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

by Mohnish Pabrai

It also has a summary every week of the stocks with the lowest price-to-earnings ratios (P/Es), widest discount to book value, highest dividend yield, and so

3. There is a publication called Portfolio Reports (www.portfolioreports.com) that is published monthly. It lists the 10 most recent stock purchases by 80 of the top value managers.

5. Take a look at Value Investors Club (VIC; www.valueinvestorsclub.com). It is a wonderful web site started and managed by Joel Greenblatt of Gotham Capital. Greenblatt has perhaps the best audited record of any unleveraged investor on the planet over the past 20 years—a compounded annualized return of 40 percent.

6. Last, but certainly not least, please read The Little Book That Beats the Market by Joel Greenblatt.

Of the fifty most important stocks on the NYSE in 1911, today only one, General Electric, remains in business. . . . That’s how powerful the forces of competitive destruction are. Over the very long term, history shows that the chances of any business surviving in a manner agreeable to a company’s owners are slim at best.1 —Charlie Munger There is no such thing as a permanent moat. Even such invincible businesses today like eBay, Google, Microsoft, Toyota, and American Express will all eventually decline and disappear.

It takes about 25 to 30 years from formation for a highly successful company to earn a spot on the Fortune 500. Geus found that it typically takes many blue chips less than 20 years after they get on the list to cease to exist. The average Fortune 500 business is already past its prime by the time it gets on the list.

Even businesses with durable moats don’t last forever. Thus, when using John Burr Williams’s intrinsic value formula, we ought to limit the number of years we expect the business to thrive. We are best off never calculating a discounted cash flow stream for longer than 10 years or expecting a sale in year 10 to be at anything greater than 15 times cash flows at that time (plus any excess capital in the business).

Dhandho 301: Few Bets, Big Bets, Infrequent Bets

Kelly Formula. Kelly calculated that the optimal fraction of your bankroll to bet on a favorable bet is:

William Poundstone entitled Fortune’s Formula

For a detailed treatise on how to calculate the Kelly bet size for such bets, go to www.cisiova.com/betsize.asp

The wise ones bet heavily when the world offers them that opportunity. They bet big when they have the odds. And the rest of the time, they don’t. It’s just that simple.3 —Charlie Munger

Papa Patel, Manilal, Mittal, and yours truly have always fixated on making very few bets—and each bet is pretty large.

We might invest up to 40% of our net worth in a single security under conditions coupling an extremely high probability that our facts and reasoning are correct with a very low probability that anything could change the underlying value of the investment.10 We are obviously only going to go to 40% in very rare situations—this rarity, of course, is what makes it necessary that we concentrate so heavily, when we see such an opportunity. We probably have had only five or six situations in the nine-year history of the partnerships where we have exceeded 25%. Any such situations are going to have to promise very significant superior performance. . . . They are also going to have to possess such superior qualitative and/or quantitative factors that the chance of serious permanent loss is minimal.... In selecting the limit to which I will go in any one investment, I attempt to reduce to a tiny figure the probability that the single investment can produce a result for our portfolio that would be more than 10 percentage points poorer than the Dow.11 —Warren Buffett

In the light of these logical facts, it is indeed amazing that the average mutual fund has 77 positions. More important, their top 10 holdings represent just 25 percent of assets. Over one-third of mutual funds have greater than 100 positions each. 12 It is no wonder that 80 + percent of mutual funds consistently lag the S&P 500 Index. It is also no wonder that fewer than 1 in 200 mutual funds delivers long-term annualized performance that beats the S&P 500 by three percent or more. 13

As we examine the investing record of those who place many bets, small bets, and frequent bets, the results are predictably pathetic.

For Greenblatt, typically 80 percent of his assets have always been invested in five of his best ideas.

