An Incredibly Powerful Value Investing Framework
The Dhando Investor, the low-risk value method to high returns is a wonderful book written by hedge fund manager Monish Pabrai. In it, he gives a comprehensive value investing framework for the individual investor.
The book is written in a straightforward style that is easy to read and comprehend. The Dhando Investor lays out the amazingly powerful value investing framework. Written with the intelligent individual investor in mind.
The Dhando method expands on the value investing principles expounded by Benjamin Graham, Warren Buffett, and Charlie Munger. In this book, we will come across phrases like “Heads I Win! Tails, I don’t lose much”, “Few bets, Big bets, Infrequent bet.”
Other concepts discussed are Abhimanyu’s dilemma, a detailed breakdown of the Kelly formula to invest in undervalued stocks.
So who is Monish Pabrai? I can hear you asking who is this guy and why are we talking about his book?
Let’s dig in a little and learn more about Monish.
Monish was born in 1964 in Mumbai, India and he moved to the US in 1983 to study at Clemson University. After graduation, he worked in the tech world until branching out on his own.
He started his own tech company with $30,000 from his 401k and $70,000 in credit card debt. In 2000 he sold the company for $20 million.
In 1999 he started Pabrai Investment Funds, that he still runs today. Since the fund’s inception, he has generated net returns of 517% versus the 43% return of the S&P 500 for the same time period. We are talking 16 years that he has made these returns.
His focus is long-only equities that are deeply distressed. He looks for two to three ideas a year, which he feels is enough. His portfolio is highly concentrated in that he generally only holds 10-20 stocks at one time. Currently, he has seven positions.
Buying and holding are only part of his strategy, he also looks very closely at his mistakes as well. Investing is a field where mistakes can be very costly and they must be looked into. He is unusual in that he doesn’t gloss over mistakes but rather spends time breaking down what happened so he can learn from the mistake. So he doesn’t repeat it in the future.
He uses a checklist of what not to do in the markets. Pabrai built this list by analyzing investors that he admires and deconstructing their mistakes. As a result, he ended up with hundreds of checkboxes on his investing checklist. This is not his exact checklist but rather an outline of his checklist and how he things about constructing his. He feels that each individual investor should come up with their own checklist as they learn more about investing.
Monish Pabrai’s primary source of investment ideas come from the 13F SEC filings from other value investment managers that he admires. 13F SEC filings are a quarterly filing required of all institutional investment managers with over $100 million in assets. In this filing, they will list all the current holdings for each fund. It will also list the prices purchased or sold as well.
This is a great source of investing ideas and is a whole investment strategy in and of itself. We will dig into this topic in a future post.
To illustrate how simple his holds are. He currently has these seven stocks in his portfolio.
- AerCap Holdings NV (AER)
- Fiat Crysler Automobiles NV (FCAU)
- General Motors (GM)
- Alphabet (GOOG)
- Berkshire Hathaway (BRK.B)
- Seritage Growth Properties (SRG)
- Ferrari NV (RACE)
Of these, Fiat, GM, and RACE hold 63% of his portfolio. So three automakers hold that much of his portfolio. Pretty simple stuff.
Ok, we have established that Monish knows his stuff and has some great results in his portfolio.
Let’s talk about the book.
Pabrai starts the book by discussing the term “dhandho” (pronounced “dhun-doe”), which is a Gujerati word meaning “endevours that create wealth” or “business”. Gujerat is a coastal province in India that has served as a hotbed for trade with Asia and Africa.
Most people think that risk and return are intertwined. Investors are told if you want high returns you must take on high risk. However, value investors like Warren Buffett, Benjamin Graham, and Joel Greenblatt have shown that it is possible to achieve incredibly high returns with very low risk.
Monish Pabrai shows that his Dhando investing framework is low risk with high returns. His framework contains nine principles.
Principle #1. Focus on Buying an Existing Business
Pabrai states that the path to wealth is investing in existing businesses through the stock market. His view is to find a few great bets that you can buy and hold, at least for 2 to 3 years.
There are few reasons to do this. First, there is little to no heaving lifting required. Secondly, you can find a multiple of bargain basement stocks to invest in. And finally, you don’t need a lot of money to start investing in the stock market. With the ultra-low transaction costs, there are very low friction costs.
As we have said before stay away from IPOs. They are extremely risky and they make money for one person and one person only. The owner of the business, not YOU!
Principle #2. Invest in Simple Businesses
Simplicity is an extremely powerful idea. After all, Einstein stated that simplicity was the highest level of intellect. Pretty smart guy.
The Dhando framework is simplicity itself. This is the power of this style of investing. Only after we buy a stock does the battle with our brain begin. This is when the yin and yang of self-doubt starts to creep into our decision-making basis.
