The Little Book of Valuation – Book Review

Howdy friends! Hope you are all doing fine, staying healthy and sticking to your investing goals amidst all of the craziness in the world right now. As if things were not depressing enough with this COVID nonsense, the sky-high inflation rates, constant talk of interest rate hikes etc. the world now has a potential-war like situation in eastern Europe. I needed a distraction. So I decided to pick up a book on investing and read. No better way to enrich my knowledge and ignore everything else in the world.

We all know that investing is not an exact science. The process cannot be simply coined as a mathematical expression such as A + B = C. That said, it is not (or rather should not) be based on “hunches” and random guesses either. As an engineer, I like to treat the subject of making decisions based on rationality and through analytical arguments. This is why the subject of valuation interests me immensely.

Simply put, if you cannot ascertain the value of something you are about to purchase, you will make a huge mistake at some point.

So I picked up “The Little Book of Valuation” by Prof. Aswath Damodaran to refresh my understanding of the subject.

Who is Aswath Damodaran?

Prof. Damodaran teaches corporate finance and valuation at the Stern School of Business at NYU. If you follow finance content on Youtube, you may have run into his channel by accident. He also maintains a blog and his website is a treasure chest of all kinds of tools, spreadsheets and models that are available for FREE for anyone to use.

I cannot think of anyone who has written/spoken so eruditely on the subject of valuation. In fact, if you have not already done so, I *strongly encourage* you to go binge watch his playlist on Valuation. It might take a few watches, but you will learn a TON. It is certainly some of best finance content on Youtube, IMHO.

Initial impressions

The “little book” series are generally very good reads. They are concise, distilled and straight to the point. From that standpoint, the reader gains a lot from just a single read and does not need to spend a lot of time reading.

Valuation, however, is a very math-intensive subject. So I was not sure how such a complicated topic could be distilled down without losing the reader. To his credit, Prof. Damodaran does a fantastic job here. He first introduces the fundamentals of why valuation is important, followed by a discussion of valuation fundamentals and tools needed for the trade. Then there is a discussion on approaches to valuation, a walk through of how valuation can be applied to companies that are at various stages in their life-cycle and finally wrapping up with special cases in valuation.

Where valuations can go wrong

Source: Prof. Aswath Damodaran, slide-deck from Valuation class Spring ’22

So everyone understands that valuation is important, but the subject that does not get as much attention is where valuations can go wrong. Prof. Damodaran covers this subject first up. Here were some of my takeaways from the book:

  • Valuation is hard and the odds of getting it wrong are very high.
  • The investor’s personal biases and preconceptions impact his/her ability to value a company objectively. I have written about this subject previously on this blog.
  • Valuation can be made over-complicated fairly quickly. If you can value a company using a model with three inputs, there is no point in using five inputs. Less is more. And while it might sound counter-intuitive, more research and data points can actually lead to more confusion.
  • All valuation models are imprecise. We are not attempting to estimate the fair value of a stock up to 3 decimal places. The idea is to be close enough to the right answer and also add in a sufficient “buffer” (aka margin of safety)

Two approaches to valuation

In the chapters that follow, Prof. Damodaran goes into the aspects of HOW to go about doing valuation. Two primary approaches are discussed: intrinsic valuation and relative valuation. For intrinsic valuation, the value of an asset is determined by the looking at its future cash flows, its potential for growth and its associated risks. Prof. Damodaran focuses primarily on Discounted cash flow (DCF) valuation method here and discusses variations of this method. At its heart, the DCF method is ideal for estimating intrinsic value of an asset since it attempts to ascertain the present value of all estimated future cash flows discounted back at a risk-free rate. That statement in bold is the key, and the endeavor is to find a reliable method of estimating future cash flows for a specific duration AND also coming up with a fair risk-free rate.

