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Notes from The Dhandho Investor By Mohnish Pabrai

Mohnish is a strong proponent of cloning i.e. copying the ideas which have been tried and tested by other successful people and are proven strategies. Dhandho is Gujarati word which is best described as endeavors that create wealth while taking virtually no risk. Chapter 1: Patel Motel Dhandho Mohnish starts with introduction to the Patel Motel business. Gujarati community (esp. Patels) in US make up less than 0.2% population but they control more than 50% of the motel business employing nearing a million people and owning over $40 billion in motel assets in US. The history of Patels in US is very interesting one and Mohnish adds some details to it. The distressed motel industry, low initial investment, easy mortgage and free accommodation were reasons compelling enough to attract the Patel community to motel business. With frugality and extremely low operating costs, Patels turned the motels into cash generating machine. Mohnish explains the idea by doing DCF analysis on various possible outcomes for a motel business and proves that it was a typical Heads, I win; tails, I dont lose much! bet the dominating theme of this book. The cash generated by one motel was used to buy another motel and very soon Patels began applying their low cost model to higher-end hotels, gas stations, convenience stores (7-Elevens) etc. The snowball effect over time ended up creating amazing results for the Patel community. Chapter 2: Manilal Dhandho Manilal started his work in US at minimum wage, worked 16 hours a day, saved money and learned the gas station business. After few years, in partnership with few Gujarati friends he bought a Motel and started operating it. In a matter of four years he had paid off most of his debt and Motel was generating enough cash for him to construct a new Holiday Inn Express in California. Manilal worked hard, saved all he could, patiently waited for right deal to materialize and then bet it all on a single no brainer bet. Classically, this story is all about Few Bets, Big Bets and Infrequent Bets. Chapter 3: Virgin Dhandho Virgin group head Richard Bransons approach to business is start a business with minimal capital and no risk Dhandho on steroids. With a bit of creative thinking, Branson launched the Virgin Airlines with an initial investment of just $2 million. The common ingredient in all 200+ businesses under virgin group is that there was very little money invested in any of them at startup. With minimal downsides, failure rates dont matter to Sir Richard Branson. Even if half these ventures fail or never scale up, it doesnt matter. There is no money put into them to begin with. Chapter 4: Mittal Dhandho Laxmi Nivas Mittal started his journey in an industry with terrible economics steel mills. He hunted for steel plants which were on the verge of closing, bought them dirt cheap and used his business acumen and experience in steel industry to turn around those sick steel plants. His approach has always been to

get a dollars worth of assets for far less than a dollar. Mohnish himself applied the Dhandho approach in his career. While continuing his day job, he used his early mornings and after office hours to build his software company. The capital came from his 401k savings and credit card debt. His company which started with $100,000 investments was sold for $20 million dollars few years later. Chapter 5: The Dhandho Framework The 9 core principles that constitute the Dhandho framework 1. Focus on buying an existing business with a well-defined business model, one with a long history of operations. This is far less risky than doing a startup. 2. Buy simple businesses with ultra-slow long-term change. A business which makes mundane products that everyone needs. 3. Buy distressed businesses in distressed industries. In such circumstances, the odds are high that an investor can pick up assets at steep discounts to their underlying value. 4. Buy businesses with a moat. Patels, Manilals and Mittals moat were created by being the lowest-cost producer. Bransons moat comes from his brand, innovative offering and a brilliant execution. 5. Bet heavily when odds are overwhelmingly in your favor. All Dhandho entrepreneurs concentrate their capital and their bets. Most of the time they do nothing but once they encounter overwhelming odds in their favor, they act decisively and place a large bet. 6. Focusing on arbitrage. Arbitrage is defined as an attempt to profit by exploiting price differences in identical or similar financial instruments. Over time, arbitrage spread narrows and then disappears. However it could easily take several years for arbitrage spread to end and meanwhile the arbitrageur can rake in supernormal profits. 7. Buying businesses at big discounts to their underlying intrinsic value ensures that even if the future unfolds worse than expected, the odds of a permanent loss of capital are low. 8. Look for low risk high uncertainty business. Once you have minimized the downside risk, the high uncertainty can be dealt with by conservatively handicapping the range of possible outcomes. 9. Be a cloner. Its better to be copycat than an innovator. Innovation is a difficult and risky game, but lifting and scaling carries far lower risk and decent to great rewards. Chapter 6: Dhandho 101 Invest in Existing Businesses A stock is ownership stake in an existing business. Having ownership stake in a few businesses is the best path to building wealth, and with no heavy lifting required, bargain buying opportunities, ultra-low capital requirements, ultra-large selection, and ultra-low frictional costs, buying stakes in a few publicly traded existing businesses is the no-brainer Dhandho way to go. Chapter 7: Dhandho 102 Invest in Simple Businesses Every business has an intrinsic value, and it is determined by the cash inflows and outflows discounted at an appropriate interest rate that can be expected to occur during the remaining life of the business.

