(Image: Zen Buddha Silence by Marilyn Barbone.)
April 30, 2017
Value investor Mohnish Pabrai wrote The Dhando Investor: The Low-Risk Value Method to High Returns (Wiley, 2007). It’s an excellent book that captures the essence of value investing:
The lower the price you pay relative to the probable intrinsic value of the business, the higher your returns will be if you’re right and the lower your losses will be if you’re wrong.
If you have a good investment process as a value investor, and you’re focused on cheap and good companies with low or no debt, then you are likely to be right on roughly 2/3 of your investments. Because losses are minimized on the other 1/3 – due to the low price paid – the overall portfolio is likely to do well over time.
Mohnish sums up the Dhando approach as:
Heads, I win; tails, I don’t lose much!
There is one very important additional idea that Mohnish focused on in his recent (October 2016) lecture at Peking University (Guanghua School of Management):
10-baggers to 100-baggers
Mohnish gives many examples of stocks – a few of which he kept holding and many of which he sold – that later became 10-baggers, 20-baggers, up to a few 100-baggers. If you own a stock that has already been a 2-bagger, 3-bagger, 5-bagger, etc., and you sell and the stock later turns out to be a 20-bagger, 50-bagger, or 100-bagger, often you have made a huge mistake by selling too soon. Link to Mohnish’ lecture: https://www.youtube.com/watch?v=Jo1XgDJCkh4
PATEL MOTEL DHANDO
(Mohnish published the book in 2007. I will use the present tense in this blog post.)
Mohnish notes that Asian Indians make up about 1 percent of the population of the United States. Of these three million, a small subsection hails from the Indian state of Gujarat – the birthplace of Mahatma Gandhi. The Patels are from a tiny area in Southern Gujarat.
Less than one in five hundred Americans is a Patel. It is thus amazing that over half of all the motels in the entire country are owned and operated by Patels… What is even more stunning is that there were virtually no Patels in the United States just 35 years ago. They started arriving as refugees in the early 1970s without much in the way of capital or education. Their heavily accented, broken-English speaking skills didn’t improve their prospects either. From that severely handicapped beginning, with all the odds stacked against them, the Patels triumphed. Patels, as a group, today own over $40 billion in motel assets in the United States, pay over $725 million a year in taxes, and employ nearly a million people. How did this small, impoverished ethnic group come out of nowhere and end up controlling such vast resources? There is a one word explanation: Dhandho. (page 1)
Dhandho means a low-risk, high-return approach to business. It means the upside is much larger than the downside, which is the essence of value investing.
Dhandho is all about the minimization of risk while maximizing the reward… Dhandho is thus best described as endeavors that create wealth while taking virtually no risk. (page 2)
Mohnish gives a brief history of the Patels. Some Patels had gone to Uganda and were doing well there as entrepreneurs. But when General Idi Amin came to power as a dictator in 1972, things changed. The Ugandan state seized all of the businesses held by Patels and other non-natives. These businesses were nationalized, and the previous owners were paid nothing.
Because India was already dealing with a severe refugee crisis in 1972-1973, the Indian-origin population that had been tossed out of Uganda was not allowed back into India. Many Patels settled in England and Canada, and a few thousand were accepted in the United States.
In 1973, many nondescript motels were being foreclosed and then sold at distressed prices. “Papa Patel” realized that a motivated seller or bank might finance 90% of the purchase. If Papa Patel could put $5,000 down, he could get a motel on the cheap. The Patel family would run things and also live there. So they had no salaries to pay, and no rent to pay. With rock-bottom expenses, they could then offer the lowest nightly rates. This would lead to higher occupancy and high profits over time, given the very low cost structure.
As long as the motel didn’t fail, it would likely be a highly profitable venture relative to the initial $5,000 investment. If the motel did fail, Papa Patel reasoned that he and his wife could bag groceries and save close to $5,000 in a couple of years. Then Papa Patel could find another cheap motel and make the same bet. If the probability of failure is 10%, then the odds of two failures in a row would be 1%, while nearly every other scenario would involve a high return on investment. Once the first motel was solidly profitable, Papa Patel could let his oldest son take over and look for the next one to buy.
The Patels kept repeating this basic approach until they owned over half the motels in the United States.
The Patel formula is repeatable. It’s not just a one-time opportunity based on unique circumstances. Consider Manilal Chaudhari, also from Gujarat, says Mohnish.
Manilal had worked hard as an accountant in India. In 1991, with sponsorship from his brother, he migrated to the United States. His English was not good, and he couldn’t find a job in accounting.
His first job was working 112 hours a week at a gas station at minimum wage. Later, he got a job at a power supply manufacturing company, Cherokee International, owned by a Patel. Manilal worked full-time at Cherokee, and kept working at the gas station as much as possible. The Persian owner of the gas station, recognizing Manilal’s hard work, gave him a 10 percent stake in the business.
In 1998, Manilal decided he wanted to buy a business. One of the employees at Cherokee (a Patel) told Manilal that he wanted to invest with him in whatever business he found. In 2001, the travel industry went into a slump and motel occupancy and prices plummeted. Manilal found a Best Western motel on sale at a terrific location. Since everyone in the extended family had been working non-stop and saving, Manilal – along with a few Patels from Cherokee – were able to buy the Best Western.
