Book Reviews, Value Investing

Book Review on The Dhandho Investor

The Dhandho Investor is a book written by a famous value investor, Mohnish Pabrai. He has another book on investing titled “Mosaic” but for some reason the book is pretty expensive. Some people have pieced together information on chapters of Mosaic that are on the web (see here).

In Dhandho Investor, Mohnish highlights the typical principles of value investing. Where it is more interesting are real-world examples of value investing principles as applied to starting and running a business (in the first few chapters), and a chapter on selling, a difficult thing to get right in value investing. One particularly interesting thing was some information on Buffett’s position sizing thoughts from his 1966 partnership letter that I have not come across before.

BTW, Dhandho means “endeavors that create wealth” and is pronounced dhun-doe.

Examples of Dhandho

  1. The main idea is: “Heads, I win; tails I don’t lose much!”
  2. The Patels bought motels in 1973 during the U.S. recession (1973 Arab oil embargo) at distressed prices of $50,000 for a 20-room motel, financed with $5,000 cash and the rest from bank loans at 10-12% interest rate with a lien on the property. By doing all maintenance and running themselves, they kept the cost very low.
    1. They net $15,000 a year after tax. Return on invested capital is 400%. If this continues for 10 years and the motel is sold for $50,000, the annualized return is over 50%.
      1. $50,000 annual revenue (rates of $12-$13 per day and 50-60% occupancy)
      2. Interest expense of $5,000, principal repayment of $5,000
      3. $5,000 to $10,000 in out-of-pocket expenses for motel supplies, maintenance, and utilities
      4. $5,000 in living expenses
    2. The risk is very low. If they cannot make the motel profitable with such low cost structure, no one can. The bank’s best option is to renegotiate terms and help the Patels get back on track. Even if it still failed entirely, the Patels simply lose their $5,000, go take on jobs at minimum wage, save for a few years, then try again.
  3. Manilal Chaudhari worked very hard, helped to manage a gas station, kept saving, and decided to buy a small business in 1998. He waited until 2001 when the travel industry went into a slump after 9/11 with significant decline in prices, and bought a Best Western motel in Moreno Valley for $4.5M ($1.4M down, bought with 3 Patels and a Parekh).
    1. In 4 years, the motel’s market value is over $9M, debt is paid down to ~$2.3M, so equity is $6.7M, which is an annualized return of 48%.
    2. Gross revenue grew from $1.6M to 2.1M, generating ~$800K+ free cash flow annually.
  4. Richard Branson started many businesses with very low cost
    1. Virgin Atlantic was started with a 747 jet leased from Boeing. Fuel and staff wages were paid 30 days, and 15-20 days after the plane landed respectively, but he would get paid 20 days before the plane took off. He hired a small ground staff. Total outlay and maximum liability was ~$2M, a small price for Virgin music which was earning $12M.
    2. Virgin Pulse was a line of designer personal electronics for Target stores. Target guaranteed them prime floor space so Virgin had zero distribution cost or risk. They found a Chinese company to manufacture at low cost and which committed capacity beyond confirmed orders.
    3. Virgin Mobile cell phone service in the U.S. does not own or operate a cell phone network. Sprint provided the entire back-end, including technology, billing, customer service infrastructure. Virgin provided the branding and product positioning and took a large chunk of the profits.
    4. Virgin Mortgage was done with Royal Bank of Scotland handling the entire back-end. Virgin provided the brand, helped with marketing, invested little cash, but it got a good chunk of the profits.
    5. Branson bought an island on sale for 3M pounds at 180K pounds, then charged $30K per night.
  5. Lakshmi Mittal made money in the steel business even though it has terrible economics (very capital-intensive, typically unionized) by buying failing steel mills for next to nothing.
    1. Bought distressed steel mills very cheaply, e.g. Karmet Steel Works in Kazakhstan, Sidek Steel plant in Romania, Sibalsa Mill in Mexico (bought for $220M even though the cost to build it was $2B). He then turned around the mills to get them to run extremely efficiently.
    2. Marwari businessmen expect all their invested capital to be returned in the form of dividends in no more than 3 years, and expect their principal investment to continue to be worth at least what they paid for. These will be ultra low-risk bets. [This is a good rule of thumb.]
  6. Pabrai himself started TransTech in 1990 at age 25 with $30K in his 401(k), and $70K of credit card limits. Expenses were kept low, downside was limited because he had 2 customers on board. Revenues went from $0 to $20M in 10 years, and it never took outside capital. Annualized return over 10 years was 65%+