Prof. Damodaran submits that while most discussions around valuation typically revolve around the DCF method, most assets in real-life are valued using relative valuation. For instance, if you are in the market for buying a house, you will look at the other similar sized houses in the neighborhood and come up with a “fair” value of the house you want to buy. Can one use a similar method for comparing stocks of two companies? The answer is yes, but with a few caveats:

  • For a fair apples-to-apples comparison, the two companies that you are comparing need to be in the same sector.
  • Then the question is what parameter one can use for the comparison. Common examples include multiples such as price to earnings multiple/ratio, price to book value, price to funds-from-operations (FFO) for REITs etc.
  • Another variation is to look at a company’s multiple against the average of a group of companies within the same sector. The understanding being that by averaging, you are most likely going to be comparing the company of interest against a more “typical” company in the sector.

Each approach (intrinsic or relative) has its pros and cons. For instance, estimating future cash flows for growth companies or companies that are relatively early in the lifecycle is quite challenging (the book dedicates a whole chapter to this subject). Relative valuation is not perfect either regardless of whether you were comparing two companies or a company against a group of companies from the same sector. For instance, during the dot-com bubble in 1999-2000, several companies that were investing in internet were all ridiculously overvalued at the same time.

IMHO, when in doubt, it might be ideal to use a combination of both the approaches to determine if this is an ideal investing opportunity or if something looks fishy.

The chapters that follow go through several interesting case studies where DCF is performed to value companies. 3M (MMM) is picked as an example for the introduction to DCF. In the second half of the book, Prof. Damodaran then discusses how valuations can be performed for companies at various stages in their lifecycle. For his discussion, Prof. Damodaran picks Under Armour (ticker: UA) as an example of a company that is growing rapidly. As an example of a mature company, Prof. Damodaran picks Hormel Foods (ticker: HRL) and explains how valuation could be performed and discusses variations to the traditional DCF method. Finally for a declining business, Prof. Damodaran picks Las Vegas Sands Corp. (ticker: LVS) and explains how such a business should be valued.

In my view, this is where I really enjoyed reading the book and where all the learnings from the previous chapters were reinforced.

Special Cases

Prof. Damodaran dedicates the final half of the book towards companies where the traditional DCF valuation may not be applicable as readily. Three examples covered are: valuing a bank or a financial institution, valuing a cyclical company and finally valuing a company with a large amount of intangible assets (for eg. patents)

Valuing a bank or a financial firm using a method such as DCF tends to be tricky for several reasons: most banks or financial firms are under regulatory constraints, making them treat capital differently than the rest of the market. The standard accounting rules for banks are slightly different as compared to other companies in the market. The treatment of debt within a bank is different as compared to a regular company. In a bank’s case, debt is more like raw material used to fund something else and as a result the process of determining the cost of capital becomes tricky. Finally, it is hard to estimate free cash flows because the aspect of defining net capital expenditure or working capital for a bank or an insurance company can be tricky. In this chapter, Prof. Damodaran introduces the aspect of Gordon Growth Model or Dividend Discount Model as an alternative to estimate fair value. For a more rigorous discussion of the subject, I point the interested reader to this page.

Valuing cyclical companies such as those belonging in the industrial sector or companies that are dependent on commodity prices is not as straightforward. For instance, for companies that rely on natural resources such as oil, how can we factor in the situation where we can potentially run out of this resource completely in our fair-value estimation? To deal with fluctuations in commodity prices, Prof. Damodaran recommends using the normalized commodity prices and earnings for such companies. Choosing this can make a critical difference in our estimation of a fair value. For instance, if the current price for a barrel of oil is $50, but our estimate for normalized price for a barrel of oil is $100, the company we are trying to value may look overvalued simply because of our chosen normalized price of that commodity.

Summary

While I am a huge fan of Prof. Damodaran’s lectures and his thoughts on the subject of valuation, my overall sense was that I was a bit disappointed with this book.

The book covers the subject of Discounted Cash Flow valuation method in sufficient detail. The associated case studies using real public companies is also very enriching and rewarding. The book does a great job of laying down the foundation material explaining the WHY of valuation and the common pitfalls with valuation.

Where the book loses its shine is when it starts covering the subject of HOW valuation is performed. I got a sense that a lot of “dense” material was crammed into a few pages to meet the requirements of being “A little book”. Valuation is a math-heavy topic and topics that involve mathematics simply cannot be distilled down. Doing so complicates things for the reader instead of making the material simpler.