Four years later, the Best Western had doubled in value to $9 million. The $1.4 million invested by Manilal and a few Patels was now worth $6.7 million, an annualized return of 48 percent. This doesn’t include annual free cash flow. Mohnish concludes (page 21):
Now, that’s what I’d call Manilal Dhandho. He worked hard, saved all he could, and then bet it all on a single no-brainer bet. Reeling from the severe impact of 9/11 on travel, the motel industry was on its knees. As prices and occupancy collapsed, Manilal stepped in and made his play. He was on the hunt for three years. He patiently waited for the right deal to materialize. Classically, his story is all about Few Bets, Big Bets, Infrequent Bets. And it’s all about only participating in coin tosses where:
Heads, I win; tails, I don’t lose much!
The year was 1984 and Richard Branson knew nothing about the airline business. He started his entrepreneurial journey at 15 and was very successful in building an amazing music recording and distribution business.
Somebody sent Branson a business plan about starting an all business class airline flying between London and New York. Branson noted that when an executive in the music business received a business plan to start an airline involving a 747 jumbo jet, he knew that the business plan had been turned down in at least three thousand other places before landing on his desk… (page 24)
Branson decided to offer a unique dual-class service. But when he presented the idea to his partners and senior executives at the music business, they told him he was crazy. Branson persisted and discovered that he could lease a 747 jumbo jet from Boeing. Branson calculated that Virgin Atlantic Airlines, if it failed, would cost $2 million. His record company was going to earn $12 million that year and about $20 million the following year.
Branson also realized that tickets get paid about 20 days before the plane takes off. But fuel is paid 30 days after the plane lands. Staff wages are paid 15 to 20 days after the plane lands. So the working capital needs of the business would be fairly low.
Branson had found a service gap and Virgin Atlantic ended up doing well. Branson would repeat this formula in many other business opportunities:
Heads, I win; tails, I don’t lose much!
Mohnish says Rajasthan is the most colorful state of India. Marwar is a small district in the state, and the Marwaris are seen as excellent businesspeople. Lakshmi Mittal, a Marwari entrepreneur, went from zero to a $20 billion net worth in about 30 years. And he did it in an industry with terrible economics: steel mills.
Take the example of the deal he created to take over the gigantic Karmet Steel Works in Kazakhstan. The company had stopped paying its workforce because it was bleeding red ink and had no cash. The plant was on the verge of closure with its Soviet-era managers forced to barter for steel for food for its workers. The Kazakh government was glad to hand Mr. Mittal the keys to the plant for nothing. Not only did Mr. Mittal retain the entire workforce and run the plant, he paid all the outstanding wages and within five years had turned it into a thriving business that was gushing cash. The workers and townsfolk literally worship Mittal as the person who saved their town from collapse.
…The same story was repeated with the Sidek Steel plant in Romania, and the Mexican government handed him the keys to the Sibalsa Mill for $220 million in 1992. It had cost the Mexicans over $2 billion to build the plant. Getting dollar bills at 10 cents – or less – is Dhandho on steroids. Mittal’s approach has always been to get a dollar’s worth of assets for far less than a dollar. And then he has applied his secret sauce of getting these monolith mills to run extremely efficiently. (pages 30-31)
Mohnish recounts a dinner he had with a Marwari friend. Mohnish asked how Marwari businesspeople think about business. The friend replied that they expect their entire investment to be returned as dividends within three years, with the principal still being worth at least the initial amount invested.
THE DHANDHO FRAMEWORK
Mohnish lays out the Dhando framework, including:
- Invest in existing businesses.
- Invest in simple businesses.
- Invested in distressed businesses in distressed industries.
- Invest in businesses with durable moats.
- Few bets, big bets, and infrequent bets.
- Margin of safety – always.
- Invest in low-risk, high-uncertainty businesses.
Let’s look at each point.
INVEST IN EXISTING BUSINESSES
Over a long period of time, owning parts of good businesses via the stock market has been shown to be one of the best ways to preserve and grow wealth. Mohnish writes that there are six big advantages to investing in stocks:
- When you buy stock, you become a part owner of an existing business. You don’t have to do anything to create the business or to make the business run.
- You can get part ownership of a compounding machine. It is simple to buy your stake, and the business is already fully staffed and running.
- When people buy or sell entire businesses, both buyer and seller typically have a good idea of what the business is worth. It’s hard to find a bargain unless the industry is highly distressed. In the public stock market, however, there are thousands and thousands of businesses. Many stock prices change by 50% or more in any given year, but the intrinsic value of most businesses does not change by 50% in a given year. So a patient investor can often find opportunities.
- Buying an entire business usually takes serious capital. But buying part ownership via stock costs very little by comparison. In stocks, you can get started with a tiny pool of capital.
- There are likely over 100,000 different businesses in the world with public stock available.
- For a long-term value investor, the transaction costs are very low (especially at a discount broker) over time.
INVEST IN SIMPLE BUSINESSES
The intrinsic value of any business – what the business is worth – is the sum of all future free cash flows discounted back to the present. This is called the discounted cash flow (DCF) approach. (Intrinsic value could also mean liquidation value in some cases.)
