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

In this book summary of The Dhandho Investor: The Low-Riskk Value Method to High Returns by Mohnish Pabrai, we will cover timeless lessons from some of the key chapters.

Chapter 1 – Patel Motel Dhandho

In the first chapter, Mohnish advises that one forgets the dogma that “high returns require high risks.” It’s a mental cloak one dives into when trying to justify inconsiderate and speculative ‘investments’.

Instead, you should learn from the Patel Cartel. From a small sub-region in India, Gujaratis, originates a group of people who migrated to the US in the 1960-1970s. They make-up 0.20% of the American population, but they own more than 50% of the US motel industry. Essentially, the Patels recognized an opportunity in the motel business, particularly in small towns and rural areas where larger hotel chains were less likely to establish a presence. By targeting these underserved markets, they were able to carve out a niche for themselves and attract customers looking for affordable lodging options. The family practised conservative borrowing and hands-on management whereby family members worked (for free) in the business and slept in vacant rooms to bring down their cost of living and thus reinvest into the business.*

To Mohnish, the Patels encapsulate the dhandho mantra of “heads, I win; tails, I don’t lose much”. In essence, dhandho is about ensuring a substantial upside potential while minimising downside risk.

Chapter 5 – The Dhandho Framework

The Dhandho Framework consists of 9 principles.

1. Focus on buying an existing business.
2. Buy simple businesses in industries with an ultra-slow rate of change.
3. Buy distressed businesses in distressed industries.
4. Buy businesses with a sustainable competitive advantage, otherwise referred to as a moat.
5. Bet big when the odds are overwhelmingly in your favour.
6. Focus on arbitrage.
7. Buy businesses at a significant discount to their underlying fundamental value.
8. Look for businesses with low risk and high uncertainty.
9. It’s better to be a follower than an innovator

The rest of the book’s chapters delve into each of these principles.

Chapter 6 – Dhandho 101: Invest in Existing Businesses

According to Mohnish, there are six advantages of investing in the stock market compared to buying/selling entire businesses:

1. It takes hard work to start a business from scratch, yet alone ensure its operations are succesful.
2. The stock market enables you to join the owner’s club of many operational companies effortlessly (at the same time).
3. When entire businesses are bought and sold, it is usually at rational prices. The stock market is different; it functions like a racetrack where we can chose to invest when the odds are in our favour.
4. Buying an entire business requires a serious amount of capital. In the stock market, you can become a co-owner for small amounts.
5. You can effortlessly buy a share in over 100,000 companies globally. This provides the opportunity for excellent risk mitigation through diversification.
6. When buying a business, there are often 5-10% costs associated with the transfer. Trading costs for stocks are significantly lower.

Chapter 7 – Dhandho 102: Invest in Simple Businesses

In chapter 5, Mohnish refers to Buffett’s wisdom when presenting this principle: “We see change as the investor’s enemy, so we look for the absence of change. We don’t like to lose money. Capitalism is pretty brutal. We look for mundane products everyone needs.”

It is much easier to calculate a business’ intrinsic value when earnings are stable, the business model is simple, it operates in a straightforward and slowly changing industry. Simplicity is at the core of Dhandho. Psychological warfare often takes place after buying a stock. The best weapon in the arsenal against this war is to buy simple companies based on simple investment theses for why they are likely to provide a good return with low risk.

Chapter 8 – Dhandho 201: Buy Distressed Businesses in Distressed Industries

Again, Mohnish refers to Buffett: “Never count on a good sale. Ensure that the purchase price is so attractive that even a mediocre sale yields good results.”

People are subject to swings of emotion between extreme fear and extreme greed. When people as a group act on these emotions, price fluctuations occur, driving the asset away from its intrinsic value. Mohnish suggests 6 ways to find distressed companies in distressed industries:

1. Headlines in the media.
2. Value Line publishes a weekly overview of the stocks that have lost the most value in the past 13 weeks.
3. Portfolio Reports list the 10 most recently purchased stocks from the 80 largest value portfolio managers, e.g., Seth Klarman, Peter Cundill, Bruce Sherman, Warren Buffett, Marty Whitman.
4. Go to www.nasdaq.com and look up the major value investors’ companies and check out their holdings.
5. Go to www.valueinvestorsclub.com. The club has about 250 members, and it takes a good investment pitch to be admitted. Non-members can access the stock pitches with a 2-month delay.
6. Configure a stock screener based on the criteria Joel Greenblatt presents in his book The Little Book that Beats the Market.

