Lessons from Dhandho Investor- An Investor’s Fantasy

The Dhandho Investor is a book on the Dhandho Style of investing. It was written by Mohnish Pabrai. Mohnish Pabari is the Founder and Managing Partner of Pabrai Funds. The book is full of examples of Dhandho Investors. He details how the Patel Community became the largest owners of the Motel Businesses. He describes how Mittal made his fortunes by following the same principles. And How Richard Branson built the Virgin Atlantic. The Dhandho Investor was my first book on investing. I picked this up because of the smaller size and simple to understand language.

Foreword

Because the book has a foreword, it’s my responsibility to write a foreword for this as well. As you may have noticed, this in no means a substitute to the original book. The summary written below is my interpretation of the principles mentioned in the Dhandho Investor. I’m a rookie in investing. So I may or may not have understood the concepts completely. Moreover, I’m writing it here to validate my observations from you. So, help yourselves and don’t continue reading if you’re substituting this for the original book.

What is Dhandho?

Dhandho means endeavors to create wealth aka Business.

An Ultra-Short Summary of Dhandho Investing.

The core principle of Dhandho Investing is to choose opportunities that have a minimal downside and a huge upside. Over the due course of the book, this principle keeps repeating in the form of, “Heads I win, tails I don’t lose much”. Without any further delay, Let’s get started.

Patel Dhandho:

The book starts with the example of how Patels became the king of Motels in the USA. So, in the 1970s or so, Patels migrated to the USA from Uganda.

Owing to poor economic policies, the USA faced a recession in the 1970s. Because of the recession, Americans reduced frivolous expenses. As a result, motels were hit very badly. The owners of the Motels weren’t able to pay the interests to banks.

So, when the Patels migrated to the USA, they had very little cash. They did odd jobs in the beginning. But one fine day, a Patel notices a board outside a motel, “For Sale- $50,000”. The Dhandho Investor in him knocks his senses.

He had little over $5000 in cash. But he raised another $5000 from other Patels. He takes a loan for the rest of the $40,000 from the bank that put up the motel for sale.

Why Did The Banks Do What They Did?

The interesting thing to observe here is, why would the bank let the Patel take over?

Coz they themselves don’t have the capability to run the motel by themselves. Their best bet is someone who wants to buy and run it. So that they can go back to collecting interest payments. As a result, when Patel approaches the bank, they give him what he wants.

Patel now has a 20-room motel all for a family of 5 people. Simplistic lifestyle coupled with doing all the chores by themselves, they were able to keep the expenses low.

For the business, Selling Price-Expenses=Profit.

Since their expenses were low compared to other motels, they reduced prices. As the prices were less, customers chose Patel’s motel compared to other American run motels. Patel made good returns on the investment made. Let’s say, he made about $20,000 per year. He will be able to repay the loan within 2 years to do this.

1. Keep expenses low.
2. A Higher Return on Capital i.e 50% per year.

When you evaluate the options available in the above case, you’ll realize this was a classic case of Dhandho Investing. Here are the scenarios:

• The motel doesn’t take off, Patel loses $5000
• The motel runs mediocrely- Patel still makes a better living than the odd jobs he did prior to this.
• The Motel just takes off and Patel pockets insane returns.

So, the downside is not that bad but the upside is insane.

“Heads Patel wins big, tails he loses only $5000.”

The author discusses many such examples Classic tales of Dhandho Investors. And on the back of such examples, he introduces the Dhandho Framework. Below I will be discussing each rule in the Dhandho framework and add my perspective to it.

The Dhandho Framework by Mohnish Pabrai

Rule #1: Buy Existing businesses

• We all know starting something from grounds up is a huge effort.
• Chances you’re not making a penny before the 3rd or 4th year kicks in.
• So as an investor, it makes sense by buy businesses that are already staffed, which is already having a sales channel established and business model figured out.
• Where can you buy such businesses? In the stock market. Although you can’t buy complete businesses a part of them in the form of a share.

A share is a piece/unit of the business that is entitled to all the profits the business makes in the appropriate ratio.

If a business is worth INR 100 and is divided into 100 shares and earns INR 100 as a profit. Technically each share is entitled to get INR 1 as a profit. Of course, there are other nuances like taxes, dividends, etc but that’s for another day.

