We would only commit up to 40% of our total assets under exceptionally rare circumstances. Precisely because such opportunities are rare, when we identify one, we must concentrate our efforts and place a large bet. Mohnish Pabrai gained fame in 2007 by paying $650,000 for a charity lunch with Warren Buffett. That same year, he published his book "The Dhandho Investor." According to his explanation, "Dhandho" is a Gujarati word from India, literally meaning "endeavors that create wealth." From this, Pabrai developed the concept of "Dhandho investing," his own unique model of "low-risk, high-return" investing.
Pabrai observed that some members of the Patel community from Gujarat, India, who immigrated to the United States in the 1970s, started with nothing and eventually came to own over $40 billion in motel assets in the U.S. Their operational model focused on maximizing returns while minimizing risk—essentially, "low-risk, high-return." Therefore, the best interpretation of "Dhandho" is "endeavors that create wealth with almost no risk." This concept challenges the "traditional wisdom" that earning high returns requires taking on high risk.
Pabrai believes that not only should every entrepreneur strive to learn from the Patels' low-risk, high-return investment model, but capital investors and allocators should be at the forefront of adopting this approach. Dhandho investing represents the optimal method of capital allocation. If investors can achieve above-average returns with essentially no risk and continue to do so repeatedly, they can generate astonishing results.
In his book, Pabrai illustrates the nine principles of this "low-risk, high-return" model through four case studies. These principles include: 1) Invest in existing businesses. 2) Invest in simple businesses. 3) Invest in distressed businesses within distressed industries. 4) Invest in businesses with durable competitive advantages. 5) Place few bets, make them large bets, and make them infrequent bets. 6) Focus on arbitrage. 7) Always seek a margin of safety. 8) Invest in low-risk, highly uncertain businesses. 9) Invest in copycat businesses, not innovative ones.
**01 The Low-Risk, High-Return Model** While outlining the principles of Dhandho's "low-risk, high-return" investment model, Pabrai also demonstrates his understanding of the fundamental principles and practical cases of value investing.
The Efficient Market Hypothesis (EMH) posits that all known information about publicly traded companies is reflected in their stock prices. Therefore, securities analysts' efforts to estimate a company's intrinsic value are largely futile. Factoring in frictional costs, proponents of EMH argue that stock picking is not just a "zero-sum game" but a "negative-sum game."
However, by 2007, Warren Buffett had been selectively investing in stocks for 56 years using a "cherry-picking" approach, amassing a stock portfolio worth over $40 billion. Despite this, Pabrai largely agrees with the EMH. Stock prices do generally reflect the fundamental realities of most companies. Therefore, for the majority of companies, trying to estimate the gap between their stock price and their intrinsic value is usually "a waste of time."
Markets are mostly efficient, but there is a significant difference between mostly efficient and perfectly efficient. It is precisely this crucial distinction that prevents someone like Buffett from ending up as a street beggar. In his 1988 letter to shareholders, Buffett offered a classic critique of the EMH. He stated that after correctly observing that markets are usually efficient, EMH scholars and Wall Street practitioners then incorrectly concluded that markets are always efficient. The difference between these two statements is like night and day.
Indeed, markets are not perfectly efficient because they are operated by people within an auction-based pricing system. People are swayed by the twin emotions of extreme fear and extreme greed. When a group is gripped by extreme fear, asset values can fall below their intrinsic worth. Conversely, when people are extremely greedy, stock prices can become very inflated.
If the owners of a company are extremely pessimistic and fearful about its future and decide to sell their shares, it typically takes them months to complete the sale. During this period, the circumstances causing the fear may ease, or rational thought may regain dominance over time. In the stock market, however, an individual investor feeling gloomy about the prospects might sell all their shares in minutes. Therefore, stock prices fluctuate more frequently than the underlying intrinsic value changes.
Psychological factors have a far greater impact on trading shares of a company on the stock market than on the acquisition of the entire company. Pabrai hypothesizes a character in the stock market named Ben Graham—a creation of the real Benjamin Graham—who makes a living from stocks, is active and emotional. He buys and sells small amounts of shares in thousands of companies every few seconds. His decision to buy or sell is not based on the company's intrinsic value but on his mood. Rapid mood swings lead to rapid price changes.
This pari-mutuel method of pricing in the stock market is vastly different from the pricing method used in the sale of an entire business. Thousands of stocks are traded rapidly, and frequently, significant negative news emerges about some of them. This often leads to extreme market fear and heavy selling of those stocks. When a seller dumps a stock, there is a buyer waiting to purchase it. That buyer is just as aware of the negative news as the seller. The only condition under which the stock can be sold is if its price is sufficiently low. This presents a significant opportunity for Dhandho investors.
The Patels focused on acquiring distressed businesses and ultimately prospered. They typically made acquisitions when an entire industry was suffering heavy losses, such as the motel industry after 9/11 or the steel industry on the brink of bankruptcy in the 1980s and 1990s. Many investment stars, like Seth Klarman, Lou Simpson, and Martin Whitman, do not necessarily focus solely on distress but invariably focus on value. Distress is one aspect of value investing, so many of their investments are in distressed businesses. In this regard, they are all inheritors of Graham's philosophy.
**02 No Impregnable Moats** Businesses with durable competitive advantages are a central focus of Dhandho investing. Generally, such companies can sustain above-average profits for at least 10 years or longer. Some have deep and wide advantages, like American Express and Coca-Cola. Others have shallower advantages or have lost them, like General Motors and encyclopedia publishers. There are also companies with potential advantages that are hidden or not yet apparent.
