The Dhandho Investor - Mohnish Pabrai

Mohnish Pabrai, the Dhandho investor

Mohnish Pabrai, managing partner of Pabrai Investment Funds, is a more prominent value investor. One striking feature of his methods, amongst many, is his willingness to hold a concentrated investment portfolio, even by value investor standards. For the curious, there’s much to learn about his philosophy and temperament in his book, The Dhandho Investor, which I found an insightful and accessible resource. In this post, I will summarise the key lessons that I took from Pabrai on value investing and capital allocation.

The Dhandho framework

Dhandho is a Gujarati word that means “endeavours that create wealth”. To Pabrai, Dhandho is about the maximisation of rewards and the minimisation of risks. He describes compounding as a snowball effect that can lead to amazing results over time. With this in mind, Pabrai outlines several core principles to Dhandho-oriented investing:

Buy existing, simple and distressed businesses

Buy existing businesses with a proven business model and history of operations. Such businesses are usually less risky than an unproven start-up.
Buy simple businesses in industries with a slow rate of change. Intense competition, capitalism and change can be rough on investment prospects. Sometimes, it’s easier to look for investment opportunities in mundane products and services that everybody needs. When it comes to buying and holding, simple tends to mean less stress. If your thesis requires more than a paragraph to defend, and requires sophisticated financial models, it’s probably a red flag, at least in Pabrai’s eyes.
Buy temporarily distressed businesses in distressed industries. The odds of buying stocks at large discounts to its intrinsic value are higher here. This rule may also apply to stocks in temporarily distressed countries, but investors should treat country-risk with even greater caution. (Note that this principle may conflict with the one above. Is the business truly simple if it is in distress? This is where judgement and experience comes in.)

Buy companies with economic moats

Buy businesses with durable and widening competitive advantages. This is a reminder to focus not only on company growth, but on the durability and magnitude of its competitive advantage. Companies with durable and widening advantages can generate better returns on invested capital over the long term.
Buy copycats rather than innovators. Pabrai believes that finding and investing in excellent innovators is difficult. By contrast, it is easier to choose good companies that can execute, lift and scale a combination of existing ideas. These companies tend to carry lower risk and yield greater rewards. (Remember that this principle is in reference to high-risk ventures. For example, we might classify low-risk companies that focus on excellent customer service as innovators. My point is to be careful with blanket application of principles)

Buy companies with a margin of safety

Buy businesses at large discounts to its intrinsic value. Benjamin Graham once referred to this idea as the margin of safety. The larger the margin of safety, the lower the risk of loss on capital.
Bet heavily when the odds are very much in your favour. To paraphrase Charlie Munger, investing involves looking for mispriced gambles and knowing when the gamble is mispriced.

The intelligent Dhandho investor

“Heads, I win… Tails, I don’t lose too much”
Mohnish Pabrai

Benjamin Graham and Warren Buffett had strong influences on Mohnish Pabrai’s investment philosophy. If the principles above weren’t a clear enough sign already, Pabrai highlights several concepts from Graham and Buffett that he found valuable:

Mr Market: The stock market is there to serve the investor. It should not guide you. Unlike baseball, there are no strikes when you decide not to swing.
Business owner: A stock represents a piece of a business. Its value is based on the amount of cash that comes in and out. It is wise to think like a business owner and not a ticket holder when making long-term investment decisions.
Margin of safety: As we’ve noted, Pabrai looks for businesses that sell for much less than his estimate of its conservative worth. The larger the discount to intrinsic value, the lower the risk and the higher the expected return.

Do remember that markets are based on an aggregation of auction pricing mechanisms. Yes, stock prices can and will deviate from intrinsic value when humans succumb to periods of extreme greed or fear. However, prices should return to rational levels over the long-run. Pabrai notes that this has been the case historically, even after the Fall of France, Korean War, Arab oil embargo, Nixon’s resignation, 1987 financial panic, 1997 Asian stock market crisis, the Russian LTCM crisis, and so on. Just because the market is usually efficient doesn’t mean the market is always efficient.

