Mohnish Pabrai’s Lessons In The Dhandho Of Investing

Mohnish Pabrai, Indian-American investor, author, and founder and managing partner of Pabrai Investment Funds, is famous primarily for his value investing approach, which draws heavily from the philosophies of investing legends Warren Buffett and Charlie Munger. His ability to simplify complex investment principles and apply them to real-world scenarios has made him a well-regarded figure in the investing world.

Pabrai gained widespread attention for achieving extraordinary returns with Pabrai Investment Funds, a hedge fund modelled on Buffett’s partnerships in the 1950s. He started the fund in 1999 and managed to outperform the S&P 500 for several years.

Another reason for his fame is his book, The Dhandho Investor, which has become a go-to guide for those interested in value investing and are looking for something simple to start with. Finally, his close alignment with Buffett’s principles, including his successful bid to have a charity lunch with Buffett in 2007 for over $650,100 also added to his fame.

Investing Principles

In The Dhandho Investor, Pabrai emphasises the importance of minimising risk while maximising returns, echoing the teachings of Buffett and Benjamin Graham, but with a unique twist.

His use of real-world examples, such as the business models of the Patel community in the US, makes the concepts both relatable and applicable to a wide audience.

Here are the nine key principles set in the book creating the Dhandho framework:

1. Invest In Existing Businesses

2. Invest In Simple Businesses

3. Invest In Distressed Businesses In Distressed Industries

4. Invest In Businesses With Durable Moats

5. Have Few Bets, Big Bets And Infrequent Bets

While the first five are self-explanatory, the next four require explanations.

6. Focus On Arbitrage: Arbitrage is the act of taking advantage of the difference in prices. His book, The Dhandho Investor, explains four types of arbitrage.

(a) Commodity Arbitrage: He asks investors to buy a commodity in one place and sell it in another place and pocket the difference between them. For instance, gold prices between London and New York have differences even after taking into account tax, transaction, and transportation costs. So, it makes sense to buy it where it is cheaper and sell it where it is costlier as you can make a profit.

(b) Correlated Stock Arbitrage: Let’s understand this through an example. Sometimes there are differences in prices of the same stock on the Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE). Therefore, one can buy from the exchange where it is cheaper and sell it on the exchange where it is relatively expensive, thus pocketing the profit.

(c) Merger Arbitrage: This happens when two companies are merging and there are differences in the price between the two shares even after adjusting for the exchange value. Unlike other forms of arbitrage previously discussed, this one involves risk, which is why it’s often referred to as “risk arbitrage”. Statistics show that a significant percentage of announced mergers fail to close due to issues, such as lack of government or shareholder approval. By understanding the factors, you can assess the likelihood of the deal going through and decide whether to place a bet accordingly.

(d) Dhandho Arbitrage: This involves making low-risk, high-reward investments by exploiting temporary mispricing or imbalances. It focuses on minimising downside risk while maximising potential gains, often by investing in distressed companies or special situations with a high probability of recovery or success.

7. Focus On Margin Of Safety (minimising downside and maximising upside): Margin of safety means investing in something that’s priced much lower than its true value, thus giving you a cushion if things go wrong. It helps protect your investment by reducing the risk of losing money, as you are buying with a built-in “safety net” between price and value.

8. Invest In A Low-Risk, High Uncertainty Business: Investing in a low-risk, high-uncertainty business means putting money into companies that have a stable foundation, but face unpredictable situations. They might be going through temporary challenges, thereby creating uncertainty about the future. However, they still carry low risk because they have solid assets, reliable cash flow, or a strong market position.

9. Invest In The Copy-Cats Rather Than Innovators: Investing in copy-cats rather than innovators means putting money into businesses that take existing successful ideas and improve or replicate them, instead of those trying to create something entirely new. Innovators take big risks by developing new products or technologies, which can fail. Copy-cats can learn from these pioneers and avoid their mistakes, which makes their businesses safer.

When to sell and how many stocks to own?

When it comes to selling a stock, Pabrai prescribes two simple rules.

First, sell a stock when the price offered is higher than the present or future estimated intrinsic value. Second, 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 current price the market is offering.

On how many stocks to own, in principle 5 (as stated earlier), Pabrai suggests investing the majority (perhaps 50-80 per cent) of the portfolio in 5-10 great ideas.

Evolving Ideas

After reading his book and listening to his interviews, it seems that his approach has evolved with time.

The first notable change is global investing. While, initially, all his investments were in the US, he now invests all over the world.

Second, he is more focused on cloning, taking ideas from other investors, and applying his own valuation perspective.

By studying the portfolios and investment decisions of top investors, he can replicate their success without reinventing the wheel. This approach minimises research time and reduces the chances of making costly errors.

Third, Pabrai’s approach to investing has shifted from a purely value-based strategy to a blended approach of looking for growth opportunities with a value bent.

In one of his recent talks, he also highlighted the importance of growth in businesses.

While appreciating the changes that he advocates is important, it is equally important to understand what has remained constant in his investing philosophy, most notably, the Dhandho framework.

*Investments in securities markets are subject to market risks, consult a Sebi-registered investment advisor before investing.

The author is a Sebi-registered research analyst and a financial writer