Worth reading, and rereading, and re-rereading. An elegant book that teaches fundamental principles of value investing, and much more.
The Dhandho Investor also has the highly unusual quality of being useful at a wide range of reader sophistication levels: you can gain tremendously from this book as a beginner or as a deeply experienced investor.
I'll single out Chapters 5 and 6 for particular mention: Chapter 5 describes author Mohnish Pabrai's investing framework, with nine interlocking and synchronistic rules. Chapter 6 describes in very simple language all of the gigantic structural advantages of investing in the stock market, as it offers low frictional costs, a tremendous selection of possible businesses, and, most importantly, periodic incredible opportunities. These two chapters explain why you will take a pass on almost all investments--but then, once in a while, make large bets on specific situations that meet your requirements.
[A quick affiliate link to Amazon for those readers who would like to support my work here: if you purchase your Amazon products via any affiliate link from this site, or from my sister site Casual Kitchen, I will receive a small affiliate commission at no extra cost to you. Thank you!]
There are many, many insights the author shares, both directly and indirectly, as he walks readers through his investing approach. See for example how Pabrai is perfectly happy to claim "I have very few original ideas," and then compare this statement of genuine egoic and epistemic humility to the stereotypical Wall Street personality: arrogant, egoically fragile, never in doubt. Better to get humble--and stay that way.
Now for a few minor flaws. If you look across Mohnish Pabrai's career and consider some of the mistakes he's made (and to his credit, candidly admitted), you'll see a few concepts that he'd likely discuss further if he were to rewrite this book today:
1) Be far, far more careful with heavily-leveraged situations: See for example Pabrai's Horsehead Holding fiasco (which played out a few years after The Dhandho Investor came out), a zinc producer whose stock went to zero under a mountain of debt.
2) When you see a cyclical company with a low P/E ratio, it may not mean the company is cheap! Sometimes it means the company is massively over-earning and no one trusts the "E" going forward. This is one of the reasons why, paradoxically, deeply cyclical companies tend to be sells when their P/E ratios are low (because the "E" is overstated and is about to decline precipitously) and buys when their P/E ratios are high (because the "E" is understated and is about to recover). Like any fraction, a stock's P/E is highly sensitive to its denominator, thus you want to consider carefully what drives the "E" and why.
3) A discussion of catalysts needed to close a valuation gap: "Finding stocks trading below intrinsic value" is only part of the puzzle: you will also need to identify catalysts that will cause that valuation gap to close. Mohnish tends to assume the valuation gap will close over time, and of course this can and does happen. But sometimes companies are cheap for a reason, and they may stay cheap--or get even cheaper. Better to have a few catalysts to help drive things along.
No investing book is perfect, but The Dhandho Investor is pretty close. Each time I read it (this is my third time!) I get thrilled about investing all over again. I go over my investments with a fine-toothed comb, asking myself, "Is this a proper Dhandho investment? Is it playing out the way I expect it to? If so, why isn't it a bigger bet?" I often do quite a bit of housecleaning in my portfolio while performing this exercise, and my investments reliably tend to perform better as a result.
Thank you Mohnish.
[Readers, as usual, what follows are my notes and quotes from the text, which are meant to help me order my thinking and better remember what I read. If you are working on your investing game, here's a rare instance where they are probably worth reading, closely. I hope you find them useful!]
Notes:
Acknowledgements:
ixff "I have very few original ideas." On Buffett and Munger as major influences. [Note that if you don't have any ego about where your ideas come from, you can have as many of them as you want! But if you do have an ego about where your ideas come from, life becomes a lot harder: "Not Invented Here" is a real syndrome and if you have it, you miss out on a lot of collective wisdom.]
Chapter 1: Patel Motel Dhandho
1ff On the amazing coincidence that half the motels in the US are owned by a Patel; on the low-risk/high-return idea of "Dhandho" which means "business" or "endeavors that create wealth"; also commentary on Idi Amin kicking the Gujarati Indians out of Uganda in the early 1970s ("Africa for Africans") at the same time Bangladeshi refugees were pouring into India, which meant that the Indian government refused to recognize or admit the Indian-origin people who were expelled from Uganda. [As I'm rereading this book for the third time I'm now able to put this into a mental matrix for a modern "resorting" of peoples that may happen in the coming generations, possibly worldwide. This has nothing to do with the book itself however. But Uganda under Idi Amin is definitely reminiscent, and a mini-example, of the "stateless peoples" problem that plagued Europe in the years leading up to the 20th century world wars. See Hannah Arendt's The Origins of Totalitarianism.]
6ff At this time because of the 1970s oil crisis, a lot of small family-owned hotels were under duress; they could be bought at cheap prices, funded largely by bank lending from banks that had no interest in putting these hotels on their bank's balance sheets. Pabrai quotes one of the first Patels: "It required only a small investment and it solved my accommodation problem because my family and I could live and work there."
