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If you have ever attended a class in finance, you probably recognized the idea that, to get higher investment returns,
you need to take higher investment risk.
In The Dhandho Investor, a book written by Mohnish Pabrai,
you will learn that this is not necessarily the case.
It is possible to get high returns with low risk,
and this is what Dhandho investing is all about.
It’s about investing only in opportunities where we can achieve the following asymmetry:
Heads: I win.
Tails: I don’t lose much.
Let’s dive in!
Takeaway number 1: The Dhandho framework
Alright, so how can I achieve this?? It sounds too good to be true!
I’m glad you asked!
And no, it’s not.
Here’s the Dhandho framework.
Nine principles that will guide you in making these heads: I win, tails: I don’t lose much, bets.
- Focus on buying existing businesses
The asset class that you’ll want to focus on is stocks.
It’s the best performing one over longer time frames, and it is less risky than creating your own startup.
- By simple businesses, in industries with slow rate of change
According to Warren Buffett,
change is the enemy of investments. Will Coca-cola and McDonald’s exists 50 years from now?
Well, most likely, we will probably have to eat and drink even then.
Will Facebook and Netflix exist 50 years from now?
Moreover you have to narrow your investing down to simple businesses,
businesses that you understand.
Otherwise you are speculating, not investing.
- Buy distressed businesses in distressed industries
“Be fearful when others are greedy, and greedy when others are fearful.”
- Buy businesses with a durable competitive advantage
Beware of businesses that don’t possess a competitive advantage over other actors within the same industry.
Companies that do not fulfill this may lose their profits rapidly, which is a terrible situation for you as the stock owner.
- Bet heavily when the odds are overwhelmingly in your favor
Don’t be afraid to bet big when you find the right opportunities.
The stock market is efficient, but only for most of the time.
Bet big when you have the odds, the rest of the time, you should sit still.
- Focus on arbitrage
An arbitrage is a situation in which there is a risk-free profit in the market, after transaction costs.
This is Dhandho on steroids. It’s heads: I win, tails: I break even or win.
Uncommon, but still possible.
- Buy businesses with a big discount to their underlying value
We’ve talked about this many times before, have a look at my summary of The Intelligent Investor, for instance.
It’s Benjamin Graham’s margin of safety that Mohnish Pabrai is referring to here.
Don’t buy anything in the market without this margin.
There’s always a risk that you’re wrong – factor this in before buying.
- Look for low risk, high uncertainty businesses
Risk and uncertainty are NOT the same thing.
An investment can have a wide range of possible future outcomes,
but the risk of taking a large permanent loss investing in such opportunities, may still be very low.
- It’s better to be a copycat than an inventor
Mohnish Pabrai argues that it’s better to invest in the copycats rather than the inventors.
Buying companies that are implementing previously proven business models can be very profitable.
Especially if they are better at executing than the competitors.
Takeaway number 2. Investing is all about the odds
Imagine that you have $25 and that you’re asked to place a bet on a coin flip with the following probabilities and payouts:
Heads: Probability: 60%, payout: doubling your bet.
Tails: Probability: 40%, payout: losing your bet.
How much would you be willing to wager of your total $25 on this coin flip?
I mentioned earlier that you must be willing to bet big when great opportunities present themselves.
This is such a case.
As Charlie Munger expresses it:
“We look for the horse with one chance in two of winning,
which pays you three to one. You’re looking for a mispriced gamble, that’s what investing is.”
But how much should you bet?
Clearly, you cannot risk your whole account on this coin flip, as there’s a solid 40% chance of losing it all.
If you repeat that with multiple bets like this, you are pretty much guaranteed to go broke at some point.
An interesting study was made with a coin like this, where participants were asked to bet for 30 minutes, being able to place approximately
300 bets in total.
Amazingly, as many as
28% of them went bust, and a staggering
66% decided to bet on tails at some point during the experiments.
Luckily, you won’t be one of them after this takeaway as, given the odds of an investment,
there is an optimal amount to bet, and this can be calculated using the Kelly formula.
How much did you guess before?
Well, according to Kelly, the answer is 20% of your total account during each flip, or
$5 for the first bet.
The Kelly formula is calculated using the following equation:
Try Google “Kelly criterion calculator multiple outcomes”, if you want to learn more and do some testing.
I did a Monte Carlo simulation of this experiment but I use 20 tosses instead of 300.
When I simulated that 100 people were participating and betting 20% of their account in each flip,
these were the results:
Clearly, using the betting size suggested by the Kelly formula is not for the faint of heart.
