Mohnish Pabrai and The Dhando Investor

Thanks to the summer holidays, I've just finished another book, Mohnish Pabrai's The Dhando Investor. For those who are unfamiliar with Pabrai, he's a true-to-label value investor in the Graham-Buffett mould. Earlier in his career, he founded an IT business, which he sold for about $20 million. (It was after this he started focusing on stock market investments.)

The Dhando Investor is a quick, easy-to-read book that, in my opinion, most investors or business people will find interesting and useful. At the heart of the book is Pabrai's concept of Dhando — making low-risk, high return bets. (This is, of course, exactly what we do as value investors.) He provides a number examples of Dhando at work: the story of the Patels and the US motel industry, Richard Branson and Virgin Atlantic, and his own business career. The philosophy, as Pabrai describes in the fifth chapter, is based on a few key ideas:

• 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 the copycats rather than the innovators.

In the sixth chapter, Pabrai discusses how to value a business listed on the stock market. As value investors know, the value of a business is the net-present value of its cash flows. Pabrai demonstrates a couple of simple NPV calculations for a private business — a gas station — and a listed company, Bed, Bath and Beyond. Despite the fact that they both businesses are relatively simple to understand, Pabrai ends up with a wide range of potential intrinsic values. This, of course, is one of the key problems with using discounted cash flow analysis: small changes in assumptions, such as the discount rate or terminal value, can lead to widely different outcomes. The key to investing successfully then, according to Pabrai, is to invest only in simple businesses — where conservative assumptions about cash flows are easy to figure out — and only when it is clear that, using these conservative assumptions, you stand to make a great deal of money and are unlikely to lose much. Sounds simple, right?

Pabrai, like many other good value investors, always writes down an investment thesis: "If it takes more than a short paragraph," he says, " there is a fundamental problem ... if it requires me to fire up Excel, it is a big red flag that strongly suggest that I ought to take a pass." This is excellent advice. If I had implemented it in my processes earlier in my investing career, I would have avoided some of my major mistakes. For his DCF calculations, Pabrai looks 10 years into the future and applies an appropriate multiple to expected cash flows in the final year to come up with an expected IRR. In chapter 15, Pabrai discusses the process of selling a stock. He suggests that investors should have a crystal-clear exit plan before ever thinking about buying a stock. He provides seven questions for investors to ask themselves before making an investment.

• Is it a business I understand very well — squarely within my circle of competence?
• 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?
• Is the business priced at a large discount to its intrinsic value today and in two to three years? Over 50 per cent?
• Would I be willing to invest a large part of my net worth into this business?
• Is the downside minimal?
• Does the business have a moat?
• Is it run by able and honest managers?

According to Pabrai, one should only consider buying a stock if the answer to all seven of these questions is a resounding yes. "If a well-understood business is offered to you at half or less than its underlying intrinsic value two to three years from now, with minimal downside risk, take it," he writes. "If not, take a pass ... There will be better chances in the future." He also discusses his rule of not selling stocks at a loss for at least two years, which was mentioned in Guy Spier's book and my previous post. There is an important caveat: Pabrai will not sell in this period unless both of the following conditions are satisfied:

• He is able to estimate its present and future intrinsic value, two to three years out, with a very high degree of certainty;
• The price offered is higher than present or future estimated intrinsic value.

The purpose of this restriction is that it stops investors from selling out of a stock during times of peak pessimism. Cheap stocks don't usually grow at a steady 15 or 20% per year as one might like — they might, for instance, drop 50% in the first year and grow 200% in the second. The rule helps us avoid selling out for psychological reasons at the low point.

All in all, I think the Dhando Investor was very good. It has given me much food for thought. There were no new ideas in the book, but Pabrai illustrated the precepts with great examples. If you are interested in learning more about Pabrai, I suggest you check out his excellent channel on YouTube. Here's one of his most recent videos, a lecture given to students at Boston College in November.

Until next time.