Chapter 9 – Dhandho 202: Invest in Businesses with Durable Moats

How do you know if a company has a strong competitive advantage? The answer often lies in the income statements. A company that generates a high return on invested capital (ROE/ROA) is often able to compound capital quickly by reinvesting the profits from store A to open store B, which both generate capital to open store C.

Wide-moat businesses are able to benefit from them for long periods of time, but sooner or later competitors “breach the moat and take over the castle”. Of the 50 most prominent companies in 1911, only one remains today: General Electric.

Since no competitive advantage lasts forever, we should never predict more than 10 years into the future when using the discounted cash flow (DCF) model, nor should we assume that we can get a higher selling price than 15 times the free cash flow after those 10 years (plus any excess capital in the company).

Chapter 10 – Dhandho 301: Few Bets, Big Bets, Infrequent Bets

Mohnish explains how investment should revolve around probability. He recommends using the Kelly Formula to determine how much of one’s portfolio should be directed to an idea: edge / odds = percentage of portfolio on the idea. He uses Buffett’s purchase of American Express after the salad oil crisis as an example (cf. Warren Buffett: The Snowball) where Buffett placed 40% of his funds in AmEx. The odds were as follows:

• Odds of 200% return within 3 years: 90%
• Odds of breaking even within 3 years: 5%
• Odds of losing up to 10% within 3 years: 4%
• Odds of total loss of capital: 1%

Based on the Kelly Formula, Buffett should have placed 98.3% of the partnership’s funds in AmEx. Mohnish’s own funds focus on 10 positions of 10% value each. He says: “Investing is like gambling. It’s all about odds. Looking for mispriced betting opportunities and betting heavily when the odds are overwhelmingly in your favor is the ticket to prosperity.”

Chapter 11 – Dhandho 302: Fixate on Arbitrage

Mohnish introduces a special type of arbitrage: dhandho arbitrage. It revolves around buying companies with a competitive advantage that ensures some form of ‘spread’ in the situation compared to the competitors. He uses CompuLink as an example of a company that, in the early PC era, could produce new cables 6 months before competitors and offer a lower price due to low costs. In the 6 months before competitors caught up, CompuLink could capitalize on the difference in quality and price versus competitors. Ford Motors’ assembly line production allowed Ford to produce far more cars at much lower costs, which for many years ensured the company a sustainable competitive advantage – a ‘spread’ between Ford and competitors.

Every ‘spread’, or competitive advantage, disappears over time. It is the analysts’ task to assess whether it lasts for 10 months or 10 years, and what the consequence of the spread’s disappearance will be. The wider the spread and the more enduring it seems to be, the better. Always be on the lookout for arbitrage opportunities. They allow you to earn a high return on invested capital with basically no risk.

Again, Mohnish turns to a Buffett quote to drive home the point: “We enjoy owning castles with large moats full of sharks and crocodiles that can keep intruders at bay – the millions of people who want to take our capital. We focus on moats that are impossible to cross, and tell our managers to expand the moat every year, even if profit doesn’t increase every year.”

Chapter 12 – Dhandho 401: Margin of Safety – Always!

In 2006, Buffett was asked which books he would recommend to fellow or would-be investors to which he replied: “The Intelligent Investor is still the best book on investment. It contains the only three ideas you really need:

1. The Mr. Market analogy. Let the stock market be your servant.
2. A stock is an ownership share of a business. Never forget that you are buying a part of a company, which has a value based on how much cash flows in and out.
3. The margin of safety concept. Make sure you pay a price you believe is far below what you conservatively estimate the company to be worth.”

When Buffett bought Washington Post in 1973, it was sold at a P/B ratio of 0.20. Its market value was $100 million, and it had assets worth $500 million. Buffett’s $10.6 million position was worth $1.3 billion in 2006.

Benjamin Graham once said: “Sooner or later, the market will catch up to intrinsic value.” Mohnish’s own experiences indicate that it often doesn’t take more than 18 months before the market regains its sanity.

“Minimizing downside risk while maximizing upside potential is a powerful concept.”

Chapter 13 – Dhandho 402: Invest in Low-Risk, High-Uncertainty Businesses

Risk is defined as the chance of capital loss. Uncertainty is interpreted as many possible outcomes and an unpredictable future. Wall Street often confuses the distinction between risk and uncertainty, which can be capitalized on enormously.

