The Dhandho Investor

“Smart, Intelligent, Brilliant, Genius, Simple.” - Einstein’s five ascending levels of intellect.

“The Dhandho Investor” by Mohnish Pabrai is short, very simple to read and understand, and yet provides a highly comprehensive and effective approach to successful value investing.

Furthermore, it goes beyond straight forward value analysis by turning upside down one of the great myths of investing. Most investors believe that higher returns can only be achieved by taking higher risks. This book shows how this is not always the case. Indeed a deep understanding of the nature of risk is of paramount importance in achieving substantial returns. It is perhaps this point above all others that is the key insight in this remarkable book.

There is no substitute to buying and reading the book yourself, but here is a short description of what appeared to me to be the key elements.

What is a Dhandho Investor?

Dhandho (pronounced dhun-doe) means “endeavors that create wealth”, and comes from the Indian state of Gujarat. For the Patels who started immigrating from Gujarat, with virtually no capital 35 years ago, the word has an additional meaning. The Patels, as a group now own over $40 billion in motel assets in the US, but they do not believe that higher returns requires taking on greater risks. For the Patels, Dhandho is thus best described as “endeavors that create wealth while taking virtually no risk”.

The story of the Patels and their approach to business is a remarkable one and has great investment implications, and forms the basis for the entire investment approach of Mohnish Pabrai, who has himself become a remarkably successful investor.

The book first starts out with examples of highly successful entrepreneurs. The stories go far beyond the Patels, through many different journeys, including Richard Branson of Virgin. Nevertheless these stories all shared a number of core principles. Again and again the message that comes through consistently is that practicing the “Heads I win; tails I don’t lose much” kind of bet in their businesses was how they looked at opportunities. With this approach they were bound to become big winners sooner or later, as they would always be able to bounce back from any failures, and the chance of failure was minimized.

Core Principles of a Dhandho Investor

The well thought out investment principles are the great highlight of the book. Here is what I would summarize are the best points:

1. Buy existing businesses. Buying stakes in a few publicly traded businesses is so much simpler than any other approach. Perhaps this is obvious, but buying whole businesses requires considerable heavy lifting in terms of capital requirements, and can also consume a huge proportion of your time. The benefits of being a shareholder are really quite considerable. With bargain buying opportunities, ultra-low capital requirements, huge selection, and minimal friction costs, buying shares is “the no-brainer Dhandho way to go”.

2. Invest in simple businesses. As discussed in Market Notes 76 the “psychological warfare with our brains really gets heated after we buy a stock”. So your chances of success increase dramatically when you focus on painfully simple businesses and equally simple ideas, with limited downside. Complex, highly innovative, high growth companies in very competitive fast changing markets may well sound very exciting and seem to have enormous potential. Then again, they are also so much harder to make informed judgements about, as there are so many moving parts, rapid changes in circumstances and uncertainties. Good decision making becomes far more demanding in these cases. 

3. Look to invest in distressed situations. There are often great opportunities in the stock market despite what “Efficient Market Theory” concludes. Warren Buffett describes succinctly why this academic theory is full of holes. “Observing correctly that the market was frequently efficient, [academics] went on to conclude that it was always efficient. The difference between these propositions is night and day.”

Markets are clearly inefficient to the extent that humans control its auction-driven price mechanism. As value is rarely a precise tool and human emotions are so involved in buying and selling decisions, it would really be extraordinary if there were not frequent inefficiencies.  Furthermore, there can be little doubt that stock prices move around much more than underlying intrinsic value of the stock.

What all this leads up to is that by looking carefully at distressed situations, it is very often possible to find incorrect pricing and great values.

4. Size your bets right. Finding deeply undervalued, low risk, easy to understand stocks to buy is not a simple task and it will only produce worthy candidates infrequently. So when you find such a situation clearly an appropriately larger position should be taken. Equally everyone has a different situation and a different level of tolerance to volatile account values. Finding out the appropriate bet size is key to optimizing risk and return.

The book describes the Kelly formula for defining the bet size, but there are many different approaches to this issue, so I will not go into detail on this point, beyond emphasizing that this issue is very important. As Charlie Munger put it; “The wise ones bet heavily when the world offers them that opportunity. They bet big when they have the odds. And the rest of the time, they don’t. It’s just that simple.”

 

5. Margin of Safety – Always! Benjamin Graham and Warren Buffett both have the same simple core principle that can not be stated enough;

a) The bigger the discount to intrinsic value, the lower the risk.

b) The bigger the discount to intrinsic value, the higher the return.

This is the remarkably simple idea that so often gets forgotten by investors, and shows how it really is sometimes possible to achieve higher returns with lower risk.

6. Invest in low risk, high uncertainty businesses. Wall Street often gets confused between risk and uncertainty, and tends to produce low prices when either risk or uncertainty is high. When this happens it is often the case that the stock price will provide situations where very little capital is invested and/or the odds of a permanent loss of capital is very low. A high uncertainty situation or business is very attractive if the risk of loss is small. This is the ideal Dhandho bet: Heads I win, tails, I don’t lose much!

7. Invest in copycats rather than innovators. Innovation is a crapshoot. From the capital requirements to fund the business, to the unknown demand for a new product, to the limited track record and untested personnel, the range of problems that can occur is substantial and one’s ability to gauge value can become pure guesswork at times.

However, investing in businesses that are simply good copycats and are good at adopting innovations created elsewhere are a much safer bet. These managers focus on lifting and scaling models already proven elsewhere, and have a far better chance of success, and it is far easier to calibrate enterprise value.

8. Most successful value investors operate as individuals. Mohnish Pabrai copied his own investment business from Warren Buffet’s model. The core similarity is that each business has just one analyst, who also happens to be the investment manager. Why does it work better like this? Most likely it is because value investing is fundamentally contrarian in nature. Low values come with negative sentiment and often bad news. To get a group of managers to agree to buy when so much appears to be so wrong with an investment is very difficult. Individual initiative and freedom of action is what works for the right individual.

 Summary

There is, of course, a great deal more in the book that I have not covered. There has been no discussion of how to sell positions, and many other examples and points were made in the book. I hope that I have nonetheless provided an introduction to “Dhandho” value investing as it is practiced by the best.

The main lessons from this book are highly important for investors to understand, and in particular I find that investors are very rarely focused sufficiently on understanding the nature of risk. Finding low risk situations is the key to long term investment success, and low risk does not mean low return. This is the key to becoming a Dhandho Investor, and for most the surest path to becoming a very successful investor.

 

 

Notice

All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions.

Opinions expressed in these reports may change without prior notice. Chris Belchamber (the author) may or may not have investments or positions in any assets or derivatives cited above.

Communications from the author are intended solely for informational purposes. Statements made by various authors, advertisers, sponsors, and other contributors do not necessarily reflect the opinions of the author, and should not be construed as an endorsement by the author, either expressed or implied. The author is not responsible for typographic errors or other inaccuracies in the content. We believe the information contained herein to be accurate and reliable. However, errors may occasionally occur. Therefore, all information and materials are provided “AS IS” without any warranty of any kind. Past results are not indicative of future results.