As Warren Buffett has noted, you generally do not get paid extra for degree of difficulty in investing. There is no reason, especially for smaller investors, not to focus on simple businesses. By patiently looking at hundreds and hundreds of micro-cap stocks, eventually you can find a 10-bagger, 20-bagger, or even a 100-bagger. And the small business in question is likely to be quite simple. With such a large potential upside, there is no reason, if you’re a small investor, to look at larger or more complicated businesses. (The Boole Microcap Fund that I manage focuses exclusively on micro caps.)
It’s much easier to value a simple business because it usually is easier to estimate the future free cash flows. You may need to have several scenarios in your DCF analysis – a low case, a mid case, and a high case. (What you’re really looking for is a high case that involves a 10-bagger, 20-bagger, or 100-bagger.) But you’re still nearly always better off limiting your investments to simple businesses.
Only invest in businesses that are simple – ones where conservative assumptions about future cash flows are easy to figure out. (pages 56-57)
INVEST IN DISTRESSED BUSINESSES IN DISTRESSED INDUSTRIES
The stock market is usually efficient, meaning that stock prices are usually accurate representations of what businesses are worth. It is very difficult for an investor to do better than the overall stock market, as represented by the S&P 500 Index or another similar index.
Stock prices, in most instances, do reflect the underlying fundamentals. Trying to figure out the variance between prices and underlying intrinsic value, for most businesses, is usually a waste of time. The market is mostly efficient. However, there is a huge difference between mostly and fully efficient. (page 60)
Because the market is not always efficient, value investors who patiently examine hundreds of different stocks eventually will find a few that are undervalued. Because public stock markets are highly liquid, if an owner of shares becomes fearful, he or she can quickly sell those shares. For a privately held business, however, it usually takes months for an owner to sell the position. Thus, a fearful owner of public stock is often more likely to sell at an irrationally low price because the sale can be completed right away.
Where can you find distressed businesses or industries? Mohnish offers some suggestions:
- Business headlines often include articles about distressed business or industries.
- You can look at prices that have dropped the most in the past 52 weeks. You can also look at stocks trading at low price-to-earnings ratios (P/Es), low price-to-book ratios (P/Bs), high dividend yields, and so on. Not every quantitatively cheap stock is undervalued, but some are. There are various services that offer screening such as Value Line.
- You can follow top value investors by reading 13-F Forms or through different services. I would only note that the vast majority of top value investors are not looking at micro-cap stocks. If you’re a small investor, your best opportunities are very likely to be found among micro caps. Very few professional investors ever look there, causing micro-cap stocks to be much more inefficiently priced than larger stocks. Also, micro caps tend to be relatively simple, and they often have far more room to grow. Most 100-baggers start out as micro caps.
- Value Investors Club (valueinvestorsclub.com) is a club for top value investors. You can get free guest access to all ideas that are 45 days old or older. Many cheap stocks stay cheap for a long time. Often good ideas are still available after 45 days have elapsed.
- The website magicformulainvesting.com is a good way to find some potentially undervalued stocks.
INVEST IN BUSINESSES WITH DURABLE MOATS
A moat is a sustainable competitive advantage. Moats are often associated with capital-light businesses. Such businesses (if successful) tend to have sustainably high ROIC (return on invested capital) – the key attribute of a sustainable competitive advantage. Yet sometimes moats exist elsewhere and sometimes they are hidden.
Sometimes the moat is hidden. Take a look at Tesoro Corporation. It is in the oil refining business – which is a commodity. Tesoro has no control over the price of its principle raw material, crude oil. It has no control [of the price] over its principal finished good, gasoline. Nonetheless, it has a fine moat. Tesoro’s refineries are primarily on the West Coast and Hawaii. Refining on the West Coast is a great business with a good moat. There hasn’t been a refinery built in the United States for the past 20 years. Over that period, the number of refineries has gone down from 220 to 150, while oil demand has gone up about 2 percent a year. The average U.S. refinery is operating at well over 90 percent of capacity. Anytime you have a surge in demand, refining margins escalate because there is just not enough capacity.
…How do we know when a business has a hidden moat and what that moat is? The answer is usually visible from looking at its financial statements. Good businesses with good moats… generate high returns on capital deployed in the business. (pages 66-67, my emphasis)
But the nature of capitalism is that any company that is earning a high return on invested capital will come under attack by other businesses that want to earn a high return on invested capital.
It is virtually a law of nature that no matter how well fortified and defended a castle is, no matter how wide or deep its moat is, no matter how many sharks or piranhas are in that moat, eventually it is going to fall to the marauding invaders. (page 68)
Mohnish quotes Charlie Munger:
Of the fifty most important stocks on the NYSE in 1911, today only one, General Electric, remains in business… That’s how powerful the forces of competitive destruction are. Over the very long term, history shows that the chances of any business surviving in a manner agreeable to a company’s owners are slim at best.
There is no such thing as a permanent moat. Even such invincible businesses today like eBay, Google, Microsoft, Toyota, and American Express will all eventually decline and disappear.
…It takes about 25 to 30 years from formation for a highly successful company to earn a spot on the Fortune 500… it typically takes many blue chips less than 20 years after they get on the list to cease to exist. The average Fortune 500 business is already past its prime by the time it gets on the list. (pages 68-69)
If you’re a small investor, searching for potential 10-baggers or 100-baggers among micro-cap stocks makes excellent sense. You want to find tiny companies that much later reach the Fortune 500. You don’t want to look at companies that are already on the Fortune 500 because the potential returns are far more likely to be mediocre going forward.