7ff The math on these hotels in this era is incredible: a $50,000 purchase with $5,000 down, with $50,000 in annual revenue, a cost structure of less than $20,000, thus the property run by a cost-conscious Patel could net $15,000 a year [!], meaning a 400% return on invested capital ($20,000 per year on $5,000 down). Furthermore, Patel's cost structure is lower than any other hotel, and he and his wife do all the work themselves.
12 On Pabrai's "heads, I win; tails, I don't lose much!" mantra.
Chapter 2: Manilal Dhandho
15ff A similar hotel investment from the early 1990s, albeit at a higher valuation, in the West Coast, done with some creative financing from partners, but everything else pretty much the same: a family that worked like hell to run the hotel, lived on very little and saved as much as they could, operating the hotel with similarly extraordinary returns.
Chapter 3: Virgin Dhandho
23ff This chapter covers Richard Branson and his various Dhandho-style investments, starting with his idea to lease a 747 from Boeing: the author goes through various idiosyncrasies of the deal: Branson calling Boeing to ask if they had an unused jumbo jet sitting that they would lease him; he collects the ticket money in advance and pays the fuel bills afterward, so his cash cycle/working capital cycle is positive, etc.
26 "My take on Virgin Atlantic is simply this: if you can start a business that requires a $200 million 747 jumbo jet and a boatload of employees in a tightly regulated industry for virtually no capital, then virtually any business that you want to start can be gotten off the ground with minimal capital. All you need to do is replace capital with creative thinking and solutions." [I would go even further: if you're an entrepreneur and you can't bootstrap your business, the business probably isn't worth pursuing. You should never just throw capital at a business just because.]
27ff Comments here on Virgin Mobile that didn't age well, since the brand failed and had to be shut down. Note however this quote: "Even if half these ventures fail or never scale up, it doesn't matter. There's virtually no money put into them to begin with." [The whole idea is to not squander capital in the first place.]
Chapter 4: Mittal Dhandho
29ff On Lakshmi Mittal, finding steel mills at huge discounts to their initial cost, in some cases buying them for free, getting a dollar's worth of assets for far less than a dollar; note also the "Marwari heuristic": I expect to get all my invested capital returned in the form of dividends in no more than three years. "This means you'll pass on most investments offered to you."
32ff Pabrai describes the company he started: he researched us bankruptcy laws and realized that they weren't that onerous; he started it while he was still at his day job at Tellabs [taking a page from the BowtiedBull roadmap for escaping W-2 hell, this also reduces downside risk tremendously]; the only downside was the loss of the paltry assets that he had at the time. "Visa and MasterCard [his credit cards] were my venture capitalists funding the rest of it." [!!!]
Chapter 5: The Dhandho Framework
35ff Nine principles:
1) Buy an existing business ("This is waaaaaaaay less risky than doing a startup.")
2) Buy a simple business in industries with slow change (quoting Buffett here: "We see change as the enemy of investments... so we look for the absence of change. We don't like to lose money. Capitalism is pretty brutal. We look for mundane products that everyone needs.")
3) Buy distressed businesses in distressed industries (quoting Buffett again: "Have the purchase price be so attractive that even a mediocre sale gives good results." Also: "Be fearful when others are greedy. Be greedy when others are fearful.")
4) Buy businesses with a durable competitive advantage--the moat (be the low-cost producer, have a brand, have sticky customers, etc.)
5) Bet heavily when the odds are overwhelmingly in your favor (the metaphor here is the peri-mutual betting system of horse racing, where are the bettor only bets when there's a major mispricing of the odds. And then you concentrate your capital and your bets, otherwise you do nothing.)
6) Focus on arbitrage (here he describes arbitrage in a very broad way, by giving an example of a barber who works in one town, but recognizes that another town some 30 miles is a place where he could offer services, so he begins a new barbershop with absolute minimum upfront capital, while still working at his part-time old job until he has a steady clientele, etc. The arbitrage "spread" here is the distance between him and his closest competitor in the next town 30 miles away.)
7) Buy businesses at big discounts to their underlying intrinsic value (margin of safety: thus the odds of permanent loss of capital are low.)
8) Look for low risk, high uncertainty businesses (giving the example here of a hotel industry that continues to suffer under a recession and high gas prices, if you're the low-cost player you'll still survive and do okay, but the "uncertainty" could involve significantly better circumstances in the future under which you would make a killing, thus the whole idea is keep your risk as low as possible so you can survive the uncertainty to profit after it passes.)
9) It's better to be a copycat than an innovator ("Innovation is a crapshoot, but lifting and scaling carries far lower risk...")
Chapter 6: Dhandho 101: Invest in Existing Businesses
48ff The author goes through the various advantages of the stock market compared to buying and selling an entire business:
1) You don't have to have the confidence (or find someone with the confidence) to run the business.