The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage.4 —Warren Buffett

Mr. Buffett hosts business school students from over 30 universities every year. The schools represent a wide range—from Harvard and Yale to the University of Tennessee and Texas A&M. The students get to ask him questions on almost any subject for over an hour before heading out to have lunch with Mr. Buffett at his favorite steakhouse. Virtually every group asks Mr. Buffett for book recommendations. Mr. Buffett’s consistent best book recommendation for several decades has been Benjamin Graham’s The Intelligent Investor,1 as he stated to students from Columbia Business School in Omaha, Nebraska, on March 24, 2006: The Intelligent Investor is still the best book on investing. It has the only three ideas you really need: 1. Chapter 8—The Mr. Market analogy. Make the stock market serve you. The C section of the Wall Street Journal is my business broker—it quotes me prices every day that I can take or leave, and there are no called strikes. 2. A stock is a piece of a business. Never forget that you are buying a business which has an underlying value based on how much cash goes in and out. 3. Chapter 20—Margin of Safety. Make sure that you are buying a business for way less than you think it is conservatively worth.2 —Warren Buffett

Very few people have adopted our approach.... Maybe two percent of people will come into our corner of the tent, and the rest of the ninety-eight percent will believe what they’ve been told (e.g., that markets are totally efficient).5 —Charlie Munger

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. Avoid investing in these businesses.

Of the three, the only one of interest to us connoisseurs of the fine art of Dhandho is the low-risk, high-uncertainty combination, which gives us our most sought after coin-toss odds. Heads, I win; tails, I don’t lose much!

For me, any sort of tech investment is a very fast fivesecond pass as they tend to be unpredictable, rapidly changing businesses. I had looked at the entire telecom sector as a very quick pass. Rapidly changing industries are the enemy of the investor.

The pivotal deal for the fledgling company in 1980 was a deal with IBM to deliver MS-DOS for the personal computer (PC) that IBM planned to introduce. There was just one problem: Microsoft did not have an operating system suitable for the PC to sell to IBM. That did not stop Microsoft. They convinced IBM that Microsoft had an operating system under development and they could deliver within IBM’s timeframes.12 It was a lie. Microsoft then went out and bought all rights to Quick and Dirty Operating System (QDOS) from a tiny outfit named Seattle Computer for $50,000. QDOS, modified by Microsoft, became MS-DOS and IBM-DOS.13 The flagship product that allowed Microsoft to scale exponentially wasn’t developed in-house. It was lifted from Seattle Computer. It didn’t stop there. In 1981, Gates visited Apple and got an early peek at Apple’s Macintosh mockup as well as two revolutionary advances Apple had incorporated—the graphical user interface (GUI) and the mouse. Gates was convinced that the mouse and GUI were part of the future of personal computing. In 1983, Microsoft engineers had figured out how to make the mouse work through a serial port. Another fundamental innovation was simply lifted from a competitor and scaled exponentially.14 Microsoft had now developed competency in language compilers (like BASIC) and operating systems. It had no competency or expertise in applications and noted that VisiCalc (an early spreadsheet) was growing rapidly. Eventually Excel lifted virtua...

Pabrai Funds also has been a shameless cloner. Prior to starting Pabrai Funds in 1999, I had never worked in the financial services industry. I had, however, spent some time studying the 1950s Buffett Partnerships and contrasted it to the way money was (and is) managed by the majority of mutual funds and hedge funds. I made some useful observations.

He charged no management fees to his partners—only performance fees. Investors paid no fee until Mr. Buffett gave them a return of at least 6 percent a year. Above that number, he took 25 percent and investors got the rest. If the fund was up 10 percent for the year, Mr. Buffett got paid 1 percent. If it was up 30 percent, he got paid 6 percent of assets. It struck me that Mr. Buffett’s structure was very fair relative to the rest of the industry. Virtually all no-load mutual funds charge between 1 percent and 2 percent of assets annually as their fees, regardless of whether they make or lose money. Most hedge funds charge a 1 percent to 2 percent management fee and 20 percent of the profits. If a 2 and 20 (2 percent fee; 20 percent of profits) is up 10 percent before fees, on an after-fee basis investors would receive just 6.4 percent.

(plus trading commissions), it is all but certain that 80 percent to 90 percent of mutual funds are likely to lag the broad indexes over the long-term. Said another way, just 10 percent to 20 percent of funds beat the broad indexes over the long haul. Because of these fundamental facts, investors are better off investing in an index fund versus most of the actively managed mutual fund universe.

