sydney where, for example, Chinese students are flooding to well-known Australian universities. But it’s also true in smaller towns in New Zealand, for instance, where you can easily get a mandarin-speaking guide to tour you around great local wineries and producers, who will tell you that a massive portion of their production gets exported to China.

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Of course, I couldn’t stay entirely away from anything related to business and investing… So, I couldn’t help but to finish reading a great book by Mohnish Pabrai titled “The Dhandho Investor: The Low-Risk Value Method to High Returns” published in 2007 (besides reading a couple of financial reports on the plane… I mean, it’s an 11-hour ride!). In short, in 1991, after working for a few years, Pabrai started an IT consulting and systems integration company which he sold in 2000 and by then had started an investment partnership strongly influenced by the famous Buffett Partnership. Mohnish is also a good friend of another great investor, Guy Spier, with whom he won a bid to have a lunch with Warren Buffett in 2007.

\The book is a short 183 page long and presents “The Dhandho Investor way of investing, which translated means “endeavours that create wealth”. The whole approach is based on “low-risk, high-return” or as Pabrai says several times in the book “Heads, I win; tails, I don’t lose much!”. Who doesn’t want that?! The book is far from anything very technical. It’s an easy read, which mainly focuses on how to approach investing (being the hardest part to tackle as an investor) and how to select your investment targets while decreasing future risks as much as possible. Below are a few important concepts from The Dhandho Investor which are worth highlighting.

Chapter 13

Chapter 13 is probably the most important chapter of The Dhandho Investor and is titled “Dhandho 402: Invest in Low-Risk, High-Uncertainty Businesses”. In this chapter, Pabrai brings to light a highly underappreciated concept. Let me explain in a few words. The argument presented in 20 pages or so is to invest in businesses where although the outcome – of the business or investment – might be uncertain, most plausible outcomes represent interesting returns and only a very low risk of reaching an outcome where some money would ever be lost. For example, picture Company A, who’s planning to invest in a great new business line, which could have a significant impact on its overall business. Out of the five plausible outcomes identified, four would result in gains ranging from immaterial to great and only one of the outcomes would result in minor losses for the firm. This is exactly a “Heads, I win; tails, I don’t lose much!”-type of situation and what investors should be looking for. Pabrai argues that markets hate that type of uncertain situations and would unreasonably punish and discount such potential targets, therefore offering an opportunity to jump in. In the short term, markets, when faced with new situations, are often quite bipolar in nature. It’s either everybody believes in a target which pushes up its market price to unreasonable levels or investors (or speculators) all dump the stock, which can offer great opportunities for intelligent investors. Potential future investment outcomes have to be carefully and logically analysed and can rarely be simplified into two extremely opposite views. (See my last post elaborating on a related topic: Forecasting the future – a matter of plausibility)

Companies don’t last forever

Although legal persons have the possibility to live forever, they don’t. One of the misconceptions we often have when analysing a business and its future cash flow (yes, think DCF models) is that businesses live forever. However, as referred to in Pabrai’s book, consider the following:

“Of the fifty most important stocks on the NYSE in 1911, today only one, General Electric, remains in business… That’s how powerful the forces of competitive destruction are. Over the very long term, history shows that the chances of any business surviving in a manner agreeable to a company’s owners are slim at best.”

–  Charlie Munger

In addition to not living forever, Mohnish also reminds us that there is no such thing as a permanent competitive moat. He also explains the following – which I can’t explain in any better terms:

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“In 1997, Arie de Geus wrote a fascinating book called The Living Company. Geus studied the life expectancy of companies of all sizes and was very surprised to find that the average Fortune 500 company had a life expectancy of just 40 to 50 years. It takes about 25 to 30 years from formation for a highly successful company to earn a spot on the Fortune 500. Geus found that it typically takes many blue chips less than 20 years after they get on the list to cease to exist. The average Fortune 500 business is already past its prime by the time it gets on the list.

Even businesses with durable moats don’t last forever. Thus, when using John Burr William’s intrinsic value formula [based on a DCF model], we ought to limit the number of years we expect the business to thrive. We are best off never calculating a discounted cash flow stream for longer than 10 years or expecting a sale in year 10 to be at anything greater than 15 times cash flows at that time (plus any excess capital in the business).”

In addition, I would argue that, as the world is far from getting slower, companies’ life cycle is increasingly getting shorter and shorter. For investors, it’s not necessarily an issue, but they certainly have to be aware of this and adapt accordingly.

Wait, but not too long

Pabrai argues that when investing, you should have a time horizon in mind of approximately two to three years. And you should expect to gain (whatever return you have in mind) within that timeframe. He explains that a time horizon of only a few months, for example, could be too short to see any significant change in the business and to expect any important change in the share price of the company. Although I would also argue that if the share price is far from its intrinsic value, a quick market adjustment of the share price isn’t impossible.

What’s interesting is also why you shouldn’t wait too long before making a move once you’ve invested. There’s always an opportunity cost when investing in a business and the more you wait, without generating any return or even having paper losses, the higher the return you’ll need to generate in the future to compensate for the time you’ve been waiting. Time horizons can sometimes be confusing as value investors will always emphasize the fact that you have to be patient and that some businesses can be held forever. Yes, be patient, but don’t overdo it. Also, as we just saw, companies don’t live forever so be ready to exit if necessary. Don’t get sentimentally attached to your investments. At the three year mark, if you realize you’ve made a mistake and don’t have any insight into why the share price should imminently increase, just cut your losses and get out.

Pabrai also refers to The Little Book That Beats the Market by Joel Greenblatt (see Making money like magic? for a book review I wrote), which calls for a systematic holding period of one year. However, if the business is well understood, an ownership period of more than a year can make a lot of sense. As an aside, I always find it very interesting and reassuring to see that the different authors and investors writing about value investing refer to one another and use similar concepts to achieve above average returns.

Heads, I win; tails, I don’t lose much!

 

Next post, next week!

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