2) When you buy a stock, that business is already staffed and running, there's no startup phase, and you can buy or sell your stake in a given business anytime you like very easily: "humanity has given you a marvelous asset compounding machine [the stock market] that's vastly superior to virtually all other alternatives and made it all amazingly cheap and easy to use... The key is to only participate in the stock market using the powerful Dhandho investing framework."
3) Buying or selling a whole business typically will have a rational price because the people on both sides of the deal have a good sense of what the asset is worth. With the stock market, however, it is more like a peri-mutuel system in horse racing: sometimes there are ridiculous divergences between value and the quoted market price because stock prices are determined by an auction process.
4) Buying an entire business requires significant capital; buying a stock can be done with a very small amount of capital that you can add to over time.
5) There are thousands of stocks available to you all the time, whereas there can only be a very small number of private businesses on sale near your home at any given time. "There is just no comparison."
6) Frictional costs are relatively low in the stock market, whereas transaction costs for a buyer and seller of a full business could be 5-10% of the purchase price.
[These points are all tremendously valuable, and they are often lost on investors. When you buy a stock you of course have to have the capital to make the investment, but that's it! You don't have to fund a low-revenue/lossmaking startup phase. The business is already up and running and throwing off profits and possibly dividends too. You only have to wait until the price is so low that it's really worth it to buy.]
Chapter 7: Dhandho 102: Invest in Simple Businesses
51ff This chapter looks at assessing intrinsic value and gives some simple examples; the thrust here is making sure that the business is simple enough you can estimate the cash flows and the cost structure with some degree of reliability, for most businesses you can't, and thus you will pass on those investments. [As Buffett phrases it, you will put them in the "too hard" pile.] You only will invest in a company that's selling clearly below--very far below--your conservative estimate of intrinsic value.
56ff On the importance of simplicity in a business to make these extremely conservative guesstimates of intrinsic value; Pabrai returns to the "Patel motel" example where the owner had a good handle on the likely cost of repairs, of capital expenses, etc.
57 "I always write the thesis down. If it takes more than a short paragraph, there is a fundamental problem. If it requires me to fire up Excel, it is a big red flag that strongly suggests that I ought to take a pass." [Note also that writing the thesis down--in your own handwriting--accomplishes a few things: it grooves the thesis in your mind, it prevents "thesis creep" and it keeps you clear on what you are trying to do with the investment, what exactly are the milestones you are looking for... and it keeps all this clear when, inevitably, the stock market imposes psychological duress on you down the road. A lot of investors--even at the institutional level!--do not do this, and they tend to get panicked out of stocks (or FOMO'd into them) at the worst possible times.]
Chapter 8: Dhandho 201: Invest in Distressed Businesses in Distressed Industries
59ff The central idea in this chapter is that, yes, markets are efficient a lot of the time, but there are certain periods where stock markets are absolutely not efficient, not even close, because human beings subject to extreme fear and extreme greed are involved. Plus those human beings have the ability to unload enormous amounts of shares in seconds if they want to! Note also a few classic Buffett quotes here on the efficient market theory: "Investing in a market where people believe in efficiency is like playing bridge with someone who has been told it doesn't do any good to look at the cards." Also: "Observing correctly that the market was frequently efficient, they went on to conclude incorrectly that it was always efficient. The difference between these propositions is night and day."
62ff Sources for finding distressed stock ideas:
* Value Line's list of biggest 13-week decliners
* 13-F filings from good value investors: Marty Whitman, Seth Klarman, Bruce Sherman, Joel Greenblatt, Warren Buffett's Berkshire Hathaway, etc.
* Value Investor's Club (non-paying guests can get ideas with a two month lag)
* Joel Greenblatt's book The Little Book that Beats the Market and his website magicformulainvesting.com
64 On taking your investment candidates and eliminating all that are not simple, as well as all that fall outside your circle of competence. "What's left is a very small handful of simple, well-understood businesses under duress. We are now ready to apply the rest of the Dhandho framework to this select group."
Chapter 9: Dhandho 202: Invest in Businesses with Durable Moats
65ff On how most instances of supernormal profits are quickly competed away, but there are certain businesses that have enduring outsize profits. The author gives Chipotle as an example [it's best not to focus too much on the specific examples that he gives, better to take away the broad concepts, because it turns out that to some extent Chipotle's competitive advantage did get competed away, although it didn't happen until some ten years after this book was published. Ultimately investors found out that the company was subject to various negative forces, starting with inflation, and the fact that it costs $16 for a burrito bowl now...]
67ff You can identify a moat often just by looking at the financials, because the company shows high and sustainable returns on invested capital. Further comments here on the impermanence of moats over time; they all erode away eventually, thus "we ought to limit the number of years we expect the business to thrive. 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 at anything greater than 15 times cash flows at that time (plus any excess capital in the business)."