Dhandho Framework

  1. Focus on buying an existing business
    • It has a well-defined business and long history to analyze, hence way less risky than doing a startup.
    • Buying an entire business is tough, you need large capital and someone to run it. Stocks are easier.
  2. Buy simple businesses in industries with an ultra-slow rate of change
    • Capitalism is brutal. Change is the enemy of investments.
    • While IT changes quickly, IT services can be considered a low-tech service where the nature and economics do not change much.
  3. Buy distressed businesses in distressed industries
    • Have the purchase price be so attractive that even a mediocre sale later gives good results.
    • Mittal bought severely distressed businesses in a severely distressed industry in severely distressed countries — distressed to the power of three.
  4. Buy businesses with a durable competitive advantage – the moat
    • Key to investing is in determining the competitive advantage of any given company and the durability of that advantage, not in how the industry will grow.
    • Moats may be hidden. E.g. Tesoro oil refineries are on the West Coast and Hawaii. This gives it a good moat because state EPA regulations in California and Hawaii are very stringent and require unique formulations, so it carries much higher margins with a captive market in California.
    • Moats show up as high Return on Invested Capital (ROIC)
    • No moats are permanent, never calculate a discounted cash flow stream for longer than 10 years, or expect a sale in year 10 to be anything greater than 15 times cash flows at that time (plus any excess capital in the business).
    • Arie de Geus in his book “The Living Company” found that the average Fortune 500 company has a life expectancy of 40-50 years: 25-30 years from formation to get into the Fortune 500, then less than 20 years to cease to exist. The average Fortune 500 business is already past its prime by the time it gets on the list.
    • Moats
      • Patel and Manilal’s motels: low-cost
      • Branson: brand, innovative offerings, and brilliant execution
      • IT services: familiarity with clients’ business and IT systems and existing relationship
      • GEICO insurance: low-cost
      • Nebraska Furniture Mart: low-cost
      • Ore mines: low-cost
  5. Bet heavily when the odds are overwhelmingly in your favour
    • Don’t bet at all when the odds are not overwhelmingly in your favour.
    • Kelly Formula
      • Edge = Expectation (e.g. heads gives $2, tails is -$1, so edge is $0.50)
      • Odds = How much you win, if you win, i.e. $2
      • Fraction of your funds that you should bet each time = Edge / Odds = 0.50 / 2 = 25%
      • For bets with more than 2 outcomes, use this Also “Fortune’s Formula” by William Poundstone describes the Kelly Formula well.
      • Kelly Formula works on sequential bets with 2 outcomes per bet, if you have 8 non-correlated bets available simultaneously, you can calculate the Kelly Formula recommendation for each bet, then scale them all proportionately to sum up to 100%. A “quarter Kelly” is a good way to go.
    • Buffett invested 40% of the Buffett Partnerships’ assets into American Express during the ‘salad oil crisis’ in the 1960s.
    • In 9 events (Fall of France, Korean war, U.S. bombs Cambodia, Arab oil embargo, Nixon resigns, Hunt silver crisis, 1987 financial panic, Asian stock market crisis, Russian LTCM crisis), DJIA lost ~17% on average over a reaction period of 1 to 2 months (average about 1.5 months). It recovered 12.4% and 18.5% in 63 and 126 days after the reaction period respectively.
  6. Focus on arbitrage
    • Arbitrage using your moat, e.g. low-cost, innovative offerings. Eventually the arbitrage spread will collapse but that might take many years. Exploit these for all their worth while they last.
    • Mittal’s arbitrage
      • Low-cost producer
      • Global access and hence arbitrage capabilities on labour, raw materials, energy costs, and the best-selling price. He can use this to optimize the type and quantity of steel produced at each geographic location to maximize his profits.
      • His scale, volume, and capacity allows him to negotiate better prices on both sides, buyers and suppliers.
