I have decided to launch a new category on this blog where I will discuss my insights gained from reading investing books written by famous investors. It is widely acknowledged in the investing community that the knowledge gained from reading such gems will be lot more fruitful for the average investor. So it seems like a good idea to (re)read them and also discuss the learnings within the community.
For my first book in this series, I decided to pick a book written by an investor whose name has come up so many times in the recent past in my readings on value investing: Mohnish Pabrai.
Who is Mohnish Pabrai?
Mohnish has an interesting history. Born in Mumbai, India, Mohnish first came to the US to pursue a degree in Computer Engineering at the Clemson university. After graduating, he worked at Tellabs as an engineer first and then in the marketing division. In 1991, he quit Tellabs to start his own IT consulting firm called TransTech. He did so by cashing out his 401(k) retirement account, which yielded about $30,000, along with a credit card debt of $70,000, giving him the capital to start his company. He eventually sold his company for about $20 million in 2000. Mohnish founded the Pabrai Investment Funds in 1999 and continues to run that to this day. Interestingly, he was motivated to get into investing after reading another classic investment book (and something I hope to cover in the near future) called “One Up on Wall Street” by Peter Lynch.
Pabrai Investment Funds started out with a sum of $1 million, which as of 2020 has mushroomed into almost $469 million. Compared to the NASDAQ-100 index (ticker: QQQ) which offers a CAGR of about 8% in the same time frame, Pabrai Investment Funds offers a CAGR of around 12%.
Mohnish proudly states that he is a student of the Charlie Munger/Warren Buffett school of investing. In fact, he even goes on to state that the Pabrai Investment Funds was setup by copying ideas that he learned by studying The Buffett Partnerships. This includes ideas such as fee structure, portfolio management and other operations.
So what does the word “Dhandho” mean? Dhandho is a word from a regional Indian language called Gujarati (from the Indian state of Gujarat). It literally means “business”. People from Gujarat in India are especially known to have an acumen for entrepreneurship. It comes as no surprise that one of the richest men in the world, Mukesh Ambani, who inherited his wealth from his father Dhirubhai Ambani, hails from this same state in India.
Mohnish begins his book by a discussion of a community from this state called “Patels” and how they have staked ownership for a sizeable percentage of motels in the USA. The book goes on to present several such case studies discussing more well-known names such as Richard Branson and how he launched Virgin Atlantic, Lakshmi Mittal and how he became a steel baron, and finally himself and how he launched Pabrai Funds.
All of the case studies are based on the one fundamental principle of a low-risk high-return bet i.e. a coin toss that is based on the following premise: “Heads: I win, Tails: I don’t lose much!“.
The Dhandho Framework
So Mohnish distills all his learnings from the case studies presented into the following core principles:
- Invest in existing businesses.
- Invest in simple businesses.
- Invest in distressed businesses in distressed industries.
- Invest in businesses with durable moats.
- Few bets, big bets and infrequent bets.
- Fixate on arbitrage.
- Margin of safety – always.
- Invest in low-risk, high-uncertainty businesses.
- Invest in copycats rather than innovators.
The first two are pretty simple and straightforward to understand. Mohnish suggests to invest your money in publicly traded companies i.e. the stock market, and to treat that as owning a piece of that business. This is far more convenient and easier to manage than starting a new business venture, has a better chance of generating a return than the other investment vehicles available. In a similar vein, businesses that are simpler to understand are easier to reason about. And why is this important? It is easier to estimate the intrinsic value of a business if it is simple to understand, because you want to know if the price you are paying for a share of a business is worth its value. Mohnish suggests using the Discounted Cash Flow (DCF) analysis to estimate the intrinsic value of a business.
The suggestion to invest in distressed businesses relies on the understanding that the markets aren’t efficient always. There are always some businesses whose current stock price have deviated from the actual health of the business itself. The suggestion here is to look past the negative headlines and to dive into the fundamentals of such businesses, while ensuring still that the business is simple to understand and within one’s circle of competence.
The suggestion to invest in businesses with durable moats is also self-explanatory. Businesses that have a competitive advantage in their domain will last for a longer time. And for the compounding of wealth to work its magic, you need business that will last decades and not a few years.
The next five suggestions in the framework are when things start to get interesting. Each of these deserve further elaboration.
Here Mohnish introduces us to this rather simple formula to determine how much money should you be investing in a particular business depending on the probability of winning, probability of losing and the payoff if you win.
The formula can be simply put as follows:
(P* W – L)/P = percentage of your money you should be betting
where P = payoff if you win.
W = Probability of Winning
L = Probability of Losing
So to illustrate this with a simple example: Let us consider a simple coin toss, where on Heads you win $1, on Tails you lose $1. The probability of winning and losing here is 0.5. Therefore, applying Kelly’s formula, you get (0.5 * $1 – 0.5) / 1 i.e. percentage of your money you should be betting on such a bet is 0. And that is not surprising since there is a equal probability of you winning or losing this bet. However, if you were to take the same coin toss example with a mispriced bet, where on Heads you win $2, on Tails you lose $1. In this example, Kelly’s formula suggest that you invest (0.5 * $2 – 0.5)/ 2 i.e. you should be betting 25% of your money on this bet.
Obviously, it is not as simple to estimate probabilities, but the general idea with this formula is that it will steer investors away from business bets that have a low payoff and high-risk (or high probability of losing). And with reasonable estimates, it should allow investors to determine how much percentage of their portfolio should be invested in what businesses.
The crux of this principle is: Bet big when the odds of winning are overwhelmingly in your favor.