Chapter 10: Dhandho 301: Few Bets, Big Bets, Infrequent Bets
71ff On the Kelly criterion, or bet sizing as a percent of your bankroll; see also William Poundstone's book Fortune's Formula that Pabrai says is well worth reading; see also at Ed Thorp who applied the Kelly criterion to blackjack, sports betting and the stock market; and then [and this is an interesting inversion on the idea] comparing the Patel family, which had enough money to buy a hotel once, but then if that bet went bad, they could make "another bet" after they had accumulated some more capital in the future, thus they could repeat the bet again over time. [Interesting to think of betting all your bankroll, but then having that amount of capital being small enough that you know you could earn it back after a few more years of saving. A temporal Kelly criterion, or a way to think about betting and risk across time. Of course, it's important to keep in mind the saying "you don't want to have to get rich twice"--meaning don't do rash things with your capital, like making gigantic bets, once you've already made it!]
73 "The wise ones bet heavily when the world offers them that opportunity. They bet big when they have the odds. And the rest of the time, they don't. It's just that simple." --Charlie Munger
74ff Discussion here of how the betting/odds are iterative in some situations like blackjack, as people like Ed Thorp figured out a basic strategy; the dealers/casinos responded by adding decks, using continuous shuffling, etc. This was when Thorp stumbled onto the realization that the stock market was a much better place for his talents: there were no-limit betting, the odds were vastly better, the house was always willing to take losses... and the mob wasn't running the casino! Also on Thorp figuring out the Black-Scholes formula for options pricing before it was actually "discovered"; on thinking of Black-Scholes as a sort of "basic strategy" for the options market. [Note that this is well-discussed in Thorp's own book A Man For All Markets.]
76ff Interesting discussion here where I think Pabrai has an oversight: he talks about finding a company trading significantly below intrinsic value, it's in distress but it has a good business, a durable moat, and it's within his circle of confidence to analyze it; imagine you've worked out what it's intrinsic value should be 2 to 3 years from now, and you see that the current stock price is less than half of that (future) expected value. However, he just expects/assumes the stock will reach intrinsic value based on nothing more than the assumption, quoting from Benjamin Graham, that "the market eventually catches up with value." [I think there's a major problem here: it's great to find a stock way below intrinsic value, but there is no guarantee that it will therefore rise to intrinsic value! You will want to also make sure there is a catalyst to unlock that value or to drive the stock to its "proper" value. You may not be able to assume it will "just happen" as if by magic. Better to look for value plus a catalyst.]
78 Useful chart here showing the recovery of the DJIA after various major short-term declines, the point Pabrai is trying to make here is that the market (usually!) comes back--and sometimes rapidly and aggressively:
81 Discussion about how, astoundingly, the average mutual fund has 77 positions, with their top 10 holdings representing only 25% of assets. Also a third of mutual funds have more than 100 positions; this is not consistent in any way with the Dhandho formula of placing "few bets, big bets and infrequent bets." Also citing the fact that most funds with zillions of (small and frequent) bets results in usually "pathetic" results.
81ff Discussion of the tremendous volatility that you'll experience using a Kelly Formula large bet/infrequent bet strategy, because it optimizes the variable of maximizing wealth and is agnostic on volatility. Note the nuance here that you can tame the volatility component by underbetting, or having seven or eight uncorrelated bets running at the same time [you can also carry a very large cash balance at all times, this would be a sort of barbell strategy]. This is what Buffett did with his fund; it's what Munger and Buffett have done with Berkshire Hathaway; it's what Joel Greenblatt and Eddie Lampert did as well. Note that Greenblatt will hold up to 80% of his assets in his five best ideas. Note that these guys have never had a down year [which is extremely interesting, but it's also extremely important to note here that Pabrai has had some very bad down years, and he was below as high water mark for something like 9 or 10 years in one of his largest funds, which means he didn't collect fees for that fund for 9-10 years! This is not a failsafe process in any way.]
82-3: Two graphics below translating Kelly Formula bets into what that would mean in terms of percentage holding size with a portfolio of eight simultaneous bets:
83ff Intriguing example here of epistemic humility from Pabrai himself where he places his initial bets/position sizes at a fixed 10% each. "Many times the bottom three to four bets outperform the ones I felt the best about." [Yep: sometimes the bets you don't expect to be the best bets do. It's always good to stay humble about these things.]
Chapter 11: Dhandho 302: Fixate on Arbitrage
85 This chapter considers arbitrage under the vanilla/standard meaning of the term, but also considers forms of arbitrage in broader terms. "Arbitrage is a powerful construct and a fundamental tool in the arsenal of any value investor. With arbitrage, we get decent returns with virtually no risk. The elimination of downside risk, even if upside is limited, is awesome--and that's exactly what arbitrage gives us. With arbitrage, the appeal is, "Heads, I win; tails, I break even or win!'"