FEW BETS, BIG BETS, INFREQUENT BETS
Claude Shannon was a fascinating character – he often rode a unicycle while juggling, and his house was filled with gadgets. Shannon’s master’s thesis was arguably the most important and famous master’s thesis of the twentieth century. In it, he proposed binary digit or bit, as the basic unit of information. A bit could have only two values – 0 or 1, which could mean true or false, yes or no, or on or off. This allowed Boolean algebra to represent any logical relationship. This meant that the electrical switch could perform logic functions, which was the practical foundation for all digital circuits and computers.
The mathematician Ed Thorp, a colleague of Shannon’s at MIT, had discovered a way to beat the casinos at blackjack. But Thorp was trying to figure out how to size his blackjack bets as a function of how favorable the odds were. Someone suggested to Thorp that he talk to Shannon about it. Shannon recalled a paper written by a Bell Labs colleague of his, John Kelly, that dealt with this question.
The Kelly criterion can be written as follows:
- F = p – [q/o]
- F = Kelly criterion fraction of current capital to bet
- o = Net odds, or dollars won per $1 bet if the bet wins (e.g., the bet may pay 5 to 1, meaning you win $5 per each $1 bet if the bet wins)
- p = probability of winning
- q = probability of losing = 1 – p
The Kelly criterion has a unique mathematical property: if you know the probability of winning and the net odds (payoff), then betting exactly the percentage determined by the Kelly criterion leads to the maximum long-term compounding of capital, assuming that you’re going to make a long series of bets. Betting any percentage that is not equal to that given by the Kelly criterion will inevitably lead to lower compound growth over a long period of time.
Thorp proceeded to use the Kelly criterion to win quite a bit of money at blackjack, at least until the casinos began taking countermeasures such as cheating dealers, frequent reshuffling, and outright banning. But Thorp realized that the stock market was also partly inefficient, and it was a far larger game.
Thorp launched a hedge fund that searched for little arbitrage situations (pricing discrepancies) involving warrants, options, and convertible bonds. In order to size his positions, Thorp used the Kelly criterion. Thorp evolved his approach over the years as previously profitable strategies were copied. His multi-decade track record was terrific.
Ed Thorp examined Buffett’s career and concluded that Buffett has used the essential logic of the Kelly criterion by concentrating his capital into his best ideas. Buffett’s concentrated value approach has produced an outstanding, unparalleled 65-year track record.
Thorp has made several important points about the Kelly criterion as it applies to long-term value investing. The Kelly criterion was invented to apply to a very long series of bets. Value investing differs because even a concentrated value investing approach will usually have at least 5-8 positions in the portfolio at the same time. Thorp argues that, in this situation, the investor must compare all the current and prospective investments simultaneously on the basis of the Kelly criterion.
Mohnish gives an example showing how you can use the Kelly criterion on your top 8 ideas, and then normalize the position sizes.
Say you look at your top 8 investment ideas. You use the Kelly criterion on each idea separately to figure out how large the position should be, and this is what you conclude about the ideal bet sizes:
- Bet 1 – 80%
- Bet 2 – 70%
- Bet 3 – 60%
- Bet 4 – 55%
- Bet 5 – 45%
- Bet 6 – 35%
- Bet 7 – 30%
- Bet 8 – 25%
Of course, that adds up to 400%. Yet for a value investor, especially running a concentrated portfolio of 5-8 positions, it virtually never makes sense to buy stocks on margin. Leverage cannot make a bad investment into a good investment, but it can turn a good investment into a bad investment. So you don’t need any leverage. It’s better to compound at a slightly lower rate than to risk turning a good investment into a bad investment because you lack staying power.
So the next step is simply to normalize the position sizes so that they add up to 100%. Since the original portfolio adds up to 400%, you just divide each position by 4:
- Bet 1 – 20%
- Bet 2 – 17%
- Bet 3 – 15%
- Bet 4 – 14%
- Bet 5 – 11%
- Bet 6 – 9%
- Bet 7 – 8%
- Bet 8 – 6%
(These percentages are rounded for simplicity.)
As mentioned earlier, if you truly know the odds of each bet in a long series of bets, the Kelly criterion tells you exactly how much to bet on each bet in order to maximize your long-term compounded rate of return. Betting any other amount will lead to lower compound returns. In particular, if you repeatedly bet more than what the Kelly criterion indicates, you eventually will destroy your capital.
It’s nearly always true when investing in a stock that you won’t know the true odds or the true future scenarios. You usually have to make an estimate. Because you never want to bet more than what the Kelly criterion says, it is wise to bet one half or one quarter of what the Kelly criterion says. This is called half-Kelly or quarter-Kelly betting. What is nice about half-Kelly betting is that you will earn three-quarters of the long-term returns of what full Kelly betting would deliver, but with only half the volatility.
So in practice, if there is any uncertainty in your estimates, you want to bet half-Kelly or quarter-Kelly. In the case of a concentrated portfolio of 5-8 stocks, you will frequently end up betting half-Kelly or quarter-Kelly because you are making 5-8 bets at the same time. In Mohnish’s example, you end up betting quarter-Kelly in each position once you’ve normalized the portfolio.