My take on Mr. Buffett’s fee structure was that it was very fair. If stocks on average deliver 10 percent a year, the typical mutual fund investor would net about 8.5 percent, the typical hedge fund investor would net about 6.8 percent (assuming a 1.5 percent and 20 percent structure), and an index fund investor would net around 9.7 percent. In this scenario, an investor in the Buffett Partnerships would net 9 percent—higher than virtually all active management options.

So I shamelessly cloned Mr. Buffett’s fee structure. It has been over seven years since Pabrai Funds started and the moat is intact. There is no trend in the money management industry toward purely performance-based compensation.

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

The typical mutual fund holds over 80 positions. Even though he likely hadn’t heard of Kelly, it implicitly made sense to Mr. Buffett to run a concentrated portfolio. It appealed to me as well and I cloned this, too. • Most hedge funds typically have large institutional investors. Most mutual funds have thousands of mom-and-pop investors. The Buffett Partnerships had neither. It had about a hundred families invested in the funds. Mr. Buffett started with eight initial investors who were close friends and family. He did a good job for them, and they in turn added more funds and brought in more investors. They were his unpaid (and highly effective) sales force. I simply cloned this, too. Pabrai Funds started with eight investors—mostly very close friends. It now has about 400 families invested in the various funds. We are likely one of the only hedge funds around where the $300 + million in assets belongs to about 400 families from all over the world, with virtually no institutional participation. • Mr. Buffett ran the Buffett Partnerships without any analysts or other General Partners. All the research into all the investments was done solely by himself. This is highly unusual. Virtually all mutual funds and hedge funds have armies of investment managers and analysts. Pabrai Funds shamelessly copied this, too. Pabrai Funds operates with an investment team size of one. I’m not aware of any mutual funds or hedge funds with over $300 million in assets operating with a single-p...

Value investing is fundamentally contrarian in nature. The best opportunities lie in investing in businesses that have been hit hard by negativity. Even the pundits of the efficient market theory, Eugene Fama and Ken French, concluded that stocks in the lowest decile of price/book ratios outperformed stocks in the highest decile by over 11 percent a year from 1963 to 1990.

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?

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.

After three years, if the investment is still underwater, the cause is virtually always a misjudgment on the intrinsic value of the business or its critical value drivers. It could also be because intrinsic value has indeed declined over the years. Don’t hesitate to take a realized loss once three years have passed. Such losses are your best teachers to becoming a better investor. While it is always best to learn vicariously from the mistakes of others, the lessons that really stick are ones we’ve stumbled though ourselves. Over time, learning from your stumbles, you’ll begin to notice a diminishing number of unsuccessful chakravyuh attempts.

Having successfully traversed the rings, the exit from the spiral is very simple. 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. The only exception is tax considerations. If you’re looking at short-term gains as a result, you should hold on until long-term gains can be realized or the price is enough of a premium over intrinsic value to cover the extra tax bite.

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

Really outstanding investment opportunities are rare enough that you should really have a go at it when it comes around, and put a huge portion of your wealth into it. I’ve said in the past you should think of investment as though you have a punch card with 20 holes in it. You have to think really hard about each one, and in fact 20 (in a lifetime) is way more than you need to do extremely well as an investor.6 —Warren Buffett

This idea (of focused value investing) has zero currency in academic circles. Investment managers don’t feel they will make enough money this way. It’s so foreign to them.7 —Charlie Munger

Billy Rose used to say that if you have a harem of a hundred girls, you never get to know any of them very well. The trick is to know a lot about what you own, and you don’t own that many things.8 —Warren Buffett

Warren Buffett has mentioned at Berkshire Hathaway annual meetings that during his first decade as an investor (1950 to 1960), he generated an annualized return of 50 percent. In Buffett’s case, he was managing just a few thousand dollars in 1950 and single-digit millions in 1960. Greenblatt was managing a few million at the outset 20 years ago and a few hundred million 10 years later.

Greenblatt’s back-testing showed that these Magic Formula stocks have generated returns as high as 20 percent to 30 percent annualized.

The Dhandho investor only invests in simple, well-understood businesses. That requirement alone likely eliminates 99 percent of possible investment alternatives.

My dear father passed away in 1997. He always said that we come to this world naked and we leave the world naked. No