Thursday, 17 May 2012

Book Review - The Dhandho Investor, by Mohnish Pabrai

"What does "dhandho" mean?"  That's likely the first question book browsers ask when their eye catches the spine of Mohnish Pabrai's The Dhandho InvestorThe ethnic group that the word belongs to defines it as a low risk, high return investment, which contradicts the conventional wisdom that outsized returns can only be had at the cost of high risk. As Pabrai likes to say, "Heads, I win; tails I don't lose much."
Many investors have helped affirm Pabrai's motto: the Patels, a people from India that account for just 1 in 500 Americans, but own half of all US motels; Richard Branson, who started serving an ignored niche in the airline industry, while risking little capital by leasing an unused plane; Lakshmi Mittal, who restored dying steel mills to profitability, but paid very little for them; or Warren Buffett, who amassed jaw-dropping returns, while taking on very little risk.  The "high-risk-high-reward" concept has been proven wrong. 
Pabrai is heavily influenced by Buffett and Charlie Munger.  As they do, he encourages investors to buy simple, predictable businesses.  Moreover, worthwhile businesses have a competitive advantage and resulting high returns on capital.  These gems, however, must be bought on the cheap.  Strangely enough, temporary market inefficiencies will give patient investors opportunities to buy gold for the price of brass.  But golden opportunities are rare enough that when they do arise, investors must bet heavily. 
Though Pabrai doesn't break much new ground in this book, he puts more emphasis on certain points than many other investors do.  For example, he broadens the term "arbitrage" from a narrow fixation on price differences, and uses it as a metaphor for investing in general.  What's a competitive advantage, after all, if not a form of arbitrage?  If one company is able to offer lower costs than competitors, it will draw in more customers; over time, though, high-cost producers will perish, and remaining ones will become leaner, narrowing the gap between the market leader and the also-rans.  Fortunately for investors, though, many "moats" last for decades.  Pabrai analyzes GEICO, owned by Buffett's Berkshire Hathaway, which has enjoyed a low-cost "arbitrage" spread for decades, and is likely to do so for decades to come.
One of the high points of the book is Pabrai's discussion of the difference between risk and uncertainty, a crucial distinction that many investors fail to make.  Risk is the potential for capital loss, while uncertainty is a wide range of possible outcomes.  Confusing uncertainty for risk frequently leads to underpriced securities - investors wise to the difference stand to make a lot of money. 
Along with case studies of Level 3 and Frontline, he candidly discusses his investment in Stewart Enterprises, a company that "rolled up" hundreds of locally-owned, mom-and-pop funeral homes, but amassed too much debt in the process.  Worried about the potential of default, the market pummeled the stock.  Pabrai wasn't fazed.  He calmly assessed the company's major alternatives: reselling some locations to their original owners, refinancing, or restructuring via bankruptcy were the most likely options.  Then he assigned a probability to each, and estimated the share price that would result from each option.  He decided that the bankruptcy would leave enough of the business intact to break even, and the other two options would give him a large profit.  Uncertainty was high, but the risk of loss was low.
Pabrai doesn't just vaguely advise investors to bet heavily when the odds are in their favor, he points them specifically to the Kelly Formula as a guideline for how much to wager given certain odds.  Much of the value of the Kelly Formula is that it encourages investors to consider a range of possible outcomes and attach probabilities.  It carries risks, though: it suggests precision, where only approximations can be made, and it suffers from the same "Garbage-in-garbage-out" weakness that many formulas do.  Pabrai recognizes the drawbacks to the Kelly Formula, and he devotes 10% of assets to each investment. (The book was published in 2007.  Pabrai got walloped in the Great Recession, as nearly all investors did, and now runs a somewhat more diversified portfolio).
Most investors agree that selling is an imprecise art.  With the help of the epic poem the Mahabharata, Pabrai offers some wise advice.  First, allow at least two to three years for the story to play out, unless it has become undeniably clear that the investment was a mistake.  Stocks often decline after investors buy them, even when the business is succeeding.  Jittery investors frequently panic and sell, only to watch the stock appreciate later.  In more serious cases, the business itself may stumble.  But all businesses face challenges, and investors must be patient and wait for improvement.  Pabrai did just that with USAP, a specialty steel maker: his investment fell by nearly two-thirds before roaring back and doubling from his initial purchase price.
Many investors offer a recipe for success that's long on theory, but scant on practical advice for finding undervalued stocks.  Pabrai, however, offers helpful suggestions about how to hunt for value: scan Value Line for battered stocks, consult and for the holdings of prominent value investors, visit Joel Greenblatt's, and read his book The Little Book that Beats the Market.  Don't be afraid to clone or copycat, Pabrai urges.
Pabrai is an excellent investor.  From 1999 to 2007, he returned 28% a year, though that number has fallen since the Great Recession.  The Dhandho Investor is a success.  He wisely sticks closely to Buffett and Munger, but has the judgment to borrow from others, too.  His book, however, isn't just an collection of other people's ideas, despite his cheerful admission to copying others.  He cites several examples that don't typically make it into case studies, but also draws on more familiar ones.  He reinterprets basic ideas and gives them much more explanatory power.  Short, clear, fun and wise - this book is a must read for any serious investor.
(1) Pabrai, Mohnish. The Dhandho Investor. Hoboken: John Wiley and Sons, 2007.

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