There are four scenarios that can lead to depressed prices:

1. High risk, low uncertainty.
2. High risk, high uncertainty.
3. Low risk, high uncertainty.
4. Low risk, low uncertainty.

Option 3) is the only option a dhandho investor should be interested in: “Heads, I win; tails, I don’t lose much!”

A series of examples follow where uncertainty was high because of e.g. industry challenges, political conditions, heightened competition, etc. But the risk was low since analyses of the balance sheets revealed near 100% chances of break-even (or more) in the event of liquidation.

Chapter 14 – Dhandho 403: Invest in the Copycats rather than the Innovators

There is too much risk associated with innovators; companies that rely on innovation or startups. The potential gain may be significant, but it’s not dhandho – it’s not low risk, high uncertainty; it’s high risk, high uncertainty. Look for companies led by individuals who have demonstrated an ability to imitate, lift, and scale.

Chapter 15 – Abhimanyu’s Dilemma – The Art of Selling

To be a good investor, one must have a robust framework for buying and selling. Buying is the easy part; a purchase should ideally scream its attractiveness to you. Before making a purchase, one should ask oneself seven questions. Only if the answer is a resounding yes should one proceed:

1. Is the company within my circle of competence?
2. Do I know the company’s intrinsic value today, and can I confidently assess how it will change over the next few years?
3. Is the company priced at a significant discount to its intrinsic value?
4. Would I be willing to invest a large portion of my wealth in the company?
5. Is the downside minimal?
6. Does the company have a competitive advantage?
7. Is it driven by competent and honest leaders?

Mohnish wonders why people panic when a stock they bought for $10 drops to $8 shortly after. You should give a stock 2-3 years to play out. If the stock hasn’t reached its fundamental value by then, get rid of it – regardless of any potential losses. He writes: “A critical rule is that any stock you buy cannot be sold at a loss within 2-3 years from the time of purchase unless you can confidently determine that the current intrinsic value is less than the current price the market is offering.”

Chapter 16 – To Index or Not to Index – That is the Question

Mohnish explains that a minimum of 80% of capital managers underperform the market. Therefore, most people shouldinvest in a low-cost index fund. However, if one chooses to pursue outperformance through stock-picking, Mohnish suggests 9 places where bargains hide:

1. Value Investor’s Club (www.valueinvestorsclub.com), where 250 ‘approved’ value investors share their ideas. Mohnish recommends finding some good stocks via screeners and then reading the analysis on VIC.
2. Subscribe to Value Line, which lists the stocks that have fallen the most in value in the past 13 weeks; those traded at the lowest P/E and P/B ratios.
3. Screen for stocks that have hit their 52-week low.
4. Subscribe to Outstanding Investor Digest (www.oid.com) and Value Investor Insight (www.valueinvestorinsight.com).
5. Subscribe to Portfolio Reports. It is a list of the stocks famous value investors’ funds are buying. These can also be found on Nasdaq.com by looking at the funds’ holdings.
6. Visit www.gurufocus.com. This site also tracks purchases and sales by famous value investors.
7. Super Investor Insight is another publication that tracks superinvestors’ transactions.
8. Subscribe to major business and financial magazines: Fortune, Forbes, Wall Street Journal, Barron’s, BusinessWeek.
9. Attend the annual Value Investing Congress in New York or Hollywood.

* Mohnish portrays an immigrant, Papa Patel, who landed in the US with his wife and three teenage children. He spots a 20-room motel with a sharply reduced price. He wonders, a seller that motivated would probably finance 80-90% of the purchase price. The family could live there, and thus reduce their living expenses to nill. He could dismiss the current personal and make it a family-run business with a negligible cost base. Papa would hence be able to offer the lowest prices and achieve the same level of profitability as the competitors. He decides to strike at the opportunity. Papa invests $5,000 in the motel; the bank and the seller finances the rest against mortgages in the assets. The motel ends up generating $50,000 in yearly revenue, of which $20,000 finds its way to the bottom line. That’s a 400% annual return on invested capital – not too shabby! There was an undeniable upside. But what about the downside risk? In the unlikely scenario that a recession or the like force the motel to shut-down, Papa would have lost a maximum of $5,000 – an amount that the family could earn back in a year or two. Heads, Papa wins; tails, he doesn’t lose much.