    • CompuLink
      • Amar Bhide’s book “The Origin and Evolution of New Businesses” talks about how the founders found that shops do not sell long enough cables, and started to produce them. When the established companies caught up, CompuLink kept staying ahead by making cables for new models of devices.
      • Their arbitrage spread vanished when computer interfaces were standardised
    • GEICO
      • Allstate or State Farm have a branch and agent network, which incurs distribution overhead costs of ~15% of the premiums.
      • GEICO sales are done through direct mail, telephone, and Internet, hence it has a 15% cost advantage.
      • Competition with Progressive, another direct writer of auto insurance, will tighten the arbitrage spread.
    • Montgomery Ward, and Sears
      • Montgomery Ward started the “Satisfaction guaranteed or your money back” trend, which Sears followed, allowing them to capture market share for several decades.
      • Now the spread has closed with all retailers offering the same as it has become expected from consumers.
      • Sears was also could not compete with Wal-Mart (price and efficiency), Target (upscale customers), Home Depot (specialised for home furnishings), or Best Buy (specialised for electronics).
    • Ford
      • Arbitrage with their assembly line innovation has been closed.
    • General Motors
      • Arbitrage with their innovation of offering brands and car models for different segments of their customers, has closed.
    • World Book and Encyclopedia Britannica
      • Killed by Google.
    • Buffalo News
      • Dominant newspaper in Buffalo but readership is declining and moat is shrinking every day
  7. Buy businesses at big discount to their underlying intrinsic value
    • The bigger the margin of safety, the lower the downside risk and the higher the return.
    • 3 main ideas from intelligent Investor: i) Mr. Market, ii) A stock is a piece of business, iii) Margin of safety
    • Buffett bought Washington Post in mid-1973 when the stock market valuation was $100M but the intrinsic value was $400M to $500M. By end-1974, the market value dropped 25% to ~$80M even though the intrinsic value grew.
    • Mohnish’s experience is that the vast majority of gaps close in under 18 months.
  8. Look for low-risk, high-uncertainty businesses
    • High uncertainty leads to depressed prices. Low-risk leads to low downsides.
    • Even if the outcome turns out to really be bad, you will still come out ok, but if the outcome turns out to be good, you can make a killing.
    • Stewart Enterprises (STEI)
      • Situation
        • Came up in Value Line’s lowest P/E stocks, there were 2 funeral service businesses that had P/E under 3.
        • In the funeral service business, owned 700 cemeteries and funeral homes in 9 countries.
        • Borrowed a ton of money to roll up mum-and-pop fun. In 2000, had $930M in long-term debt with $500M due in 2002.
        • High uncertainty: The market thinks that they were going to go bankrupt and its stock went from $28 to $2.
      • Low-risk businesses
        • Lowest rate of failure of any class of business was funeral homes.
        • Families likely use the services of the same funeral home.
        • Morbid nature of the business keeps upstarts down.
        • Last rites are slow to change.
        • Population of the U.S. continues to grow.
        • Increased life expectancy is counterbalanced with increased pre-need sales (makes up 25% of total revenue)
      • Valuation
        • P/E under 3
        • P/B = 0.5 (Tangible book value of $4)
        • P/FCF under 3. Annual FCF was about $76M so in 2002 they would need to come up with another $350M.
        • P/S = 0.25
      • Scenario analysis
        • 25% chance that it can sell back 100 to 200 funeral homes to their original owners at 4 to 8 times cash flow (bought at 8 or more times cash flow). Equity value in 2 years would be more than $4 per share.
        • 55% chance that the debt can be refinanced or loan maturity extended, especially if the company offered a higher interest rate. Equity value in 2 years would be more than $4 per share.