Few, big and infrequent bets

Good investments ideas are far and few between. To be successful, we have to make high quality bets when the opportunity arises. Pabrai likens investing to blackjack, in that we must think about our edge and odds. He highlights, for example, the helpfulness of the Kelly Formula, which can help us to think about capital allocation:

Kelly Formula: Fraction of bankroll to bet = Edge / Odds

Intuitively, the Kelly Formula suggests that your willingness to bet should increase the closer your edge or expected return is the the potential upside. But it assumes knowledge of the probabilities and payoffs of probable outcomes. In reality, our estimates of probabilities and value can be wrong.

For this reason, Mohnish Pabrai runs a concentrated portfolio of bets, each comprising around 10 percent of assets. On many occasions, he found that his favorite bets were not always the top performers. This concentration rule helped him to manage his biases and blindspots in stock selection and capital allocation.

Low risk and high uncertainty

Pabrai notes that Wall Street and business schools sometimes confuse risk with uncertainty. The former focuses on the possibility and severity of permanent capital loss, while the latter describes the knowability of the likelihood of future outcomes. For the interested, Mervyn King and John Kay wrote extensively about this in Radical Uncertainty.

The Dhandho-oriented investors look for low-risk, high-uncertainy investments. Such investments may trade at discounts if they’re misunderstood by the market. Low-risk, low-uncertainty stocks, by contrast, tend to trade at very high multiples as they’re well understood. And high-risk, high-uncertainty investments aren’t attractive to Pabrai as the likelihood of permanent capital loss is higher.

Tips and reminders from Mohnish Pabrai

Since value investing is inherently contrarian, independence of thought is critical. Pabrai believes that a small team size is central to this. Large teams may inhibit one’s ability to make contrarian bets. The author also recommends investors focus their analysis on one company at a time, and avoid discussing their positions publicly. This is to minimize noise and distractions.

While Dhandho investing seeks durable companies, Pabrai reminds us that companies cannot survive forever. Arie de Geus’ research in The Living Company for example found that the average life expectancy of Fortune 500 companies varied between 40 to 50 years. For this reason, Pabrai doesn’t estimate cash flow streams beyond ten years. He also doesn’t estimate the sale of business in year ten, for the purpose of calculating intrinsic value, beyond 15 times cash flows plus excess capital. (These were interesting insights into his process I thought)

Investment ponds

To find undervalued companies, Pabrai likes to filter for companies with very low P/E ratios, very high dividend yields and/or trade at 52-week lows. Sometimes, he’ll find good ideas from websites such as The Value Investor’s Club, Value Line, Value Investor Insight, Dataroma and Guru Focus. He also subscribes to news publications such as WSJ, Barron’s, Fortune, Forbes and BusinessWeek. Good opportunities should present themselves if we read consistently and wait patiently.

Entry and exit strategies

Pabrai recommends that investors have a clear entry and exit strategy before buying stocks. Here, he provides several self-assessment questions, which I paraphrase below:

Is this business within my circle of competence?
Can I estimate its intrinsic value today and into the next few years with confidence?
Is there a sufficiently large margin of safety today and into the near future?
Am I comfortable investing a large fraction of my net worth in this business?
What are the downsides and are they minimal?
Does the business have durable competitive advantages?
Is the business operated by able and honest managers?

Take caution when you cannot answer yes to the questions above. Students of the Warren Buffett Way will observe the similarities it shares with Berkshire Hathaways’s investment tenets: (1) durable long-term businesses; (2) rational and honest managers; and (3) purchasable at attractive discounts to intrinsic value.

Three year rule

Finally, Pabrai recommends that the Dhandho investor avoid selling his or her stock within two to three years of purchase. The three-year rule gives an opportunity for the stock price to converge to its intrinsic value, but an opportunity to exit if your investment thesis is incorrect. The aim is to avoid inflating your opportunity cost by selling too early or holding too long.

The exception to this rule is if you deem, with a high degree of confidence, that the intrinsic value of the company is now less than its current market price. Outside short-term tax considerations, Pabrai suggests to sell your holdings when the market price of your stock exceeds your estimation of intrinsic value.

The Dhandho Investor – Mohnish Pabrai and his investment philosophy