The Dhandho Investor: The Low-Risk Value Method to High Returns

by Mohnish Pabrai

The fourth logical combination, low risk and low uncertainty, is loved by Wall Street, and stock prices of these securities sport some of the highest trading multiples.

Always take advantage of a situation where Wall Street gets confused between risk and uncertainty. The results will usually be quite acceptable.

The lesson here is that we always have a free upside option on most equity investments when competent management comes up with actions that make the bet all the more favorable.

Wall Street could not distinguish between risk and uncertainty, and it got confused between the two. Savvy investors like Buffett and Graham have been taking advantage of Mr. Market’s handicap for decades with spectacular results. Take advantage of Wall Street’s handicap by seeking out low-risk, high-uncertainty bets.

For me, any sort of tech investment is a very fast fivesecond pass as they tend to be unpredictable, rapidly changing businesses.

Rapidly changing industries are the enemy of the investor.

Good management gives you upside options for free.

A high dividend yield is sometimes indicative of a stock being undervalued. So, like low P/E or 52-week low lists, it’s a worthwhile screen.

In investing, all knowledge is cumulative.

Fear and greed are very much fundamental to the human psyche. As long as humans drive buying and selling decisions in equity markets, pricing will be affected by these fear and greed attributes. When extreme fear sets in, there is likely to be irrational behavior. In that situation, the stock market resembles a theater that is filled to capacity. Someone sees some smoke and yells “Fire, Fire!” There is a mad rush for the exits. In the theater called the stock market, you can only exit if someone else buys your seat—each share has to be held by someone! If there is a mass rush to leave the burning theater, what price do you think these seats would go for? The trick is to only buy seats in those theaters where there is a mass exodus and you know that there is no real fire, or it’s already well on its way to being put out.

Read voraciously and wait patiently, and from time to time these amazing bets will present themselves.

It is a battle between an innovator versus a cloner. Good cloners are great businesses. Innovation is a crapshoot, but cloning is for sure.

Because of these fundamental facts, investors are better off investing in an index fund versus most of the actively managed mutual fund universe.

Despite our policy of candor, we will discuss our activities in marketable securities only to the extent legally required. Good investment ideas are rare, valuable and subject to competitive appropriation just as good product or business acquisition ideas are.16 —Warren Buffett

Independence of thought is fundamental to sound investing. And not discussing portfolio positions in real-time keeps noise and distractions down to a minimum.

Value investing is fundamentally contrarian in nature. The best opportunities lie in investing in businesses that have been hit hard by negativity.

Real business change takes months, if not years. If you invest in a business, you ought to be quite content to get a datapoint on its valuation once a year.

In seeking to make investments in the public equity markets, ignore the innovators. Always seek out businesses run by people who have demonstrated their ability to repeatedly lift and scale. It is the Dhandho way.

To be a good investor, we need a robust framework for both the buying and selling of stocks.

Selling a stock is a more difficult decision than buying one—thus the need for a robust framework

The lesson Abhimanyu has for us is to have a crystal-clear exit plan before we ever think about buying a stock.

This is by no means a summary, but here are seven questions that an investor ought to be thinking about before entering any stock market chakravyuh: 1. Is it a business I understand very well—squarely within my circle of competence? 2. Do I know the intrinsic value of the business today and, with a high degree of confidence, how it is likely to change over the next few years? 3. Is the business priced at a large discount to its intrinsic value today and in two to three years? Over 50 percent? 4. Would I be willing to invest a large part of my net worth into this business? 5. Is the downside minimal? 6. Does the business have a moat? 7. Is it run by able and honest managers?

It is best to give the business some time to adapt to this change.

A critical rule of chakravyuh traversal is that 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.

cannot be sold at a loss today for three reasons: 1. It has been less than two to three years since we bought. 2. We are unable to come up with a realistic intrinsic value with a very high degree of certainty. 3. Present offered price is well below our conservative estimate of present intrinsic value.

As a corollary, the only time a stock can be sold at a loss within two to three years of buying it is when both of the following conditions are satisfied: 1. We are able to estimate its present and future intrinsic value, two to three years out, with a very high degree of certainty. 2. The price offered is higher than present or future estimated intrinsic value.

The key to being a successful investor is to buy assets consistently below what they are worth and to fixate on absolutely minimizing permanent realized losses. Warren Buffett’s two main rules are: Rule No. 1: Never lose money. Rule No. 2: Never forget rule No. 1.2

Markets are mostly efficient and, in most instances, an undervalued asset will move up and trade around (or even above) its intrinsic value once the clouds have lifted. Most clouds of uncertainty will dissipate in two to three years.

It is very hard to make up the lost non-compounding years.

Given the cyclical nature of the business, the odds were decent that things might get better as demand came back. We had a significant unrealized loss, less than two years had passed, and intrinsic value was tough to figure out. These are classic signs of being engaged in a furious battle in the heart of the chakravyuh. To have a shot at coming out alive, the answer was obvious—do nothing. Just hold. As my mom always said, “Time is the best healer!”

Within three years of buying, there is likely to be convergence between intrinsic value and price—leading to a handsome annualized return.

Anytime this gap narrows to under 10 percent, feel free to sell the position and exit. You must sell once the market price exceeds intrinsic value.

A lot of great fortunes in the world have been made by owning a single wonderful business. If you understand the business, you do not need to own very many of them.5 —Warren Buffett

The mantra always is “few bets, big bets, infrequent bets”—all placed when the odds are overwhelmingly in your favor.

There is a large body of research and empirical data that suggests that indexing is an excellent investing strategy.1 Active managers have very real and significant frictional costs.

As long as there are frictional costs, the vast majority of actively managed assets will underperform the broad indexes. This will always be true.

I enjoyed reading Swensen’s most recent book, Unconventional Success: A Fundamental Approach to Personal Investment.

recommendations for the individual investor in The Little Book.5 Greenblatt has done the individual investor a huge favor by writing the book and setting up the free web site, www.magicformulainvesting.com

Greenblatt goes on to suggest that an investor ought to build a portfolio of about 25 to 30 of these Magic Formula stocks. He recommends buying five to seven of them every two to three months. After a given stock has been held for a year, it is sold and replaced with another one from the updated Magic Formula list. Greenblatt’s back-testing showed that these Magic Formula stocks have generated returns as high as 20 percent to 30 percent annualized. It trounces the S&P 500—with no thinking or analysis required.

We could keep it very simple, only analyzing Magic Formula stocks day in and day out, and become quite wealthy over time. I strongly recommend this approach. It is simple.

However, here are nine other ponds where we are likely to find more of these fifty-cent dollars.

www.valueinvestorsclub.com

Subscribe to Value Line (or review it at a library).

Look at the 52-week lows on the New York Stock Exchange (NYSE) daily.

Most stocks will be ones you’ve never heard of. Ignore these. Fixate on familiar names and then dig deeper on any that pique your interest.

Subscribe to Outstanding Investor Digest (OID; www.oid.com) and Value Investor Insight (www.valueinvestorinsight.com). Both carry detailed interviews and write-ups with some of the best value money managers in the United States.

Subscribe to Portfolio Reports.

Another web site that is free and can partly replace Portfolio Reports is Guru Focus (www.gurufocus.com

sister publication of Value Investor Insight is Super Investor Insight. It too tracks the 13-F filings of the super investors of our time.

Subscribe to the major business publications—Fortune, Forbes, the Wall Street Journal, Barron’s, and BusinessWeek—at a minimum.