As an engineer, I did not find any issue with following the math. I quite enjoyed it on the contrary. I just wished it was given enough “love” in the book :).

Where this book excels is when it covers the subject of valuing companies at different stages in their life cycles and also the special cases where DCF cannot be readily applicable. I thoroughly enjoyed those chapters and gained some interesting insights for me ponder over further.

Have you read this book? What are your thoughts regarding it? Let me know in the comments below.

Richer, Wiser, Happier – Book Review

Every now and again you come across a book that you simply cannot put down because it is blowing you away with so many profound thoughts, questions and wisdom. I just happened to stumble upon one such book titled “Richer, Wiser, Happier” by William Green. I had first heard of this book when I was listening to William Green being interviewed on The Investor’s Podcast’s show. Since then, I have heard of this book on several other channels and social media with very high recommendations. I stumbled on this book on another recent trip to the library and said to myself “Wow! I cannot wait to read this!”.

I was actually not sure what to expect from this book before reading it. Would it be simply a collection of interviews with famous investors? If yes, how it be different from the countless interviews I have already seen of these same investors. Would I learn anything new? Maybe yes, maybe no. But would there be an underlying theme common to all interviews?

All my doubts were dispelled very early in the book as I was going through the contents and reading the introduction. William has cleverly focused on crafting the chapters in this book such that each chapter corresponds to one central theme that is broadly stated such that it is applicable not just to investing, but life in general. And all of the learnings and content from the various interviews with the investors have been organized such that they would fit in this theme.

I cannot even begin to imagine the amount of material William Green must have collected for this book. Just to give you a sense of this, here is a partial list of investors that William interviewed or consulted in preparation for this book: Charlie Munger, Howard Marks, Joel Greenblatt, Bill Miller, Mohnish Pabrai, Guy Spier, Jeffrey Gundlach, Li Lu, Peter Lynch, Bill Ackman, Mario Gabelli, Sir John Templeton, Jack Bogle and so on. To distill learnings from so many smart individuals into a coherent and engaging 250-odd page book is a herculean effort.

So to further condense this book in a blog post is almost an impossible task and something that I will not even begin to attempt. Instead, I will focus on some of my key learnings from this book.

Simplicity is the Ultimate Sophistication

The best investors have the discipline not to be swayed by distractions. Have a simple strategy that makes sense to you and stick with it through thick and thin.

Joel Greenblatt

One of my biggest learnings from the book is the importance of being disciplined and having a simple, repeatable strategy. This is just a simple, yet profound idea and it is equally applicable to dividend growth investors such as myself. If you have been investing in the market over the last 2 years, you would have seen the hype surrounding stocks related to Electric Vehicles (EVs). Then the advent of other meme stocks or various cryptocurrencies where concepts surrounding valuations have been thrown out of the window. There would be comments thrown around the internet where people would “pity” dividend growth investors because of lack of capital appreciation in their portfolios.

It is extremely difficult to remain disciplined and stick to the slow and steady strategy such as dividend growth investing in the face of so many distractions. But this is what separates the serious long-term investors from those investors who keep shifting from one strategy to the other every other day of the week.

Dividend growth investing is also a relatively simple and straightforward strategy. If you understand the essence of it, you will be hugely successful with it.

Intelligent people are easily seduced by complexity while underestimating the importance of simple ideas that carry tremendous weight… when you apply a handful of such simple but powerful ideas with obsessive fervor, the cumulative effect becomes unbeatable.

– Mohnish Pabrai

And the idea that one can build a sound foundation of knowledge in investing built around such simple ideas was something that I kept finding as a common advice amongst many of these famous investors. This is one of my biggest takeaways from my book.

Beware of your emotions and biases

People are crazy and emotional. They buy and sell things in an emotional way, not in a logical way, and that’s the only reason why we have any opportunity… So if you have a way to value businesses that’s disciplined and makes sense, you should be able to take advantage of other’s emotions.