        • 19% chance that it goes into bankruptcy. In a distress sale, the funeral homes should sell for 5 to 7 times cash flow. Equity value in 2 years would be more than $2 per share.
        • 1% chance that an extreme event takes the equity value to $0.
      • How it played out
        • Management announced on March 15, 2001, that it had begun to explore the sale of funeral homes in Europe, Mexico, etc. Those homes generated 20% of revenues but not much cash flow. They expected to generate $300M to $500M in cash from these sales. The stock rallied from $2 to $3.
        • By March 2001, Stewart paid down $50M+ of debt, and its stock price went to over $4. After the international sales, the stock went to $8
    • Level 3 (LVLT) Convertible Bonds
      • Situation
        • Came up in a Barron’s article in mid-2001 that Buffett was rumored to have bought LVLT’s bonds.
        • By 2001, the company $6B debt outstanding, $1.5B cash, $650M bank line of credit.
        • Most of the debt was coming due in 2008. FCF was negative. Analysts were projecting that they will have a $500M cash shortfall.
        • Management assured that they will tie future capex to revenue and they are fully funded to free cash flow break with a substantial cushion.
        • Unsecured debt was trading at 18 to 50 cents on the dollar.
      • Low-risk
        • Convertible bonds were at 18 cents on the dollar, with 6% coupon. All Wall Street projections showed them paying interest on the bonds for at least 3 years. So you would get your money back before the company ran out of cash.
        • Founder and Chairman was Walter Scott Jr. He was on Berkshire’s board and good friends with Buffett for over 50 years. CEO Jim Crowe shared Buffett’s shareholder orientation.
        • 1% chance of Walter Scott Jr or Jim Crowe lying. If they are not lying, they will conserve their $2.1B liquidity, which is sufficient to pay interest or at least 3 years.
        • If major investors injected money and took away the liquidity crisis, the stock will trade on underlying fundamentals. When Buffett invested in GEICO, he could not lose money on the investment.
      • Scenario analysis
        • 50% chance of receiving $1 in 2009 and 30+ percent interest from 2002 to 2009
        • 45% chance of getting back the $0.19 investment (break-even after 3 years)
        • 2% chance of a loss of $0.13 (only get 1 year’s interest)
        • 3% chance of total loss
      • How it played out
      • In 2003, Level 3 did a private convertible debt offering to Berkshire Hathaway, Longleaf Partners, and Legg Mason Value Trust.
      • The bonds went up from 54 cents to 73 cents on the dollar. Current yield was 20% to 30%, YTM was 30% to 40%.
      • Average annualized gain was ~120%
      • In 2006, most of the bonds are trading above par.
    • Frontline (FRO)
      • Situation
        • Came up in Value Line’s list of stocks with the highest dividend yields, there were 2 crude oil shipping companies that had dividend yield over 15%.
        • Knightsbridge (VLCCF) ordered a few oil tankers. Each Very Large Crude Carrier (VLCC) or Suezmax costs $60M to $80M, and takes 2-3 years to be delivered. Knightsbridge had long-term leases with Shell where Shell will pay a base lease rate regardless of usage, plus a percentage of the difference between the base rate and the spot market rates. The base rate was sufficient to cover the interest and principal payments for the original debt taken on by Knightsbridge to pay for the tankers.
        • When tanker rates rose dramatically, Knightsbridge dividend yield went through the roof, but it was not sustainable.
        • Frontline had the largest oil tanker fleet among all public companies, and the entire fleet is on the spot market (few long-term leases).
        • Frontline needs $18,000 a day per tanker to break even.
        • In 3Q 2002, oil tanker rates collapsed down to $6,000 a day. The stock went from $11 to $3 per share.
      • The tanker market
        • There were two kinds of tankers: single hull and double hull.
        • Regulations require all new tankers to be double hull after 2006 as they are less likely to spill oil