85ff On the four standard forms of arbitrage:
1) traditional commodity arbitrage (arbing the gold price in London versus a different gold price in New York)
2) correlated stock arbitrage (arbing BRK.A vs BRK.B)
3) merger arbitrage (long the target, short the acquiring firm)
4) "Dhandho arbitrage" where there is an exploitable competitive advantage over time (like the barber example from Chapter 5; the example here of Compulink, a company that built cable connectors at a faster turn speed than large computer companies could; or GEICO with its structural cost advantage over Allstate because it doesn't have to pay agents, etc.)
Note that all these spreads eventually will close, some will last longer than others, you have to think about the duration and safety of the moat here. Note also that at times you will find instances where a company actually widens its moat every year.
Chapter 12: Dhandho 401: Margin of Safety--Always!
100 Buffett on the three key ideas from The Intelligent Investor by Benjamin Graham:
1) Chapter 8 and the Mr. Market Analogy; also "there are no called strikes in investing"
2) A stock is a piece of a business: you're buying a business which has an underlying value based on how much cash goes in and out
3) Margin of safety: make sure you are buying a business for way less than you think it is conservatively worth
Thus Pabrai arrives at this two-part syllogism that totally conflicts with conventional investment wisdom:
1) the bigger the discount to intrinsic value, the lower the risk.
2) the bigger the discount to intrinsic value, the higher the return. [Pointy-headed finance academics assume the higher the risk the greater the return when the opposite is true.]
101ff On Buffett's Washington Post investment: he purchased the stock at one-fourth of intrinsic value in 1973 [of course the stock then fell to 1/5 of intrinsic value! Cheap stocks might get even cheaper.] Over the following 33 years the investment yielded a 124x return not even counting dividends; also today's [this is when this book was published] dividend equals the ~$10m price Buffett paid when he first purchased the entire company. [Note also that the Washington Post was sold to Jeff Bezos in 2013].
103 Interesting quote here: "Whenever I make investments, I assume that the gap is highly likely to close in three years or less. My own experience as a professional investor over the past seven years has been that the vast majority of gaps close in under 18 months." [Once again I would add here that you want to see a large valuation gap but you also want to have a catalyst or some combination of events that will cause the valuation gap to close. You can't just hope or assume that it will close, although sometimes it just... does. Just remember, hope is not a strategy!]
Chapter 13: Dhandho 402: Invest in Low-Risk, High-Uncertainty Businesses
107ff Contrasting low-uncertainty businesses like ADP or Procter & Gamble that always seem to trade at high P/E ratios and rarely get to bargain prices with the example of Stewart Enterprises, the funeral services company, which went through liquidity problems after the a few major players including Stewart had "rolled up" the fragmented industry; the stock collapsed to $2.00 and Pabrai thought that it was worth $4 under most circumstances; he saw the business as low-failure and low-change because funeral traditions are very stable over time; what's interesting here is he had worked out five different possible scenarios but the scenario that actually happened involved the company doing something that he totally didn't expect: they sold off their international business which wasn't that meaningful in terms of cash flows--thus the result was a solution that he didn't even anticipate and that was better than he envisioned. [A couple of things: 1) sometimes you just get lucky and the thing works out for reasons you didn't expect. 2) Also very much worth noting that when a company has heavy debt load, it doesn't matter how "certain" or "low-change" or "low risk" the underlying business is. The leverage itself is what produces the uncertainty; so on some level this was a highly uncertain situation masquerading as a stable, safe business.]
115ff On Level 3 convertible bonds: "For me, any sort of tech investment is a very fast five-second pass as they tend to be unpredictable, rapidly changing businesses... Rapidly changing industries are the enemy of the investor." Here, however, Pabrai reverse-engineered one of Buffett's investments, and then suspended temporarily his rule against tech investments. [Note that the numbers here seem hilariously small today (although they were big numbers for the 2000-era tech boom and bust) as LVLT only spent $10B building out its fiber optic network: compare this to say Kinder Morgan or Williams and what they spent on their crude oil and LNG pipeline networks; also it's worth considering LVLT's peak market cap of around $46 billion which is nothing compared to the trillion and multi-trillion market caps of some of the tech giants today. It's worth remembering that the economics of the stock market go through orders of magnitude size changes 20-30 years or so, and numbers that would have seemed huge in the past seem tiny a generation later.] LVLT's unsecured debt was trading betwee 18c to 50c on the dollar, these were performing bonds, although this pricing level obviously indicates strong presumptions that the company is going to go through bankruptcy, which it actually never did, apparently. Also interesting to note here that LVLT was founded by Peter Kiewit & Company in Omaha, also Buffett's hometown. See also the famous quote from LVLT CEO Jim Crow that the company was "funded to cash flow breakeven" [this phrase gives me the creeps because sell-side analyst Jack Grubman kept saying it about every single overleveraged telecom stock in the 2000s, most actually were far from fully funded]; Pabrai also mentions here the outperformance stock options that LVLT issued to employees: the company had a unique stock performance plan where they were only paid if the company outperformed the s&P 500 [and I'm pretty sure these options got repriced, but I'm not sure]; also Walter Scott was on LVLT's board as well as on Berkshire Hathaway's board: Buffett and Scott had known each other for 50 years at this point. [It's also very important to note here that if Buffett bought in on LVLT debt there would be the imprimatur of solvency, a big deal for the company.] Pabrai goes through the math: if a bond is trading at 18c on the dollar and it yields 6% you get all your money back in three years just from the interest payments alone, thus this would happen before the company was supposed to run out of cash. He ended up exiting after about a year with a gain of slightly over 100%.