Mohnish quotes Charlie Munger again:
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. (page 73)
When running the Buffett Partnership, Warren Buffett invested 40% of the partnership in American Express after the stock had been cut in half following the salad oil scandal. American Express had to announce a $60 million loss, a huge hit given its total market capitalization of roughly $150 million at the time. But Buffett determined that the essential business of American Express – travelers’ checks and charge cards – had not been permanently damaged. American Express still had a very valuable moat.
Buffett explained his reasoning in several letters to limited partners, as quoted by Mohnish here:
We might invest up to 40% of our net worth in a single security under conditions coupling an extremely high probability that our facts and reasoning are correct with a very low probability that anything could change the underlying value of the investment.
We are obviously only going to go to 40% in very rare situations – this rarity, of course, is what makes it necessary that we concentrate so heavily, when we see such an opportunity. We probably have had only five or six situations in the nine-year history of the partnerships where we have exceeded 25%. Any such situations are going to have to promise very significant superior performance… They are also going to have to possess such superior qualitative and/or quantitative factors that the chance of serious permanent loss is minimal… (pages 79-80)
There’s virtually no such thing as a sure bet in the stock market. But there are situations where the odds of winning are very high or where the potential upside is substantial.
One final note: In constructing a concentrated portfolio of 5-8 stocks, if at least some of the positions are non-correlated or even negatively correlated, then the volatility of the overall portfolio can be reduced. Some top investors prefer to have about 15 positions with low correlations.
Once you get to at least 25 positions, specific correlations typically tend not to be an issue, although some investors may end up concentrating on specific industries. In fact, it often may make sense to concentrate on industries that are deeply out-of-favor.
For instance, oil touched $26 earlier this year. But the long-term market clearing price of oil – based on supply and demand over a period of years – is likely to be around $60-70, although it could easily be higher (at least for some time) because oil wells deplete. Under these conditions, it may make sense to concentrate on oil-related companies (some producers, some drillers, etc.). That’s not to say that there is no risk in such a strategy. Specific companies may encounter issues. Or perhaps there will be a sudden wide adoption of electric vehicles, rather than a slow, gradual adoption.
We don’t benchmark at all…We’ll go where we think the value is and let the weightings fall where they may. – Steven Romick
…It’s 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. It’s all about letting the Kelly Formula dictate the upper bounds of these large bets. Further, because of multiple favorable betting opportunities available in equity markets, the volatility surrounding the Kelly Formula can be naturally tamed while still running a very concentrated portfolio. (page 84)
In sum, top value investors like Warren Buffett, Charlie Munger, and Mohnish Pabrai – to name just a few out of many – naturally concentrate on their best 5-8 ideas, at least when they’re managing a small enough amount of money. (These days, Berkshire’s portfolio is massive, which makes it much more difficult to concentrate, let alone to find hidden gems among micro caps.)
You have to take a humble look at your strategy and your ability before decided on your level of concentration. The Boole Microcap Fund that I manage is designed to focus on the top 15-25 ideas. This is concentrated enough so that the best performers – whichever stocks they turn out to be – can make a difference to the portfolio. But it is not so concentrated that it misses the best performers. In practice, the best performers very often turn out to be idea #9 or idea #17, rather than idea #1 or idea #2. Many top value investors – including Peter Cundill, Joel Greenblatt, and Mohnish Pabrai – have found this to be true.
MARGIN OF SAFETY – ALWAYS!
Nearly every year, Buffett has hosted over 30 groups of business students from various universities. The students get to ask questions for over an hour before going to have lunch with Buffett. Mohnish notes that students nearly always ask for book or reading recommendations, and Buffett’s best recommendation is always Ben Graham’s The Intelligent Investor. As Buffett told students from Columbia Business School on March 24, 2006:
The Intelligent Investor is still the best book on investing. It has the only three ideas you really need:
- Chapter 8 – The Mr. Market analogy. Make the stock market serve you. The C section of the Wall Street Journal is my business broker – it quotes me prices every day that I can take or leave, and there are no called strikes.
- A stock is a piece of a business. Never forget that you are buying a business which has an underlying value based on how much cash goes in and out.
- Chapter 20 – Margin of Safety. Make sure that you are buying a business for way less than you think it is conservatively worth. (page 100)
The heart of value investing is an idea that is directly contrary to economic and financial theory:
- The bigger the discount to intrinsic value, the lower the risk.
- The bigger the discount to intrinsic value, the higher the return.
Economic and financial theory teaches that higher returns always require higher risk. But Ben Graham, the father of value investing, taught just the opposite: The lower the price you pay below intrinsic value, the lower your risk and the higher your return.
Mohnish argues that the Dhandho framework embodies Graham’s margin of safety idea. Papa Patel, Manilal, and Branson all have tried to minimize the downside while maximizing the upside. Again, most business schools, relying on accepted theory, teach that low returns come from low risk, while high returns require high risk.
Mohnish quotes Buffett’s observations about Berkshire’s purchase of Washington Post stock in 1973:
We bought all of our [Washington Post (WPC)] holdings in mid-1973 at a price of not more than one-fourth of the then per-share business value of the enterprise. Calculating the price/value ratio required no unusual insights. Most security analysts, media brokers, and media executives would have estimated WPC’s intrinsic business value at $400 to $500 million just as we did. And its $100 million stock market valuation was published daily for all to see. Our advantage, rather, was attitude: we had learned from Ben Graham that the key to successful investing was the purchase of shares in good businesses when market prices were at a large discount from underlying business value.