While the definition is simple, calculating it for a given business may not be so simple. Dhandho way to deal with this problem is to invest in businesses that are simple ones where conservative assumptions about future cash flows are easy to figure out. How to know that a business is simple? Always write down the thesis behind buying the business. If it takes more than a short paragraph, there is fundamental problem. If it requires a spreadsheet, its a big red flag. Chapter 8: Dhandho 201 - Invest in Distressed Businesses in Distressed Industries Efficient market theory (EMT) says that markets are efficient and its futile to study the fundamental of businesses, but markets arent fully efficient because the price of securities is controlled by auctiondriven pricing mechanism where human beings are participants. Humans are subject to extreme fear and extreme greed, which occasionally creates pockets of inefficiency in the markets. To take advantage of this inefficiency, all we need to do is to narrow the universe of candidate businesses down to ones that are understood well and are in distressed state. There are many sources to find the distressed businesses 1. Business headlines - Negative news about certain business or industry like scams or scandals. 2. List of stocks with price drop from 20% - 70% in last 10-15 weeks. Similarly, list of stocks with lowest P/E, lowest Price to book value, highest dividend yield. 3. Find out what other well-known value investors are buying. They dont always buy distressed businesses but focus on value. However, some of their picks fall in the distressed businesses category. 4. Look at the filings of institutional investors. 5. You can use magic formula screen to filter a list of stocks. Read The little book that beats the market by Joel Greenblatt. These are just the starting points. You dont have to analyze all the businesses found using above sources. Eliminate businesses which arent simple to understand and which fall out of your circle of competence. Apply the Dhandho framework to select group of stocks left after elimination. Chapter 9: Dhandho 202 Invest in Businesses with Durable Moats In the overwhelming majority of businesses, the various moats are mostly hidden or only in partial view. It takes some digging to get to the moat. Good businesses with good moats, generate high returns on invested capital. However, there is no such thing as permanent moat. Even such invincible businesses today like eBay, Google, Microsoft, Toyota and American Express will all eventually decline and disappear. So 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 anything greater than 15 times cash flows at that time. Chapter 10: Dhandho 301 Few Bets, Big Bets, Infrequent Bets Mohnish describes the Kellys formula here, which is used for determining the bet size based on your odds of winning and the total money that you have for investing. To be a good capital allocator, you have to think probabilistically. In investing, there is no such thing as sure bet. Its all about the odds.