To help fight this psychological battle with ourselves. We need to buy painfully simple businesses with painfully simple ideas. This will help you make a decent profit and reduce the need to create complicated spreadsheets to track all the data about the stock.
The framework is simple. Find a company you can understand. Buy it for a discounted price. Hold on to it until it is no longer a reasonable price or the story changes about the company. Rinse and repeat.
Principle #3. Invest in Distressed Businesses
Stock prices do not always reflect the fundamentals of the underlying business. In other words, price does not equal value of the company.
Pabrai states that the human psychology affects the buy and selling of stocks much more than the buying and selling of entire businesses. Bad news can lead to extreme fear, stock dumping, and a very low valuation as a result. Sell the news, is a phrase that is used in the market.
In other words, the stock you are looking at will rise and fall based on a piece of good/bad news.
You should look for simple businesses that are under duress. So you can buy them at incredibly low prices. If you see bad news about a company you are interested in this could be great news for you. If the underlying businesses fundamentals have not changed but the bad news has driven the price down out of fear. Then step up to the counter and buy all you can at the huge discount.
This is the secret of value investing. Finding wonderful businesses on sale and buying into them when everyone else is fearful.
A couple of recent examples of distressed companies that are selling at a discount right now but their fundamentals haven’t really changed much.
- Volkswagen-with the emissions tests fraud
- Wells Fargo-fraudulent account openings
- Chipotle-food poisonings
All three of these companies are outstanding businesses that are going some rough times right now. You could argue that they are selling at a discount to their value and would possibly be great investments. The trick is to know what they are worth and buy it at a discount to that price.
Principle #4. Invest in Business with Durable Moats
Only a business with a durable moat or a company with a sustainable competitive advantage is able to show above average returns on their invested capital. These are the companies that are able to earn more money for their investors than companies without a durable moat.
What is a moat? It is a durable competitive advantage that makes the company sustainable for many, many years.
An example of a moat would be Walmart. Love them or hate them, they are a great example of a company that has built a wide moat. Their buying power and infrastructure have created a wide and sustainable moat. Retailers trying to go head-to-head with Walmart on a price basis have not fared well.
Another example of a moat would be the brand power of Coke, McDonald’s, and Nike. The strong brand name gives them the ability to charge a premium for their services compared to competitor’s prices. Which helps boost their profits.
One thing to keep in mind with moats. Nothing lasts forever, just remember that of the top 50 businesses from 1911 only one is still in business. General Electric. You should take this into account when you are considering investing in any business.
Principle #5. Few bets, big bets, and infrequent bets
Warren Buffett once said that diversification is a protection against ignorance. In the end, investing is just like gambling. Especially, if you are speculating.
According to Pabrai, “looking out for mispriced betting opportunities and betting heavily when the odds are overwhelmingly in your favor is the ticket to wealth.”
This particular style of value investing is a big part of the success of investors like Warren Buffett, Seth Klarman, and of course Monish. Because of the patience, they exhibit during the process that when they do find opportunities they go in big to take advantage of that opportunity. This is a chance to really hit it big when you do guess right.
Warren Buffet often talks about investing opportunities are like pitches in baseball. The only advantage you have is that unlike in baseball you don’t have to swing at every pitch. You just need to pick the one you can hit and then swing with all of your might.
Principle #6. Fixate on Arbitrage.
Always look for arbitrage opportunities with spreads as wide and long as possible. Arbitrage opportunities help you to earn a high return on invested capital with low levels of risk.
Arbitrage strategies can lower volatility and smooth out returns. They can also provide a cushion in down markets.
For the readers who aren’t familiar with this topic, risk arbitrage (workouts) is a term that usually refers to a situation where an investor buys stock in a company that is getting acquired by another company. Usually when a merger is announced, the stock of the company getting acquired will jump (sometimes significantly) to a level that is close to the buyout price. But there is always a small spread between the current price and the buyout price. For example, let’s say Company A is trading at $30 per share. Company B thinks Company A is undervalued, and decides to buy the whole company for $45 per share. The stock in Company A will immediately jump to a level close to that $45… let’s say in this example $43. The difference has to do with many variables including the likelihood of the deal closing, terms of the deal, interest rates, and many other variables. But that $2 spread eventually closes if the deal works, and that is how arbitrageurs profit.
John Huber, Base Hit Investing
Principle #7. Margin of Safety – Always
Having a margin of safety is critical to your investing success. This goes hand in hand with finding distressed companies or companies that are trading at a discount to their intrinsic value.
The bigger the discount to intrinsic value the lower the risk. The bigger the discount to intrinsic value, the higher the return. Most of the time companies trade at their intrinsic value or above. This is when you need to let those pitches go by and wait for your pitch. When the company starts to fall below its intrinsic value is when you start to pay attention for that moment when you will be able to take advantage.