        • Frontline’s entire fleet is double hulled.
        • The single hull were leased at lower rates (e.g. $20,000 vs $30,000) and used to ship to China or India. Double hull tankers are used to ship to Europe and the West.
        • When the rates crashed to $6,000, everyone shifts to rent double hull tankers. Single hull tankers stopped being rented, their owners get jittery and they sell their tankers for scrap (they know that by 2006, they will be in trouble). This caused the tanker supply to be taken out.
        • When tanker demand comes back up, tanker supply cannot be added quickly (2 to 3 years), so the rates shoots up very quickly, from under $10,000 a day in 3Q 2002 to $80,000 a day in 4Q 2002.
        • Worldwide fleet in 2002 was ~400 ships. Usually 10-12 new ships (2.5-3% of 400) are added each year to take on 2-4% growth in worldwide oil consumption. With too much scrapping of single hull ships, the rental rates skyrockets.
        • If rental rates remain high for long enough, orders for new ships increase.
      • Low-risk
        • There is an active market in oil tankers. The price per ship dropped only by about 10-15% even with the rental rates collapse. Frontline had 70 VLCCs, with the distressed market for ships, the liquidation value is still more than $11 per share.
        • Frontline had plenty of cash and liquidity to handle the losses for several months.
        • Total annual interest payments were $150M. It can sell a ship to raise $60M, so if needed, it can sell 2 to 3 ships a year.
      • How it played out
        • Frontline’s Chairman was buying a lot of stock on the open market.
        • Mohnish bout at $5.90 per share, unloaded around $10, for a 55% return (annualized 273%).
  9. It’s better to be a copy cat than an innovator
    • The Patels copied the other Patels and executed a proven, virtually risk-free business model.
    • Many innovations do not come from within the company, but from street-smart franchisees and competitors. The company needs to be smart enough to adopt them.
    • MacDonalds
      • E.g. Ray Kroc acquired the McDonalds name and know-how, and adopted the following from his franchisees (Ronald McDonald, Filet-o-Fish, Big Mac, Egg McMuffin, drive-thru, Might Kids Meal).
    • Microsoft
      • Lied to IBM in 1980 that it had an operating system for the IBM PC that was under development and can deliver on time.
      • It then bought QDOS from Seattle Computer for $50,000 and modified it into MS-DOS.
      • They copied the Graphical User Interface (GUI) and mouse combination from Apple in 1981 after he saw the Macintosh mockup.
      • Excel features were copied from Lotus 1-2-3 and VisiCalc.
      • Word features were copied from Word Perfect.
      • Powerpoint was developed by a small San Francisco company acquired by Microsoft.
      • It copied most of Novell Netware’s and Unix’s networking features and bundled them into Windows NT.
      • Microsoft Money was copied from Intuit’s Quicken but failed to take off.
      • Pocket PC and Windows Mobile were lifted from Palm.
      • Internet Explorer was licensed from Spyglass to match Netscape’s browser.
      • XBox was inspired by Nintendo and PlayStation.
      • SQL server was licensed from Sybase.
      • Media Player looks like Real Player.
      • MSN search tries to match Google.
    • Microsoft have repeatedly looked for customer validation of someone else’s innovation before embarking on their own.
    • Sam Walton lifted all the good stuff from Kmart and other retailers.
    • Pabrai Investment Funds
      • Copied from the Buffett Partnerships
      • Moat: Charged no management fees. Above 6% return, Buffett took 25% and investors got the rest. Typical hedge funds charge 1-2% management fee and 20% of profits.
      • Self-selection of long-term investors: Berkshire performance numbers are reported to investors only once a year. Pabrai Funds does it once a quarter.
    • Good cloners are great businesses. Innovation is a gamble, but cloning is for sure.
    • In making investments in public equity, ignore the innovators, seek out businesses run by people who have demonstrated their ability to repeatedly lift and scale.