Looking out for mispriced betting opportunities and betting heavily when the odds are overwhelmingly in your favor is the ticket to wealth. Kelly formula dictates the upper bounds of these large bets. Mohnish bets 10% of his assets on each bet. [In one of his recent talks, Mohnish mentioned that using the Kelly criterion on individual bets is not the right strategy, instead it should be used at the portfolio level. And he accepted the fact that the explanation given by him in this book was not entirely correct. So please do your due diligence before implementing the concepts described in this chapter] Chapter 11: Dhandho 302 Fixate on Arbitrage With arbitrage you eliminate the downside risk even if upside is limited. The appeal is, Heads, I win; tails, I breakeven or win!. Mohnish compares various types of arbitrages like commodity price gaps between two exchanges, price spread between BRK class A and class B stocks, merger arbitrages etc. CompuLink is the perfect example of Dhandho arbitrage, where super-normal profits are totally free but last for just few months. Leo Goodwin started GEICO to exploit the fact that nobody was selling direct an arbitrage opportunity. Ray Kroc scaled the McDonalds as an arbitrage play. However, over time all arbitrage opportunities disappear, but an enduring arbitrage spread is what Warren Buffett called a moat. We need to have some perspective on whether the moat is likely to last 10 months or 10 years. Chapter 12: Dhandho 401 Margin of Safety The bigger the discount to intrinsic value, lower the risk and higher the return. Mohnish explains the idea of Margin of safety with the example of Buffetts Washington Post purchase. It is during times of extreme distress and pessimism that rationality goes out the window and prices of certain assets go well below their underlying intrinsic value. Most of the time assets trade hands at or above their intrinsic value. The key, however, is to wait patiently for the right idea at the right time. Chapter 13: Dhandho 402 Invest in Low Risk, High-Uncertainty Business All the Dhandho entrepreneurs that have been talked about here, had thought through the range of possibilities and drew comfort from the fact that very little capital was invested and/or the odds of a permanent loss of capital were extremely low. Whenever Wall-Street gets confused between risk and uncertainty, there is chance to make a profit. Mohnish has taken 3 case studies from his own portfolio to elaborate on this 1. Funeral industry and a company in the same industry was facing temporary problems which created lot of uncertainty about future of the company as a result Wall-Street got confused between risk and uncertainty and collapsed the stock price. Also, when you have most of the possible downsides ruled out, there is always a possibility of free upside option which can happen, like competent management striking a good deal or a stroke of good luck. He exited with 100% return in 6 months. 2. Second example that Mohnish discusses is of Level 3 communications convertible bonds. He got interested in those bonds based on a rumor that Buffett has bought them. He did an extensive research including listening to annual meeting recordings and evaluating the

possible future scenarios, and came to the conclusion that odds of total capital loss were less than 5%. He made 120% annualized gain on this deal. 3. Mohnish scans the high dividend yield list regularly to find undervalued companies. This led him to do research on crude oil shipping industry. In investing, all knowledge is cumulative. The crude oil shipping industry knowledge came handy later when he bought a Frontline stock. The company was going through temporary cash problems but had sufficient assets to cover few years of losses. He made 273% annualized returns on this stock. Read voraciously and wait patiently, and from time to time these amazing bets will present themselves. Chapter 14: Dhandho 403 Invest in Copycats rather than the Innovators Innovation is a difficult ballgame, but investing in businesses that are simple good copycats and adopting innovations created elsewhere rules the world. Thousands of Patels simply copied the Motel business model from the first few Patels who had figures out the model. Most entrepreneurs lift their business ideas from other existing businesses or from their last employer. Some of the examples of copycat models 1. Ray Kroc bought the McDonalds rights from McDonald brothers and scaled the idea. Many of the subsequent innovations in the MCD menu were done by the franchisees and were adopted company wide. 2. The flagship product (MS-DOS) that allowed Microsoft to scale exponentially wasnt developed in-house. It was lifted from Seattle Computer. GUI and the mouse was copied from Apple, Excel was copied from Lotus 1-2-3 and VisiCalc, MS word was lifted from Word Perfect and Powerpoint was developed by a little software company that Microsoft acquired. Microsoft has repeatedly looked for customer validation of someone elses innovation before embarking on its own. Its a powerful strategy. 3. Mohnish himself cloned the Buffett partnership fee structure for Pabrai funds. It wasnt something that could be adopted by most mutual funds and hedge funds even if they recognized the competitive advantage it would bring. Having a moat that your competitors can see in broad daylight but never ever cross is just fantastic. Mohnish not only copied the fee structure but copied many other aspects of Buffetts investing style like not discussing the portfolio positions and discussing the performance only once a year, very small investment team size, keeping a concentrated portfolio etc. In seeking to make investments in the public equity markets, ignore the innovators. Always seek out businesses run by people who have demonstrated their ability to repeatedly lift and scale. Chapter 15: Abhimanyus Dilemma The Art of selling In the great epic Mahabharata, there is a mention of a deadly military formation called Chakravyuh which was used by Kauravas in the final battle. Arjuns son Abhimanyu was the only one who knew how to break into a Chakravyuh but didnt know the exit strategy. The decision to enter, traverse and finally exit a Chakravyuh is akin to figuring out when to buy, hold and sell a given stock. The idea is, to have a