120 "...at the end, the [LVLT] thesis was very simple:"
1) the cast of characters was reliable because of associations with Buffett, Pabrai thought it very unlikely that they were lying,
2) if they weren't lying then probably the company would stay out of bankruptcy,
3) the injection of money from Buffett more or less fix their liquidity crisis,
4) after Buffett's initial investment the company raised still more money from a group of value investors, Legg Mason, Longleaf Partners, etc., thus the company was then very unlikely to go to zero; at this point the bonds rallied. [Note finally that Level 3 was acquired by CenturyLink which pretty much collapsed some 80% over the years to follow; today the combined entity is currently trading at a measly 5 billion dollars in market cap.]
122 "Being a chicken, I only put 10% of the assets I managed into Level 3 converts." [There is no shame in being a chicken! You have to survive, you don't want to get your face ripped off.]
123ff On Frontline: [note that this thesis is particularly interesting because there is a bit of an upcycle happening now (in 2025) in the crude oil tanker sector. When I first read this book I kind of glossed over the Frontline discussion and promptly forgot all about it, when I'm re-reading the book this time around I'm paying a lot closer attention!] This stock turned out to be an interesting journey for him, he started by looking at the company Knightsbridge, which had one of the highest dividend yields in one of his scans of the Value Line report; he passed on this particular tanker company, but as he says, "in investing, all knowledge is cumulative" and he used the context he learned about the tanker sector, applying it later on with the tanker company Frontline. Note that in 3Q2002 oil tanker rates collapsed to well below breakeven, and FRO stock went from $11 a share to $3 in about three months. Then a discussion about the liquidation value and tangible book value of the company, all of which fluctuate along with tanker dayrates: Pabrai believed that Frontline had a liquidation value of more than $11 a share while it was trading at less than a third of that liquidation value. Furthermore Frontline could handle losses for several months without any liquidity problems and it could also sell a ship for, say, $60 million; thus the company could sustain itself through several years of catastrophically low $6,000/day dayrates just by selling two to three ships a year. [Note the paradox here however: if dayrates are that low and they stay that low, nobody will buy your ship at any price!] Also during this period was the transition from single-hull to double-hull tankers (this became a requirement for all tankers after 2006), but with the 2006 requirement just over three years away, this meant that a big chunk of the global tanker capacity of single-hull tankers (which were used by the third world) would eventually go away. Finally he saw Frontline's chairman buying stock "hand over fist" so Pabrai bought some to, at $5.90, about half of what he thought would be the company's liquidation value. He then sold between $9-10. [He's looking at it the right way, he sees the feedback loop that happens in the tanker marketplace. The cure for low prices is low prices, and since it takes a couple of years to order a new ship, any capacity constraint gets reflected in much higher day rates; also Frontline was heavily exposed to the spot market. The painful part here, however, was if Pabrai had held for say three or four more years he would have received repeated gigantic dividends--multiples more than the stock price he paid--and the stock would have gone much, much higher. Sometimes it pays to just sit and not sell after you've caught your double! Note also that the sector went into a complete euphoric boom in the next few years and then a really long bust/oversupply period after the industry built tremendous excess capacity thanks to expectations of China shipping much more crude: only recently does it look like this industry is beginning to see supply/capacity constraints again.]
129 "Read voraciously and wait patiently, and from time to time these amazing bets will present themselves."
Chapter 14: Dhandho 403: Invest in the Copycats Rather Than the Innovators
131ff [Here Pabrai talks about what he will call "cloning" in the years after he published this book]. The central ideas here are: don't take risks of the innovator, instead copy what you can see clearly works: Pabrai gives the Patel example again, how they copied each other's hotel ownership model in different towns; other examples are McDonald's lifting and scaling business ideas from their own franchisees (Ronald McDonald and the Filet-O-Fish were ideas that came from franchisees); Microsoft gives us lots of examples: MSFT essentially stealing an operating system and renaming it; likewise Microsoft Money which cloned Intuit's Quicken; likewise Microsoft Explorer which ripped off Netscape; even the graphical user interface of Windows was cloned from Apple; the Xbox was cloned from Nintendo's and Playstation's consoles. The idea here is that Microsoft looks for market and customer validation of something before they embark on it themselves. And, ironically, whenever Microsoft attempts to innovate they suck. [We can see some of the vilest business "ethics" in history by watching what Microsoft did over the years. There's cloning, and there's literal stealing.]
136 "Good cloners are great businesses. Innovation is a crapshoot, but cloning is for sure."