This is the Dhandho principle on steroids, where the outcome of a coin toss could lead to the following results: “Heads: I win; Tails: I break even or even win!“i.e. the investor gets decent returns at virtually no risk. Mohnish provides several examples to illustrate this point. One such example is comparing GEICO’s insurance business to that of AllState or StateFarm. Given GEICO’s business model of directly underwriting insurance policies out of call-centers of through geico.com, they have a 15% cost advantage over StateFarm and AllState, who operate through brick and mortar stores independently owned by a commissioned agent. Mohnish states that while this arbitrage spread will eventually disappear, if the savvy investor can find such an opportunity and determine that the spread will last for a while, the investor can make decent returns with very limited risk.
Margin of Safety
This is perhaps one of the core founding principles of any investor, but especially true for a value investor.
One of the best books on investing titled “The Intelligent Investor” was written several years back by the godfather of value investing, Benjamin Graham. This book has a chapter dedicated to this subject of “Margin of Safety”. Graham states the following at the start of the chapter:
“Confronted with a like challenge to distill the secret of sound investment into three words, we venture the motto, MARGIN OF SAFETY.“
At the heart of it, the principle is simply the following: When buying a business, ensure that the price you are paying is way less that what you think it is worth. Thus, when attempting to estimate the intrinsic value of a business, after you have arrived at a figure, you pad that with some extra percentage for uncertainty in your calculations, similar to how a structural engineer would add a “margin of safety” to his/her specifications for a building/design project.
Investing in low-risk and high-uncertainty businesses
Mohnish draws a distinction between businesses where the range of possible outcomes of investing are very large versus the odds of permanent loss of capital. He states that Wall Street confuses the aspects of uncertainty and risk and this confusion can result in an opportunity for the watchful investor. Mohnish argues that Wall Street prefers the low-risk low-uncertainty businesses and these, therefore, typically trade at very high multiples. He gives examples of ADP (ticker: ADP), Paychex (ticker: PAYX), Procter and Gamble (ticker: PG), Costco (ticker: COST) as low-uncertainty businesses and suggests to avoid such businesses since they rarely trade at a discount.
I can see where Mohnish is coming from in this context when viewing these as value investing opportunities. However, as a dividend growth investor, my perspective is slightly different here. PG and ADP are fantastic companies from a dividend growth investor perspective, they are dividend aristocrats. They have been around for decades, have a stable cash flow and, in my opinion, should find their place as a core/foundation stock in a dividend growth investor’s portfolio.
Investing in copycats rather than innovators
Mohnish states the following:
Innovation is a crapshoot, but investing in businesses that are simply good copycats and adopting innovations created elsewhere rules the world.
Mohnish provides several examples to emphasize his point. One such example was regarding Microsoft (ticker: MSFT). Mohnish argues that the origins of the MS-DOS operating system can be traced back to the QDOS (Quick and Dirty Operating System) developed by Seattle Computer. MSFT went out and bought the rights for this and scaled it.
In relation to MSFT, Mohnish also contends the following:
- the original idea for mouse and GUI for the PCs were inspired from Apple’s (ticker: AAPL) Macintosh computers.
- Excel’s features were lifted from Lotus 1-2-3 and VisiCalc. Word inspired from WordPerfect.
- Xbox was inspired from Nintendo and Sony’s PlayStatation.
- …and so on
While I can see where Mohnish is going with this, I have to disagree with this principle slightly. I certainly do not see innovation as a crapshoot and a copycat as a homerun in all cases. Take MSFT’s Bing search engine versus Google’s search engine. Google dominates the search space in comparison to Bing. MSFT’s Internet explorer browser, which has been around for a lot more longer, is a joke in comparison to Google’s Chrome browser. The Internet Explorer was created to trounce Netscape Navigator, and MSFT tried everything in their might to achieve that, but Netscape lives on today in the form of Firefox which is an awesome internet browser. There are several other such examples: Zune Portable media player vs Apple’s iPod, Windows Phones vs Android etc.
When to Sell?
In this regard, Mohnish states the following:
any stock that you buy cannot be sold at a loss within two to three years of buying it unless you can say with a high degree of certainty that current intrinsic value is less than the current price the market is offering.
In other words, Mohnish recommends holding a stock for two-three years at a minimum. Why two-three years? Why not a few months? This is because any meaningful change in a business takes some time to play out. Why not five years or more? Because the cost of waiting is appreciable and there is the associated opportunity cost wherein the same capital could have been invested in some other business.
What about after three years and if the stock price as crossed our estimated intrinsic value? Mohnish recommends selling if we are convinced that the stock is overvalued while also considering the capital tax implications of such a sale.
As a dividend growth investor, I will only sell a stock if the underlying fundamentals of the business have changed with respect to my original investment thesis and reasons for investing in the business. I am a buy-and-hold investor and the compounding effect of the dividend snowball can only be realized if I can hold onto a stock for not three years, but several years. Selling a stock would kill that compounding growth machine, and that is something I cannot afford in my strategy.
Final Remarks and Summary
So there you go! Those were my takeaways from this book. It is nicely written in a very easy-to-read language. I am pretty confident that I would have been able to breeze through this book in a single sitting. Some of the ideas discussed are in sync with what I have read in other investing books. And while I did not necessarily agree with some of the principles, I enjoyed the slightly different perspective of approaching the same underlying philosophies. There is a LOT of reference to Charlie Munger and Warren Buffett’s letters and quotes, not at all surprising in a book authored by Mohnish Pabrai.
I will re-read this in a few years from now, just to see if the ideas presented in this book provide a renewed perspective to my outlook on investing.
Have you read this book? If yes, what are your takeaways? What are your favorite books on investing? Please share in the comments below.
Thank you for reading thus far.
Disclosure: Long MSFT, AAPL, PG, COST