– Joel Greenblatt

Most people get led astray by being excessively careless and optimistic when they have big profits, and by getting excessively pessimistic and too cautious when they have big losses.

– Sir John Templeton

The reluctance to reexamine our views and change our minds is one of the greatest impediments to rational thinking. Instead of keeping an open mind, we tend consciously
and unconsciously to prioritize information that reinforces what we believe.

– Charlie Munger

I have written about how the investor’s biases can be a huge impediment to evaluating any investing opportunity. Emotions are similar. Unsurprisingly, this came up repeatedly in the book as well. In my opinion, for any investing strategy to be successful, the investor needs to develop a solid mindset such that he/she can stick with a strategy even during turbulent times.

One of the solutions to overcome this is something that Charlie Munger stated very eloquently as follows:

If Berkshire has made modest progress, a good deal of it is because Warren and I are very good at destroying our own best-loved ideas. Any year that you don’t destroy one of your best-loved ideas if probably a wasted year.

So it is important to seek out counter-arguments to your investment thesis for a particular company i.e. see why someone else might be bearish when you are bullish on a particular stock and vice-versa.

Don’t be afraid of taking a contrarian stance

Skepticism calls for pessimism when optimism is excessive. But it also calls for optimism when pessimism is excessive. Turn cyclicality to your advantage by behaving countercyclically.

– Howard Marks

The art of being wise is the art of knowing what to overlook….Ignore the flood of short-term financial data and recommendations gushing out of wall street, brokerage firms, which have an incentive to spur activity among investors, crank out estimates for next quarter’s EPS for thousands of companies….You need to be wired to not believe the bullshit, to not be listening.

– Nick Sleep

One common theme that I would observe among most of the investors interviewed in the book is an attitude equating to “I don’t give a f*ck what the world thinks about this, because I know I am right“. This attitude to go unorthodox, to think independently is probably very unique to most value investors. And there are times when I feel that dividend growth investing is also tied to value investing at some level, which makes dividend growth investors also share some of these qualities.

On this particular subject, I absolutely enjoyed reading about two investors called Nick Sleep and Qas Zakaria, who have a whole chapter in this book dedicated to them. Both Nick Sleep and Qas Zakaria have interesting backgrounds. Nick originally wanted to be a landscape architect and Qas, born in Iraq, wanted to be a meteorologist because he enjoyed reading weather reports. Eventually, they in meet in London and launch an investment fund called Nomad with a singular focus to return as much value back to their investors (their rough target was for every $1, they would return approx. $10 back).

In you look at the table above, for a 12 year period between Sep. 2001, to Dec. 2013, the Nomad fund very nearly achieved this goal providing a staggering annualized returns of 18.4% (after fees) in comparison to the 6.5% provided by the MSCI World Index.

One of the keys to Nomad’s success is the long-term view of thinking about investments. Quoting Nick Sleep here:

It’s all about deferred gratification. When you look at all the mistakes you make in life, private and professional, it’s almost always because you reached for some short-term fix or some short-term high… And that’s the overwhelming habit of people in the stock market. The ability to resist such urges is one of those big superpowers…You need to give it huge weight when you’re weighing what works.

As a part of this exercise, Sleep and Zakaria would perform, what they call destination analysis of every business where they would ask the following questions when analyzing:

  • What is the intended destination for this business in 10-20 years?
  • What must management be doing today to raise the probability of arriving at that destination?
  • What could prevent this company from reaching such a favorable destination?

In their quest, they came across their idea of a business model where businesses would be run by far-sighted executives whose focus would be on building revenue over time. Their first case study was Costco (ticker: COST), a company I have covered on my blog before. The company was dismissed by Wall Street due to its low profit margins. What Wall Street was not seeing was that Costco was returning value back to its shoppers by marking up the sold good by no more than 15%, while other retail stores were marking them up by approx. 30%. In return, they would charge their members a nominal annual membership fee. What this would do was build up such enormous “brand-loyalty” because members would keep coming back to shop again and again. This business model was summarized by Sleep as “increased revenues begets scale savings begets lower costs begets lower prices begets increased revenues”. They coined this business model as scale economies shared and saw similar examples in other sectors such as Dell Computers, Southwest Airlines, Tesco and then finally, the grand-daddy of them all, Amazon. This became the bedrock of their investment strategy and their overall investment success.