Value per share = Total business value /No of shares

Profit per share = Total profit / No of shares

Rule #2: Focus on buying Simple businesses with an ultra-slow rate of change

• Simple business, the author means the ones where you can estimate how the business is gonna run in the near future.
• So as to be able to predict how the cashflow would be and in turn calculate the intrinsic value.
• While that makes sense, I don’t completely agree with the remarks on the rate of change.
• In this time and age, technology is disrupting each and every sector.
• So we need to be cognizant of the fact that businesses are going to change.

Rule #3: Buy distressed businesses in distressed industries

• The assumption behind this rule is that the distress is temporary
• However, I don’t agree that all distressed businesses are supposed to be bought.
• If the distress is because of a temporary management issue that didn’t actually affect the day-to-day business, then yes buy those.
• If the distress is because the business is becoming irrelevant because of technology adoption, then don’t buy it.

Rule #4: Buy Businesses with a durable competitive advantage

• This rule should actually be followed along with Rule #3.
• A business that has a durable competitive advantage and is currently in distress is a perfect buy opportunity.

Rule #5: Bet heavily when the odds are overwhelmingly in your favor

• I think this rule is applicable to a lot of things in life.
• When you love something, give it all you can.
• So, when you find a distressed business with a durable competitive advantage, bet heavily.
• Mr. Pabrai suggests using the Kelly Formula. This formula helps to determine how much of your cash you should bet on this business.

Rule #6: Focus on Arbitrage

• Though traditional definitions in finance make Arbitrage an art of capitalizing on the price difference of the same “thing” between two markets.
• But I like to see arbitrage as the ability to capitalize on the difference between the two markets.
• The best example I can think of it is the inception of Flipkart in India, inspired by Amazon. Indian markets didn’t have an e-commerce company. The founders saw that difference and capitalized on it.

Rule #6: Buy Businesses at big discounts to their underlying intrinsic value.

• This is a no brainer.
• If you can buy anything at a price less than what it’s actually worth, it’s a good deal. Much better if it’s a company with real cash flows.
• But how do you calculate intrinsic value? Well, I’m still figuring it out.
• I know you’ll stick around until then and read how it’s done. (Hint: Subscribe to get that blog post in your email directly)
• This principle is fundamental to Dhandho Investor and Value investors alike.

Rule #7: Look for low risk, high-uncertainty businesses.

• This rule isn’t as simple as it sounds.
• For example, the 2×2 matrix of risk and uncertainty have 4 possible cases.
• Of which this is the only option that constitutes the Dhandho investing framework.
• The rationale behind low risk is that you don’t lose much.
• High uncertainty situations mean higher fluctuations in pricing. Because everyone is panicking about what’s going to happen, you “may” have an opportunity to buy good businesses at a good discount.
• Because of its low-risk nature, it’s a perfect pick for a Dhandho Investor.

Rule #8: Better to be a copy cat than innovators.

• I was really moved by the arguments put forward for this rule.
• Mr. Pabrai states that innovation has a lot of complexities.
• Innovation has inherent risks of not paying off.
• Innovation is costly to pursue. There is a lot of uncertainty.
• If an innovative company delivers business value despite the concerns. Then I think you should bet on it.
• Also, the copy cats are scavengers who are there to capture a piece that the innovator already owns.
• An even better strategy to pursue is to invest in both copy cat businesses 😉

The Dhandho Checklist

I loved this part of the book because it’s an actionable step. You just have to go one line after the other and cross-check. If a particular stock meets all the criteria mentioned in the checklist, go ahead and invest. The seven questions to answer before buying a stock.

1. Is it a business you understand well enough. In Warren Buffet’s words, stick to your circle of competence. Do what you know.
2. What’s the intrinsic value of the business today? How confident are you about that value? How is it going to change in the coming few years?
3. Is the current price at large discounts to intrinsic value? and Do you believe it’s gonna bounce back in 2-3 years to over 50 percent? If yes, why do you think so and how did you come to that conclusion.
4. Are you willing to bet a large part of your net worth on that company? This actually questions your confidence in the intrinsic value you’ve assigned.
5. Is the downside minimal?
6. Does that business have a moat? and How strong is it? Why do you think it is as strong as you think it is?
7. Is it run by able and honest managers?

Those are my takeaways from the Dhandho Investor. I hope you had something to take away from the summary. If the above points piqued your interest in the subject, I would strongly recommend you to read the book.

You can purchase the book here on amazon. I’ll get a small percentage of your purchase at no extra cost to you when you do so. It will help continue run this website and put out content you love.

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