The Art of Selling

  1. Only consider buying if you answer Yes to the following:
    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%?
    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?
  2. Selling Rules
    1. Any stock that you buy cannot be sold at a loss within 2 to 3 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.
    2. After 2 years, you can sell at its intrinsic value at that time or higher (which can be at a loss) if you have a compelling investment alternative.
    3. After 3 years, you can sell at any reasonable price even if it means a big loss.
    4. Anytime the gap between intrinsic value and price is under 10%, feel free to exit the position.
    5. You must sell the position once the price exceeds intrinsic value.
  3. Corollary — A stock can be sold at a loss within 2 to 3 years of buying it only if BOTH of the following conditions are satisfied:
    1. We are able to estimate its present and future intrinsic value, 2 to 3 years out, with a very high degree of certainty.
    2. The price offered is higher than present or future estimated intrinsic value.
  4. If some events happened and you cannot come up with a realistic intrinsic value with a very high degree of certainty, then you cannot sell. This is to allow time for the events to fully play out, which are hard to predict. [I disagree with this point. If you can no longer estimate the value of the business, you need to look at the downside risk. If you can’t estimate downside risk, then you have to get out, else you might be holding something down to $0.]
  5. Most clouds of uncertainty will dissipate in 2 to 3 years, and markets would, in most instances, trade around its intrinsic value once the clouds have lifted. 3-year rule allows us to exit a position where we are simply wrong. If you wait too long, it becomes very hard to make up for opportunity cost in the lost non-compounding years.
  6. Example: Universal Stainless & Alloy Products (USAP)
    1. Overview
      1. Manufactured specialty steel products used in niche applications like power generation, aerospace, and heavy equipment manufacturing.
    2. Positives
      1. All 3 plants have flexible labor agreements.
      2. No legacy costs (pensions/health care) or environmental liabilities.
      3. Acquisition of the 3 plants was cheap ($10M).
      4. USAP could earn $2.75 to $3.75 per share based on historical plant earnings, so was worth well over $30 per share.
      5. Specialty steel gets premium pricing and is manufactured by a limited set of mills. A new mill (Dunkirk) allowed them to deliver finished products instead of semi-finished products.
    3. Negatives
      1. Steel business is cyclical.
      2. Dunkirk would lose money until it got to at least $25M-$30M in annual sales.
    4. How it played out
      1. Pabrai bought in the $14-$15 range in April 2002.
      2. One year later, it was trading at $5. The power generation and aerospace markets crashed and Dunkirk was losing money while the other 2 plants are barely breaking even. The entire steel industry was in a downturn, not USAP-specific. Intrinsic value was indeterminate. Pabrai did nothing.
      3. One year later in April 2004, stock was trading at $10 to $11 per share. The company is profitable, had a growing backlog and future looked good.
      4. In early 2005, USAP crossed $15 per share. Pabrai added to its USAP position the maximum it could buy throughout 2005 (from $10 to $17 per share).
      5. In April 2006, stock hit $31.50 and Pabrai unloaded from then until $35.
      6. Stocks held for 4 years yielded annualized gain of ~19%, rest are even higher.

Key Principle: Focus

  1. There are hundreds of thousands of businesses, and tens of thousands of other securities.
  2. Only invest in simple, well-understood businesses, that would eliminate 99% of possible investment alternatives.
  3. Learn all you can about the business that jumps out for whatever reason and fixate solely on it. Focus intently on it until it’s either rejected as an investment or passes all the Dhandho filters and you make the investment. Don’t make the fatal mistake of looking at five businesses at once.

Places to go Hunting

  1. Headline stories
  2. Value Line weekly summary of stocks that dropped the most in the preceding 13 weeks, and stocks with the lowest P/E, P/B, highest dividend yield, etc.
  3. Portfolio Reports lists the 10 most recent stock purchases by 80 top value managers.
  4. Read 13-F of institutional investors at EDGAR or search for a symbol at, click on “Holdings/Insiders”, then through to the name of an institutional investor.
  5. Value Investors Club by Joel Greenblatt
  6. Look at 52-week lows on the NYSE daily.
  7. Subscribe to Outstanding Investor Digest and Value Investor Insight, or Super Investor Insight.
  8. Gurufocus
  9. Subscribe to Fortune, Forbes, WSJ, Barron’s, and Businessweek.
  10. Attend the biannual Value Investing Congress.


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