I would be keeping an eye out to read more about Nomad and Nick Sleep in the near future, because I find it a fascinating story.

Summary

There is so much more to write about this book because the learnings are innumerable. Each chapter in this book could have been a book by itself! Which is why I think William Green did a phenomenal job in condensing it in a digestible manner. I have tried capturing a few notes I made while reading this book. You can find them on a Twitter thread here.

I think this is one of the best investment books that I have read in my lifetime and I am very glad that I read this book very early this year. I am hopeful that I can adopt the learnings from this book and inculcate them into my investing journey. I highly recommend everyone to go buy this book and read it, because you will gain a lot out of it. I will certainly be re-reading it several times again in the years to come.

Until next time, cheers!

Discl: Long COST

Bad Blood: Secrets and Lies in a Silicon Valley Startup – Book review

Last week I made a quick stop at the library after picking up my kid from school to pick up a few books and while I was there, I checked out the personal finance/business section to see what books they had around that seemed interesting. I stumbled upon “Bad Blood: Secrets and Lies in a Silicon Valley Startup” and thought “Aha! this might be a quick interesting read”.

For those of you that may not know, this is a book about Theranos, a health technology company founded in 2003 by Stanford-dropout Elizabeth Holmes, that made tall claims about being able to perform several blood tests using a small amount of blood (from a finger prick) in an automated fashion using machines developed in-house. The claims also stated that the machines would be small enough such that the consumers could have these setup at their homes, and have their lab tests done and ready within a few hours instead of relying on a doctor and/or third-party labs and wait for days to have their test results. As one could imagine, this was such a big deal because it would revolutionize lab testing and the associated industries.

There was one tiny problem though: Theranos’s technology simply did not work and their claims were based on a mountain of lies. This is probably the largest scandal after the infamous Enron scandal that saw the downfall of one of the largest companies in the US. At the time of writing this, Elizabeth Holmes is being charged with wire fraud and the jury is deliberating on this case.

For what it is worth, I had already seen some documentaries on this topic and therefore knew a lot of the story beforehand. That said, I wanted to read the book by John Carreyrou, as he was the journalist that broke out the story on Wall street journal that marked the beginning of the end for Theranos. I have now finished this book and it did not disappoint one bit.

I chose to write about it here. Why? Not because I wanted to restate the same story over here. But rather I wanted to talk about interesting learnings from this book, as several investors were duped investing their capital in this business. While this is not one of those classical books on investing, there are important takeaways that are worth pondering over.

And they were all fooled…

So on the face of it, Theranos’s claims had a lot of appeal. Even a lay person, who does not necessarily have a background in lab-testing technology, could see the potential of how such a business could be profitable, if they had a solution that actually worked. What else did Theranos have going for it? It had a star-studded panel board of directors, ranging from former US Secretary of States (Henry Kissinger, George Schultz), to top defense lawyers (David Boies), to a retired 4-star marine (Jim Mattis). On top of that, it had political connections (association with Clintons) and backing from other high-profile investors (Rupert Murdoch, Larry Ellison etc.).

Furthermore, Theranos struck deals with Walgreens and Safeway allowing them to open up “wellness centers” within these stores and have patients sign up for a variety of lab tests at cheaper rates.

To top this off, Elizabeth Holmes was being covered heavily on the media, her face was everywhere, and this whole narrative of the “next Steve Jobs” was being drummed up.

Surely, the board of directors and these high-profile investors were not dumb enough that they could not have seen through the lies. Did they not do their due diligence? Or was it a case of the bandwagon effect or herd mentality i.e. Everyone is buying this stock, therefore it must be a good business. To me it seems more like the latter. None of these investors were savvy in the field of medical sciences, and they had not seen the technology demonstrated or understood it well enough. They simply believed that since some other big names had invested their capital, this business must have some merit.