…Through 1973 and 1974, WPC continued to do fine as a business, and intrinsic value grew. Nevertheless, by year-end 1974 our WPC holding showed a loss of about 25%, with a market value of $8 million against our cost of $10.6 million. What we had bought ridiculously cheap a year earlier had become a good bit cheaper as the market, in its infinite wisdom, marked WPC stock down to well below 20 cents on the dollar of intrinsic value.
As of 2007 (when Mohnish wrote his book), Berkshire’s stake in the Washington post had grown over 33 years from the original $10.6 million to a market value of over $1.3 billion – more than 124 times the original investment. Moreover, as of 2007, the Washington Post was paying a modest dividend (not included in the 124 times figure). The dividend alone (in 2007) was higher than what Berkshire originally paid for its entire position. Buffett:
Most institutional investors in the early 1970s, on the other hand, regarded business value as of only minor relevance when they were deciding the prices at which they would buy or sell. This now seems hard to believe. However, these institutions were then under the spell of academics at prestigious business schools who were preaching a newly-fashioned theory: the stock market was totally efficient, and therefore calculations of business value – and even thought, itself – were of no importance in investment activities. (We are enormously indebted to those academics: what could be more advantageous in an intellectual contest – whether it be bridge, chess, or stock selection – than to have opponents who have been taught that thinking is a waste of energy?)
Most businesses either have problems or will have problems. Virtually every week there are companies or whole industries where stock prices collapse. Many business problems are temporary and not permanent. But stock investors on the whole tend to view business problems as permanent, and they mark down the stock prices accordingly.
You may be wondering: Due to capitalist competition, nearly all businesses eventually fail, so how can many business problems be temporary? When we look at businesses experiencing problems right now, many of those problems will be solved over the next three to five years. Thus, considering the next three to five years, many business problems are temporary. But the fate of a given business over several decades is a different matter entirely.
INVEST IN LOW-RISK, HIGH-UNCERTAINTY BUSINESSES
The future is always uncertain. And that’s even more true for some businesses. Yet if the stock price is low enough, high uncertainty can create a good opportunity.
Papa Patel, Manilal, Branson, and Mittal are all about investing in low-risk businesses. Nonetheless, most of the businesses they invested in had a very wide range of possible outcomes. The future performance of these businesses was very uncertain. However, these savvy Dhandho entrepreneurs 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… Their businesses had a common unifying characteristic – they were all low-risk, high-uncertainty businesses. (page 107)
In essence, says Mohnish, these were all simple bets:
Heads, I win; tails, I don’t lose much!
Wall Street usually hates high uncertainty, and often does not distinguish between high uncertainty and high risk. But there are several distinct situations, observes Mohnish, where Wall Street tends to cause the stock price to collapse:
- High risk, low uncertainty
- High risk, high uncertainty
- Low risk, high uncertainty
Wall Street loves the combination of low risk and low uncertainty, but these stocks nearly always trade at high multiples. On the other hand, Dhandho entrepreneurs and value investors are only interested in low risk and high uncertainty.
Mohnish discusses an example of a company he was looking at in the year 2000: Stewart Enterprises (STEI), a funeral service business. Leading companies such as Stewart Enterprises, Loewen, Service Corp. (SRV), and Carriage Services (CSV) had gone on buying sprees in the 1990s, acquiring mom-and-pop businesses in their industry. These companies all ended up with high debt as a result of the acquisitions. They made the mistake of buying for cash – using debt – rather than buying using stock.
Loewen ended up going bankrupt. Stewart had $930 million of long-term debt with $500 million due in 2002. Wall Street priced all the funeral service giants as if they were going bankrupt. Stewart’s price went from $28 to $2 in two years. Stewart kept coming up on the Value Line screen for lowest price-to-earnings (P/E) ratios. Stewart had a P/E of less than three, a rarity. Mohnish thought that funeral services must be a fairly simple business to understand, so he started doing research.
Mohnish recalled reading an article in the mid-1990s in the Chicago Tribune about the rate of business failure in various industries. The lowest rate of failure for any type of business was funeral homes. This made sense, thought Mohnish. It’s not the type of business that aspiring entrepreneurs would dream about, and pre-need sales often make up about 25 percent of total revenue. It’s a steady business that doesn’t change much over time.
Stewart had roughly $700 million in annual revenue and owned around 700 cemeteries and funeral homes. Most of its business was in the United States. Stewart’s tangible book value was $4 per share, and book value was probably understated because hard assets like land were carried at cost. At less than $2 per share, Stewart was trading at less than half of stated tangible book value. By the time the debt was due, the company would generate over $155 million in free cash flow, leaving a shortfall of under $350 million.
Mohnish thought through some scenarios and estimated probabilities for each scenario:
- 25% probability: The company could sell some funeral homes. Selling 100 to 200 might take care of the debt. Equity value > $4 per share.
- 35% probability: Based on the company’s solid and predictable cash flow, Stewart’s lenders or bankers might decide to extend the maturities or refinance the debt – especially if the company offered to pay a higher interest rate. Equity value > $4 per share.
- 20% probability: Based on Stewart’s strong cash flows, the company might find another lender – especially if it offered to pay a higher interest rate. Equity value > $4 per share.
- 19% probability: Stewart enters bankruptcy. Even assuming distressed asset sales, equity value > $2 per share.