The term Margin of Safety was first introduced by Benjamin Graham and is of course adhered to by his most famous pupil. Warren Buffett.
Buffett is known as a staunch believer in a margin of safety and has been known to insist on a 50% rate before he will buy.
Why is this important? An example to illustrate. For example, if you were to determine that the intrinsic value of ABC’s stock is $162, which is well below its share price of $192, you might apply a discount of 20%, for a target purchase price of $130. In this example, you may feel that ABC has a fair value at $192 but wouldn’t consider buying it above its intrinsic value of $162. In order to absolutely limit your downside risk, you set your purchase price at $130.
Using this model, you might not be able to purchase ABC stock anytime in the foreseeable future. However, if the price does decline to $130 for reasons other than a collapse of ABC’s stock earnings outlook, you could buy with confidence.
This is a big deal because let’s say you lose 50% on a company, it will take a 100% increase to break even.
Principle #8. Invest in low-risk, high-uncertainty businesses
Think safe, boring incredibly successful business.
“we see change as the enemy of investments…so we look for the absence of change. We don’t like to lose money. Capitalism is pretty brutal. We look for mundane products that everyone needs.”
Some examples of companies that have proven to be low-risk, high uncertainty businesses would be Coke, McDonalds, Disney, American Express, Colgate
Why buy $1 for $.50? That is the Dhando way. You are looking for those discounted bets that you can really buy into. Let’s use an example to illustrate.
An AWESOME company is worth $1 but the uncertainty in the market has dropped the price to $.50. People are afraid and are dumping the company sending it down to $.50, even though the underlying fundamentals have stayed the same. There is the possibility that our friend, Mr. Market could get sick and drive down the price to $.30. So now people are selling $1 for $.3o. Some intelligent investors start loading up on the $1 for $.50. When they see the price drop they load up even more for the $.30.
Now days, months, years go by and little to nothing happens with the stock. Eventually, Mr. Market gets out of the hospital and starts to feel better and more optimistic. People start to notice and buyback the depressed stock. They push the price above the $1, which is higher than it is worth. Through all of this, the fundamentals have never changed.
The intelligent investor now unloads everything and makes a HUGE PROFIT!
Principle #9. Invest in the copycats rather than the innovators
According to Pabrai investing is a crapshoot but cloning is a slam dunk. Look for good businesses that have reliable earnings, that is the safe way to invest. Looking for the cutting edge companies that are trying to blaze a trail is a sure way to a lot of heartache.
A company that immediately springs to mind is the stock market darling, Tesla. Elon Musk, the companies founder is a dynamic, energetic, brilliant man that has had success with everything that he has touched. His vision of the world is a wonderous thing.
BUT, his electric car company has been a struggle to the least. It is a wonderful idea and dream and may very well be the way of the future. His company has struggled with production, design, delivery and just plain not selling very well. The cars are extremely expensive and the infrastructure is just not there yet.
Musk has great vision and is extremely creative but several factors are against him. First, the Big Boys of the car world have started to catch up to him in the electric car world. They have more money, better production facilities, and better distribution networks. His company is bleeding cash in a big, bad way and hasn’t even made a profit yet. Tesla is living off the reputation of its CEO right now. Investing in this type of company is a huge risk, it could pay off huge but I doubt it.
Monish certainly admires Musk, but would never invest in this type of company. Way too much risk for him. Remember his motto is “Heads I win, Tails I don’t lose much.”
I hope you have enjoyed our discussion of this awesome book. It is truly an enlightening book that is extremely easy to read. I couldn’t put it down and read it in a few days.
The principles of Dhando that he lays out are a terrific framework for value investing. Monish is a wonderful investor that has had great success by following the very principles that he lays out for you. Always remember his motto “Heads I win, Tails I don’t lose much.”
One of my favorite discussions in the book is his talks about a margin of safety. This is a principle that rings very dear to me. I will give you a personal example of not following this principle.
Very early in my investing journey, I was reading and learning. I came across this website that had a great following and had what I thought was great advice and guidance about buying stocks. I liked some of the recommendations but I was still new to this and naive. The website had a paid subscription that would give you all kinds of buy recommendations for stocks. The analysis was very thin but dressed up to look good with fancy layouts and such. Anyway, I purchased 3 stocks from these suggestions. And at first they did great but then the bottom dropped out. 2 of the stocks fell precipitously. One went from $42 a share to now trading at $13 a share. The other went from $12 a share to $1.55 a share. Those are just huge losses. I will never be able to recoup that money that was lost.
This was before I understood margin of safety and how to properly value a company. It is still a learning process and I will never know everything but that is the fun of the journey.
Thank you for taking the time to read this book review. I do appreciate it. If you think this would be of value to someone else, please share it with them.
Until next time,