What about Walgreens (ticker: WBA), a name that is quite popular in the dividend investing community? They have been around in the retail pharmacy business for such a long time. Surely, they would have seen through Theranos’s BS. This is their area of expertise after all, right? Well they didn’t. A lot of this probably points to a highly inept management at the helm when this deal was struck. But then there is also the possibility of being blind-sided by the question: “What if we do not invest in this opportunity and CVS did and this took off?”.

Takeaways

Here in lies my three biggest take-aways from this book:

  • High-profile investors also make mistakes: To think otherwise would defy logic. This is where investing in a business simply because popular investors like Warren Buffett have invested in it, would be dangerous. There are several reasons for this.
    • The average retail investor does NOT have the same information available to him/her as Warren Buffett does, to tell if this investment choice makes sense to their specific situation and portfolio.
    • The amount of downside may be different. If this investment turns out to be a loss, this might mean different things to you or me as it would do to Warren Buffett.
    • Warren Buffett could be wrong. Yes, the Oracle of Omaha, like all of us, had also made investing mistakes.
  • FOMO is not restricted to the average retail investor: It is equally applicable to big corporations and other high-profile investors as well. IMO, this well and truly affected Walgreens in particular.
  • Do not overlook the quality of the management running the company: Far too often, we investors are so hyper focused on the quantitative aspects of the business and use that to value it. Yes, this is important, but this is not all there is to valuing a business. It is also important to know that companies can do all kinds of “engineering” in their financial statements to portray a rosy picture. IMHO, the qualitative aspects are just as equally important in valuing/understanding a business. One of the qualitative aspects is the management that is leading the company. Neither one of Elizabeth Holmes or Sunny Balwani, the former president and COO of Theranos, had a background in medical science or lab testing technology. To top it off, they simply could not tolerate being challenged or questioned on the merits of their technology. This made the working environment at Theranos very caustic and unhealthy. As a result, Theranos saw a very high attrition rate with people being fired left and right if they would even raise a question about the technology or bring-up any concern whatsoever. These were massive red flags and unfortunately they were simply ignored by the board of directors and the other investors.

Summary

Overall, I really enjoyed reading the book. I think John did a pretty good job of not missing any important details of the entire story. The writing was engaging and very gripping and I kept coming back to read some more. I would like to share one of the stories from the book that I found particularly hilarious. As I had stated earlier, the working environment at Theranos was far from ideal with strict surveillance, people being fired randomly. In one such incident, an employee had had enough and decided to quit, emailed his resignation, served his notice period, picked up his belongings and was about to leave when he was confronted by Elizabeth and Sunny who stated that he could not leave without signing a non-disclosure agreement. The employee refused stating he had already signed a confidentiality agreement when he was hired, had already served his notice period and was free to leave. As he pulled his car out of the parking lot, Sunny sends over a security guard to stop him, the employee ignores the guard and drives off. Sunny then calls the cops and when an officer finally arrives, Sunny complains about how the employee had quit and departed with company property. When the officer asked what was taken, Sunny responds “He stole property in his mind.” This just goes to show the kind of paranoia that was present in the working environment at Theranos.

The Theranos story is far from over and we will learn more about this as time passes by. It is also worth nothing that such incidents are not isolated. I can see a lot of parallels with the story for another company called Nikola, whose founder is also in the dock for similar securities fraud.

I will end this post by wishing my readers a Merry Christmas and a Very Happy New Year. Here is hoping that y’all have a very happy and prosperous year ahead and make great strides in your personal finance journey.

Until next time…

The Dhandho Investor – Book Review

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.

Dhandho?

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:

  1. Invest in existing businesses.
  2. Invest in simple businesses.
  3. Invest in distressed businesses in distressed industries.
  4. Invest in businesses with durable moats.
  5. Few bets, big bets and infrequent bets.
  6. Fixate on arbitrage.
  7. Margin of safety – always.
  8. Invest in low-risk, high-uncertainty businesses.
  9. 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.

Kelly’s Formula

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.

Arbitrage opportunities

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