136ff Finally Mohnish gives an example of his own investment company, which copied its partnership structure from Buffett's original hedge fund partnership: he charged no management fee and an incentive fee of 25% of returns above a minimum 6% compounding hurdle. This compares to most mutual funds that charge 1% or more of assets regardless of gains or losses, and hedge funds that charge 2 and 20, so Pabrai considered this fee structure to be a competitive advantage for him. [Note again here that turns out that certain of Pabrai's funds were underwater for some ten years after the 2000 tech crash: thus a "no maintenance fee" structure can be a problem if you aren't lean enough (say if you have analysts salaries to pay, Bloomberg terminals to pay for, etc. But Pabrai runs an extremely lean, Patel-like organization, I think it's mostly just him.]
139 Note also: a good reminder here that Buffett reinvested virtually all his fund's management fees back into his partnerships, eventually making in the largest investor in the partnership [but with none of his original capital, this capital was all earned off of investors' capital by way of incentive fees; he became (indirectly) rich on his customers' capital!]
139ff Other aspects of Buffett's investing style that Pabrai cloned: not discussing his holdings except to the extent legally required; having a concentrated portfolio with not too many positions; having small stable of close friends as his initial investors and letting things spread by word of mouth; not having any analysts or other general partners; all the investment work is done solely by Buffett/Pabrai as owner, etc.
141-2 Interesting comments here on how Buffett uses Munger: much of the time he doesn't consult Munger at all, see for example the big acquisition of General Re; and sometimes when Munger is skeptical or negative on an idea, Buffett proceeds anyway. The two of them do not require consensus and sometimes they don't even consult each other. Further useful thoughts here on how committees do not make good investment decisions and something like Buffetts' American Express investment would never happen unless just one person has the balls to do it by himself.
143 Pabrai also cloned Joel Greenblatt's "Magic Formula" approach of looking at bottom decile price-to-book valuation stocks, the kinds of companies that have the most "hair" on them. [Or as Harris Kupperman phrases it, "most of the returns come from when a stock goes from hopelessly fucked to sort of shitty."]
144 Finally, after studying Buffett's partnership Pabrai concludes that it results in the right kind of self-selected long-term investor/client base; a wide moat that was sustainable; and it made money management and running his fund "a very relaxed, blissful career to follow."
Chapter 15: Abhimanyu's Dilemma--The Art of Selling
147ff On the ancient epic poem Mahabharata and the 18-day battle between the Pandavas and the Kauravas, and the chakravyuh/"Archimedes spiral" battle formation. For Pabrai, "penetrating the spiral" is a metaphor for buying, holding and then selling a given stock. We have to have a crystal-clear exit plan before we think about entering a buy. Note that in the story, Abhimanyu did not have an exit plan when he entered the spiral.
150 Reviewing the seven questions to ask before entering the spiral:
1) Is it a business I understand well and is it inside my circle of competence?
2) Do I know the intrinsic value and whether it will change over the next few years?
3) Is the business priced at a greater than 50% discount to intrinsic value today and in two or three years?
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?
"One should only consider buying if the answer to all seven is a resounding yes."
151ff Helpful example here--although maybe not in the way the author intends it--of a business that you bought where you assumed that intrinsic value was double what you paid, and then you were offered 95% of intrinsic value after two years: Pabrai argues that this is a no-brainer to sell. [The implicit (and often wrongheaded!) assumption here is that you know for certain what intrinsic value will be, and that it ignores the idea that intrinsic value might be a flywheel, thus the stock goes much much higher than you expect. This is where you look at compounding stories for example, or bankruptcy risk reversion stories: in such cases you may not want to sell all of your shares, you may want to hang on to some or most of the position after you've pulled out most of your initial risk capital.]
153ff Here's where Pabrai offers his rule that you cannot sell any stock within two to three years of buying it. [I've found this to be an incredibly helpful rule, and also a helpful metarule, because it causes you to be even more picky about what you choose to invest in in the first place. It is a great, great rule.] "When stock prices drop dramatically, the fear that sets in is similar to hearing the lion roar. Our first instinct is to sell the turkey, purge the memory of ever having owned it and run away. This is one of the primary reasons why most investors do worse than the stock market indexes." [You have to condition yourself to buy more, and when it goes lower still, buy more still.]
155 "While valuations of public companies can go through dramatic change in a matter of a few minutes, real business changes take months, if not years."
156ff See also Joel Greenblatt's "magic formula" that requires stocks to be held for exactly a year. Also on balancing the opportunity cost of holding something when it's not compounding beyond the two to three year period: if you can recognize intrinsic value quickly, sometimes it's best to take profits sooner rather than later [Again, subject to the concerns above on underestimating the upside]. The main thing about the two to three year rule is that it stops you from selling in a panic when something negative happens.