The worst-performing of the 100 participants had an account size of just $3 at the end of the experiment.
I imagine that most investors would probably have left the markets altogether with such a downswing.
Therefore, it’s common practice to use a “fraction Kelly”, perhaps decide to bet just 25% of what Kelly suggests.
Takeaway number 3: DCF analysis
Okay. So using the Kelly formula sounds simple enough, in theory.
But how do you know what the payout is when that is not given?
I’m sorry to tell you this, but there is no easy way.
Deciding the intrinsic value, which could be compared to the potential payout of a company, is not an exact science,
and it involves a lot of guesswork.
We’ve talked about the net current asset strategy used by Benjamin Graham as one example of deciding the underlying value of a business.
Let me now present another one: the DCF analysis.
DCF stands for “discounted cash flow”.
Ultimately, the only reason why a business is worth anything, is because it’s expected to generate a cash flow to its owners in the future.
And would you rather be paid $1,000 today or $1,000 in ten years?
I thought so, that is the reason why we need to discount the cash flows.
For example, if we think that $1,000 today is worth, say
$1,050 next year, we can use a 5% discount rate.
If we could invest in a business that will definitely generate
$1,000 in cash flow per year, for the next ten years,
it would be valued at $7,700 according to DCF analysis, using 5%.
investing in the stock market never comes with such a guarantee of cash flows, and
therefore, most investors require more than $1,050 next year for $1,000 invested in a business today.
Say that perhaps
$1,100 is sufficient. If we think that, we use a 10% discount rate instead.
The same business as mentioned before would now be worth just $6,100 in today’s value.
You probably understand why you must only focus on simple businesses now.
Estimating future cash flows is difficult enough as it is,
doing it for a business in a complicated industry, that you do not understand, is impossible.
A helpful guideline is to never estimate the cash flow more than ten years into the future.
Also, if you want to estimate a selling price in year, ten, never use a higher p/e ratio than 15.
Takeaway number 4: Look for low risk, high uncertainty businesses
Would you like to invest in this?
10% chance of returning 1,000%
40% chance of returning 300%
40% chance of returning -20%
10% chance of returning -100%
You should want to. And according to Kelly, you should bet big.
75% of your account would be optimal.
However, many masters would not take this bet when faced with its shrouded version in the stock market.
Because of uncertainty.
Mohnish Pabrai states that:
“Wall Street, sometimes gets confused between risk and uncertainty and you can profit handsomely from that confusion.”
What you should avoid in the stock market is not uncertainty or volatility.
What you should avoid is a large permanent loss,
or a streak of permanent losses, that is enough to take you out of the investing game.
Wall Street loves low risk and low uncertainty, and therefore such stocks can almost never be found at bargain prices.
What they want to see is something like this:
90% chance of returning 10%
9% chance of returning 100%
1% chance of returning – 100%
But they would shy away from the opportunity presented before, because of its higher volatility.
Calculate a DCF for different scenarios,
perhaps an aggressive, a standard and a conservative estimate for the future of the business that you want to invest in.
Assign probabilities to each outcome.
Don’t be afraid to bet big if the Kelly formula suggests it,
even if the uncertainty is high.
Takeaway number 5. The art of selling
Making investment is just half of the battle.
Having an exit plan is just as important, and you should have one before you go into an investment.
Here’s Mohnish Pabrai’s most important rule regarding selling:
“Any stock that you buy cannot be sold at a loss within two to three years of buying it,
unless you can say with a high degree of certainty,
that the current intrinsic value is less than the price that the market is offering.”
The market prices of stocks can change within minutes, but real business changes take months, if not years.
Don’t submit to the bipolar behavior of Mr. Market,
unless you can state with a high degree of certainty that you agree with him.
You must give your investments enough time to reach their intrinsic value.
Simultaneously though, the cost of waiting is very real. So you cannot postpone the decision to sell forever.
A two to three years period is a good balance between these two conflicting arguments.
After three years, all shackles are off though. By then, you can (and probably should) sell at any
reasonable price possible, even if it doesn’t agree with your calculated intrinsic value.
After all, you could be wrong.
Here’s a quick summary:
Follow the Dhandho framework.
Size your bets using odds and the Kelly formula, or a predetermined fraction of Kelly.
Calculate the underlying value of a business using a DCF analysis.
Look for investments with a wide range of possible outcomes.
People are generally afraid of making such investments which results in lower prices than warranted.
Allow your investments sufficient time to reach their intrinsic value, but realize that there’s also a cost of waiting.
Sometimes you have to admit that you’re wrong and take a loss.