The Dhandho Investor

Mohnish Pabrai · 2007

Thesis

The highest returns come not from taking big risks but from bets where the downside is small and the upside large, a principle Mohnish Pabrai draws from Gujarati Patel motel owners and applies to investing through a short framework: buy simple, existing, distressed businesses with durable moats at a large discount, bet rarely but heavily, and favor copycats over innovators.

The main ideas

Dhandho, a Gujarati word, means endeavors that create wealth. Its essence is minimizing risk while maximizing return.
The ideal bet pays off well if it succeeds and loses little if it fails.
Invest in existing, simple businesses rather than speculative new ones.
Distressed businesses in distressed industries are often priced far below their value.
Low risk and high uncertainty are different things. The market confuses them, which creates bargains.
Make few bets, big bets and infrequent bets, sized by the odds, and always with a margin of safety.
Copycats who adopt proven ideas often earn more than the innovators.

The Patel motels

Mohnish Pabrai, an engineer who founded an IT consulting firm in 1991 and then the investment partnership Pabrai Investment Funds in 1999, modeled on Warren Buffett's early partnerships, opens with the Patels, a Gujarati community from India whose families came to own roughly half of America's motels.

His account of their method is the book's foundation. A Patel family buys a struggling motel cheaply, often during a downturn, borrowing most of the price. The family lives on the premises and runs it themselves, so their costs are lower than any competitor's. They can charge less, fill more rooms and generate cash even when the business is weak. If the motel fails, the family loses its small down payment; if it succeeds, the return on that down payment is very large.

Pabrai calls this Dhandho, a Gujarati word for endeavors that create wealth, and summarizes the attitude in the line he uses throughout: heads, I win; tails, I don't lose that much.

Implication: before any investment, ask what you lose if it fails and what you gain if it succeeds. Look for situations where the second is much larger than the first.

Low risk, high uncertainty

Pabrai's central distinction is between risk and uncertainty. Risk is the chance of permanent loss; uncertainty is how unpredictable the outcome is. Markets often treat high uncertainty as high risk and price such businesses cheaply, even when the chance of permanent loss is small.

His examples come from outside the stock market. Richard Branson started Virgin Atlantic with a secondhand Boeing 747 that Boeing agreed to lease him for a year, limiting his loss if the airline failed while leaving him the full upside if it succeeded. Lakshmi Mittal built a steel empire by buying mills, often distressed and state-owned, for a fraction of what they had cost to build.

The mechanism is that investors flee uncertainty, so situations whose outcomes are hard to predict but whose downside is protected sell at prices that offer high expected returns.

Implication: do not avoid an investment because its future is hard to predict. Avoid it only if the downside is large.

The framework

Pabrai organizes the method into nine principles. Invest in existing businesses, with records that can be examined, rather than start-ups. Invest in simple businesses that can be understood. Invest in distressed businesses in distressed industries, where pessimism depresses prices. Invest in businesses with durable moats, competitive advantages that protect their returns.

Make few bets, big bets and infrequent bets. Fixate on arbitrage, situations where a price gap is likely to close. Insist on a margin of safety, always: buy at a large discount to value, following Benjamin Graham. Invest in low-risk, high-uncertainty businesses. Invest in the copycats rather than the innovators.

The last principle reflects the Patels themselves, who copied a business model that worked rather than inventing a new one. Innovators bear the cost of experimentation; copycats adopt what has been proven.

Implication: run any prospective investment through the nine principles as a checklist, and be suspicious of those that fail several of them.

Few bets, big bets

Pabrai argues against wide diversification. An investor who finds a situation with a strongly favorable balance of odds should bet heavily on it, and should wait patiently for such situations rather than investing constantly.

He uses the Kelly formula, a mathematical rule from gambling theory for sizing bets according to the odds and payoff, to show how much an investor should commit when the odds are favorable.

His chapters on selling and on index funds complete the method. The selling chapter, named after Abhimanyu, a warrior in the Mahabharata who knew how to enter a battle formation but not how to leave it, addresses the hardest decision in investing: when to get out.

Implication: concentrate capital in the few opportunities where the odds are clearly in your favor, and keep the rest of the time for waiting.

Limits

Its own record shows the cost of concentration. Pabrai's funds compounded at more than 29 percent a year from 1999 to mid-2007, but by his own later account fell by about two-thirds from the 2007 peak to the bottom in March 2009.
Its sizing rule depends on estimates that are hard to make. The Kelly formula assumes the odds are known, but an investor's estimates of value and probability can be badly wrong, and betting heavily on a wrong estimate magnifies the loss.
Its examples are selected successes. The Patel motels, Branson and Mittal are cases that worked; the book does not examine families, entrepreneurs or investors who followed the same approach and failed.

The Intelligent Investor — the margin of safety at the center of Pabrai's framework.
The Essays of Warren Buffett — the investor Pabrai models his partnership and his concentrated bets on.
Safe Haven + The Dao of Capital — another argument for structuring bets around asymmetric payoffs.