- 1% probability: A 50-mile meteor comes in or Yellowstone blows or some other extreme event takes place that destroys the company. Equity value = $0.
The bottom line, as Mohnish saw it, was that the odds were less than 1% that he would end up losing money if he invested in Stewart at just under $2 per share. Moreover, there was an 80% chance that the equity would be worth at least $4 per share. So Mohnish invested 10 percent of Pabrai Funds in Stewart Enterprises at under $2 per share.
A few months later, Stewart announced that it had begun exploring sales of its international funeral homes. Stewart expected to generate $300 to $500 million in cash from this move. Mohnish:
The amazing thing was that management had come up with a better option than I had envisioned. They were going to be able to eliminate the debt without any reduction in their cash flow. The lesson here is that we always have a free upside option on most equity investments when competent management comes up with actions that make the bet all the more favorable. (page 115)
Soon the stock hit $4 and Mohnish exited the position with more than 100% profit.
It’s worth repeating what investor Lee Ainslee has said: Good management tends to surprise on the upside, while bad management tends to surprise on the downside.
In 2001, Mohnish noticed two companies with a dividend yield of more than 15 percent. Both were crude oil shippers: Knightsbridge (VLCC) and Frontline (FRO). Mohnish started reading about this industry.
Knightsbridge had been formed a few years earlier when it ordered several tankers from a Korean shipyard. A very large crude carrier (VLCC) or Suezmax at the time cost $60 to $80 million and would take two to three years to be built and delivered. Knightsbridge would then lease the ships to Shell Oil under long-term leases. Shell would pay Knightsbridge a base lease rate (perhaps $10,000 a day per tanker) regardless of whether it used the ships or not. On top of that, Shell paid Knightsbridge a percentage of the difference between a base rate and the spot market price for VLCC rentals, notes Mohnish. So if the spot price for a VLCC was $30,000 per day, Knightsbridge might receive $20,000 a day. If the spot was $50,000, it would get perhaps $35,000 a day. Mohnish:
At the base rate, Knightbridge pretty much covered its principal and interest payments for the debt it took on to pay for the tankers. As the rates went above $10,000, there was positive cash flow; the company was set up to just dividend all the excess cash out to shareholders, which is marvelous…
Because of this unusual structure and contract, when tanker rates go up dramatically, this company’s dividends go through the roof. (page 124)
In investing, all knowledge is cumulative. I didn’t invest in Knightsbridge, but I did get a decent handle on the crude oil shipping business. In 2001, we had an interesting situation take place with one of these oil shipping companies called Frontline. Frontline is the exact opposite business model of Knightsbridge. It has the largest oil tanker fleet in the world, among all the public companies. The entire fleet is on the spot market. There are very few long-term leases.
Because it rides on the spot market on these tankers, there is no such thing as earnings forecasts or guidance. The company’s CEO himself doesn’t know what the income will be quarter to quarter. This is great, because whenever Wall Street gets confused, it means we likely can make some money. This is a company that has widely gyrating earnings.
Oil tanker rates have ranged historically from $6,000 a day to $100,000 a day. The company needs about $18,000 a day to breakeven… Once [rates] go above $30,000 to $35,000, it is making huge profits. In the third quarter of 2002, oil tanker rates collapsed. A recession in the United States and a few other factors caused a drop in crude oil shipping volume. Rates went down to $6,000 a day. At $6,000 a day Frontline was bleeding red ink, badly. The stock went from $11 a share to around $3, in about three months. (pages 124-125)
Mohnish notes the net asset value of Frontline:
Frontline had about 70 VLCCs at the time. While the daily rental rates collapsed, the price per ship hadn’t changed much, dropping about 10 percent or 15 percent. There is a fairly active market in buying and selling oil tankers. Frontline had a tangible book value of about $16.50 per share. Even factoring in the distressed market for ships, you would still get a liquidation value north of $11 per share. The stock price had gone from $15 to $3… Frontline was trading at less than one-third of liquidation value.
Keep in mind that Frontline could sell a ship for about $60 million, and the company had 70 ships. Frontline’s annual interest payments were $150 million. If it sold two to three ships a year, Frontline could sustain the business at the rate of $6,000 a day for several years.
Mohnish also discovered that Frontline’s entire fleet was double hull tankers. All new tankers had to be double hull after 2006 due to regulations following the Exxon Valdez spill. Usually single hull tankers were available at cheaper day rates than double hull tankers. But this wasn’t true when rates dropped to $6,000 a day. Both types of ship were available at the same rate. In this situation, everyone would rent the double hull ships and no one rented the single hull ships.