157ff Case study here on ticker USAP, Universal Stainless and Alloy Products. A specialty steel company that had bought a mothballed Dunkirk, NY steel mill at pennies on the dollar; Pabrai buys at $14-15 but then the stock drops to $5; he decides to do nothing [interesting that he didn't average down, to at least bring the position back up to the typical 10% of his portfolio?] He then waits until things get clearer and he buys more at prices between $10-17, acquiring almost 10% of the company; also his intrinsic value estimate by 2007 went over $35 a share as the steel industry recovered, he started selling at $31.50, selling more as it went higher, then stopping selling at the stock dropped below $30, etc. "The 'holding losers for at least two to three years' rule prohibited a sale at that point of maximum pessimism for USAP."
160ff [It is genuinely helpful to think of the decision to buy or "enter" a stock as a type of metaphor for "entered the spiral": entering a whirlpool of confusion, emotions, a battle on many fronts; things get very confused, there's a fog of mental, emotional and informational stuff flying all around you, and you have to stay calm--and often just do nothing at all.]
165ff Questions here on how many simultaneous "chakravyuh battles" should you run, how many emotional battles should you enter at the same time: Pabrai's answer is not that many, just a few, and only where you have a lot of competence and can buy in at a significant discount to intrinsic value; this also ties in bet size rules from the Kelly Formula; also it ties in to the concept of Buffett's "punch card with 20 holes in it" idea [that over the course of your investing life you'll have maybe 20 genuinely great investment opportunities, you'll punch your card, and you don't want to waste a punch card hole on a mediocre investment]. This also points out the insanity of a mutual fund owning 100 or more names, it's too many simultaneous chakravyuh traversals all at once.
Chapter 16: To Index or Not to Index--That Is the Question
169ff On the frictional costs of most active managers; on the intrinsic benefits of indexing, and then lessons to learn both from the small minority of value investors who have done better than the market, and then also lessons to learn directly from the way indexes themselves operate.
170ff see David Swenson's insight that there isn't much of a difference between the top and bottom performing bond funds, but there were huge differences between top and bottom performer among venture capital funds and private equity funds. Note that Swenson in his book Unconventional Success suggests that people stick to indexing; also comments here on Joel Greenblatt's book and website again; brief discussion and how the Magic Formula actually works: taking a ranking of companies by ROIC (from high to low) and P/E (ranked from low to high), then adding these two numbers and ranking those. [If you've read Greenblatt's book--it is worth reading--you'll see how elegant this is!] on the Magic Formula as "an index on steroids" or a Dhandho index.
174ff Sources to go to find Dhandho ideas:
* Using "magic formula" stocks as a starting point
* Using the Value Investors' Club's ideas [Pabrai calls it "American Idol for Hedge Fund Managers," also note that he uses the site not just to generate ideas but also to find good asset managers to put money with, very, very creative]
* Value Line's "bottom lists"
* 52-week low lists on the NYSE
* Gurufocus.com
* Pabrai also suggests subscribing to the Wall Street Journal, Fortune, Forbes, Barron's and BusinessWeek [all of which I suggest ignoring totally, the quality of all of these publications has tanked in recent years, they are all "consensus-narrative" publications, they are increasingly AI written, and all are regime-compliant. Thus from reading them you'll not only lose money, you'll also get filled with propagandized ways of looking at the world, the only opposition viewpoints you will ever see will be "approved opposition" and these publications will have you focusing on all the wrong things. Don't do it.]
177 "An investor runs a portfolio of 5 to 10 stocks and holds them for one to three years, he or she needs to come up with an investment idea or two just every few months." [This is an insight worth parsing and thinking about, it's deeper than it sounds at first. I have found over my 30+ years of investing that I really only need to add a few names per year to my investment portfolio. You really don't need to make major changes that often if you traffic in individual stocks--and if you're mostly indexing, you hardly need to do anything: just rebalance every quarter or every year. This game can be played on very easy settings and still work well for you.]
Chapter 17: Arjuna's Focus: Investing Lessons from a Great Warrior
179ff Zen-like story here from the Mahabharata about truly seeing the target ("the fish's eye") before firing your arrow; this is an analogy for focusing closely on your next Dhandho investment. Finally a good quote from Kahlil Gibran's The Prophet and thoughts on how and why to give to others after using Dhandho investing to maximize your wealth.
To Read:
Arie de Geus: The Living Company
Richard Branson: Losing My Virginity
John Burr Williams: The Theory of Investment Value
Peter E. Kaufman, ed.: Poor Charlie's Almanack
William Poundstone: Fortune's Formula: The Untold Story of the Unscientific Betting System
Warren Buffett: Letters to Partners of the Buffett Partnerships: 1956-1970
Paul Carroll: Big Blues: The Unmaking of IBM
David F. Swenson: Unconventional Success: A Fundamental Approach to Personal Investment
Kahlil Gibran: The Prophet
Amar Bhide: The Origin and Evolution of New Businesses
Joel Greenblatt: The Little Book that Beats the Market