crystal-clear exit plan before we ever think about buying a stock. If a well-understood business is offered to you at half or less than its underlying intrinsic value 2-3 years from now, with minimal downside risk, take it. If not, take a pass on entering this Chakravyuh. 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. To counterbalance our greed and fear, we have to put rational Chakravyuh traversal rules in place to promote rational behavior. Markets are mostly efficient and in most instances an undervalued asset will move up and trade around its intrinsic value once the clouds have lifted. Most clouds of uncertainty will dissipate in 2-3 years. Joel Greenblatts magic formula also dictates that you should hold your stock for at least one year, the assumption being you dont understand the business and relying blindly on the magic formula. You have to select your Chakravyuhs carefully and that mandates a concentrated portfolio. If you can get to holding 5 to 10 diverse, well-understood value stocks in your portfolio, youre well on your way to trouncing the markets and decimating one Chakravyuh after another. Chapter 16: To Index or Not to Index If you invest passively into index funds, you are going to do better than 80% of the managed funds primarily because of the frictional costs involved in actively managed funds. A slightly better strategy is to find out the Dhandho Investors and put your assets with them. Mohnish is highly impressed with Joel Greenblatts Magic formula investing. He calls the magic formula investing as Index on Steroids. Some of the places where you could find bargain stocks 1. A website maintained by Joel Greenblatt. 2. Bottoms list - List of stocks having low P/E, highest dividend yield, low Price to Book value ratios. 3. 52 week lows stock list. Most of the stocks in this list will be obscure ones, so fixate on familiar names and dig deeper. 4. Read the interviews of the best value money managers. Find out what these guys are buying. 5. Subscribe to major financial publications. These publications give you a lot of information about different companies, people and industries. Chapter 17: Arjuns Focus Investing Lessons from a Great Warrior The great warrior Arjuna (Mahabharata fame) was known to have extraordinary focus which helped him to become the greatest archer at his time. The Dhandho investor, like Arjuna, remains squarely inside his circle of competence and doesnt bother about all the noise outside the circle. Within your circle of competence, read pertinent books, publications, company reports, industry periodicals and so on. Every once in a while something about a business will jump out at you. At that point, you need to become ultra-focused like Arjuna. Shut everything else out except this one business. Drill down and see if it truly is an exceptional investment opportunity. Most times it wont be as cheap as youd like or something will bother you and youll take a pass. In that case, go back to scanning the radar within your narrow circle. Dont make the fatal mistake of looking at five businesses at once. Learn all you can about th e business that jumps out for whatever reason and fixate solely on it. Books and Resources suggested by Mohnish 1. 2. 3. 4. 5. 6.

Fortunes Formula William Poundstone. The Living Company Arie de Geus The Little Book that Beats the Markets Joel Greenblatt The Origin and Evolution of New Businesses Amar Bhinde Edward Thorpes paper The Kelly Criterion in Blackjack, Sports Betting and the Stock Market Unconventional Success: A Fundamental Approach to Personal Investment - David Swensen

Note: This book was written in the year 2007 so all the facts and figures quoted are latest up to 2007. Mohnish invests primarily in US markets so some of the things which he has mentioned may not be applicable in Indian context. You can buy the book from here Buy The Dhandho Investor