Owners of the single hull ships were likely get jittery and to sell the ships as long as rates stayed at $6,000 a day. If they waited until 2006, Mohnish explains, the ability to rent single hull ships would be much lower. And by 2006, scrap rates might be quite low if a large number of single hull ships were scrapped at the same time. The net result is that there is a big jump in scrapping for single hulled tankers whenever rates go down. Mohnish:
It takes two to three years to get delivery of a new tanker. When demand comes back up again, inventory is very tight because capacity has been taken out and it can’t be added back instantaneously. There is a definitive cycle. When rates go as low as $6,000 and stay there for a few weeks, they can rise to astronomically high levels, say $60,000 a day, very quickly. With Frontline, for about seven or eight weeks, the rates stayed under $10,000 a day and then spiked to $80,000 a day in fourth quarter 2002. The worldwide fleet of VLCCs in 2002 was about 400 ships. Over the past several decades, worldwide oil consumption has increased by 2 percent to 4 percent on average annually. This 2 percent to 4 percent is generally tied to GDP growth. Usually there are 10 to 12 new ships added each year to absorb this added demand. When scrapping increases beyond normal levels, the fleet is no longer increasing by 2 percent to 4 percent. When the demand for oil rises, there just aren’t enough ships. The only thing that’s adjustable is the price, which skyrockets. (page 127)
Pabrai Funds bought Frontline stock in the fall of 2002 at $5.90 a share, about half of liquidation value of $11 to $12. When the stock moved up to $9 to $10, Mohnish sold the shares. Because he bought the stock at roughly half liquidation value, this was a near risk-free bet: Heads, I win a lot; tails, I win a little!
Mohnish gives a final piece of advice:
Read voraciously and wait patiently, and from time to time amazing bets will present themselves. (page 129)
Important Note: Had Mohnish kept the shares of Frontline, they would have increased dramatically. The shares approached $120 within a few years, so Mohnish would have made 20x his initial investment at $5.90 per share had he simply held on for a few years.
Mohnish recently gave a lecture at Peking University (Guanghua School of Management) about 10-baggers to 100-baggers, giving many examples of stocks like Frontline that he had actually owned but sold way too soon. Link: https://www.youtube.com/watch?v=Jo1XgDJCkh4
A SHORT CHECKLIST
Mohnish gives a list of good questions to ask before buying a stock:
- Is it a business I understand very well – squarely within my circle of competence?
- 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?
- Is the business priced at a large discount to its intrinsic value today and in two to three years? Over 50 percent?
- Would I be willing to invest a large part of my net worth into this business?
- Is the downside minimal?
- Does the business have a moat?
- Is it run by able and honest managers?
If the answers to these questions are yes, buy the stock. Furthermore, writes Mohnish, hold the stock for at least two to three years before you think about selling. This gives enough time for conditions to normalize and thus for the stock to approach intrinsic value. One exception: If the stock increases materially in less than two years, you can sell, but only after you have updated your estimate of intrinsic value.
In any scenario, you should always update your estimate of intrinsic value. If intrinsic value is much higher than the current price, then continuing to hold is almost always the best decision. One huge mistake to avoid is selling a stock that later becomes a 10-bagger, 20-bagger, or 100-bagger. That’s why you must always update your estimate of intrinsic value. And don’t get jittery just because a stock is hitting new highs.
A few more points:
- If you have a good investment process, then about 2/3 of the time the stock will approach intrinsic value over two to three years. 1/3 of the time, the investment won’t work as planned – whether due to error, bad luck, or unforeseeable events – but losses should be limited due to a large margin of safety having been present at the time of purchase.
- In the case of distressed equities, there may be much greater potential upside as well as much greater potential downside. A few value investors can use this approach, but it’s quite difficult and typically requires greater diversification.
- For most value investors, it’s best to stick with companies with low or no debt. You may grow wealth a bit more slowly this way, but as Buffett and Munger always ask, what’s the rush? Buffett and Munger had a friend Rick Guerin who owned a huge number of Berkshire Hathaway shares, but many of the shares were on margin. When Berkshire stock got cut in half – which will happen occasionally to almost any stock, no matter how good the company – Guerin was forced to sell much of his position. Had Guerin not been on margin, his non-margined shares in Berkshire would later have been worth a fortune (approaching $1 billion).
- Your own mistakes are your best teachers, explains Mohnish. You’ll get better over time by studying your own mistakes:
While it is always best to learn vicariously form the mistakes of others, the lessons that really stick are ones we’ve stumbled through ourselves. (page 165)
Warren Buffett and Bill Gates are giving away most of their fortune to help many people who are less fortunate. Bill Gates devotes much of his time and energy (via the Gates Foundation) to saving as many human lives as possible.
Mohnish Pabrai and his wife started the Dakshana Foundation in 2005. Mohnish:
I do urge you to leverage Dhandho techniques fully to maximize your wealth. But I also hope that… you’ll use some time and some of that Dhandho money to leave this world a little better place than you found it. We cannot change the world, but we can improve this world for one person, ten people, a hundred people, and maybe even a few thousand people. (page 183)
BOOLE MICROCAP FUND
An equal weighted group of micro caps generally far outperforms an equal weighted (or cap-weighted) group of larger stocks over time. See the historical chart here: http://boolefund.com/best-performers-microcap-stocks/
This outperformance increases significantly by focusing on cheap micro caps. Performance can be further boosted by isolating cheap microcap companies that show improving fundamentals. We rank microcap stocks based on these and similar criteria.
There are roughly 10-20 positions in the portfolio. The size of each position is determined by its rank. Typically the largest position is 15-20% (at cost), while the average position is 8-10% (at cost). Positions are held for 3 to 5 years unless a stock approaches intrinsic value sooner or an error has been discovered.
The goal of the Boole Microcap Fund is to outperform the Russell Microcap Index over time, net of fees. The Boole Fund has low fees.
If you are interested in finding out more, please e-mail me or leave a comment.
My e-mail: firstname.lastname@example.org
Disclosures: Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Boole Capital, LLC.