Successful businesses with significant advantages earn high returns on invested capital. Such companies possess wide and deep "economic moats." The concept of an economic moat was introduced by Buffett in his 1993 letter to shareholders and has been refined over time. The moat is a wonderful castle surrounded by a deep, dangerous moat. The castle's owner is an honest and noble person, and the castle's primary source of strength is the owner's brilliant mind. The moat permanently serves as a barrier against attacking enemies. The castle owner produces gold but does not keep it all for himself. Buffett favors dominant large companies whose franchises are difficult to replicate and possess great or permanent staying power.
Of course, no castle is impregnable forever. Even companies that seem unassailable today, like Google, Microsoft, Toyota, and American Express, may eventually decline or disappear. Companies with weak or vanished advantages once had very strong castles but have gradually declined over time, just as the most well-defended castle eventually falls to enemies. Charlie Munger once commented on this, noting that of the 50 most important stocks on the New York Stock Exchange in 1911, only General Electric remains today. This illustrates the powerful force of competitive destruction.
From a long-term historical perspective, the likelihood of a company surviving indefinitely as its owners might hope is extremely small. Some companies' competitive advantages are relatively more durable. Wells Fargo and American Express were both founded over 150 years ago, and both companies' advantages remain very strong today. However, if an investor were picking stocks 100 years ago, it would have been impossible to select these two from the myriad choices. Moreover, even if they picked the bluest of blue chips, those stocks would very likely have eventually perished.
In 1997, Arie de Geus wrote an excellent book, "The Living Company." Studying the lifespans of companies of various sizes, he was surprised to find that the average lifespan of a Fortune 500 company is generally only 40-50 years. It takes about 25-30 years for a company to form and grow into a successful Fortune 500 member. He also found that many blue-chip companies typically last less than 20 years from their IPO to their demise. Fortune 500 companies have often passed their peak growth phase by the time they go public.
Even companies with durable advantages cannot exist forever. Therefore, when using John Burr Williams' method to calculate a company's intrinsic value, one should appropriately lower expectations for the company's continued prosperity. It is best not to include discounted cash flows beyond 10 years or to assume a terminal value multiple of more than 15 times the cash flow in year 10. Williams first proposed the method for estimating intrinsic value in his 1938 book, "The Theory of Investment Value." He believed a company's intrinsic value is determined by the expected cash inflows and outflows during its remaining life, discounted at an appropriate interest rate.
**03 A Principle Similar to the Kelly Criterion** An important principle of Dhandho investing is to place few bets, make them large bets, and make them infrequent bets. This principle shares remarkable similarities with the Kelly Criterion. To understand the Kelly Criterion, the best treatise is William Poundstone's "Fortune's Formula."
The Kelly Criterion avoids ruin through "fractional" bet sizing. One must divide the total capital available for betting into many fractions and bet only a fraction on each wager. Since each bet uses only a portion of the total capital, one never runs out of money entirely, thus avoiding total loss. Operating by the Kelly Criterion, wealth can grow geometrically, which is the result of fractional betting. As the principal grows, the bet size increases accordingly. If a person has an edge in a wager, over the long term, they will naturally win more than they lose because each win is added to the principal and used for subsequent bets. Therefore, the simplest expression of the Kelly Criterion is: bet heavily when you have an edge; do not bet, or bet very little, when you have no edge.
Suppose one employs the "low-risk, high-return" investment method and finds a publicly traded existing business with a simple operating model that is currently in a temporary downturn, with its stock price depressed. Fortunately, it is a company with a durable competitive advantage and is within one's circle of competence. We calculate its current intrinsic value and its likely intrinsic value in two to three years, finding that the current stock price is less than half of the projected future intrinsic value. But how can the stock price align with intrinsic value in a few years? On this, Graham once said, "In the short run, the market is a voting machine but in the long run, it is a weighing machine." Experience shows me that market price and intrinsic value eventually converge. When tail events occur, stock prices can be severely impacted in the short term but subsequently rebound. Sudden crises in the business world, like Johnson & Johnson's Tylenol scare, Exxon's Valdez oil spill, and American Express's "salad oil scandal" in the 1960s, share similar characteristics. The panic and fear from these tail events immediately caused sharp stock price declines. But after some time, as rationality returned, the stock prices recovered to more reasonable levels.
Whether investing in companies whose stock prices are too low or too high, the stock price will fluctuate around the company's intrinsic value, creating certain profits and losses. We can fully regard this as an investment law and abide by it. Thus, if we can estimate a company's intrinsic value two to three years from now and can purchase its shares now at a significant discount, we can ensure a profit.
As for how much to invest, the Kelly Criterion is a useful reference. However, using the Kelly Criterion for investment can lead to relatively high volatility. The formula helps optimize one variable—achieving maximum returns in the minimum time—but does not control volatility. Basing investment size on a fraction of the Kelly result (e.g., "half-Kelly") may alleviate volatility pressure, but doing so makes capital allocation less than optimal.
In 1963, when Buffett bought American Express, he invested 40% of his partnership's net liquid assets into it. Buffett later explained in a letter to his partners: "We would only commit up to 40% of our total assets under exceptionally rare circumstances. Precisely because such opportunities are rare, when we identify one, we must concentrate our efforts and place a large bet. In the history of our partnership, there have probably been only five or six times where we invested more than 25% of our total assets. Each time, it had to promise exceptionally outstanding performance... These investments also had to possess qualitative and quantitative superiority, with a very low probability of serious permanent loss..."
We consider this the best example of applying the Kelly Criterion. Investing involves seeking pricing anomalies, placing large bets when the odds are heavily in your favor to create wealth. One should calculate the maximum portion of assets to bet using the Kelly formula. Because several favorable investment opportunities can appear simultaneously in the market, the volatility issue the Kelly formula cannot solve can be naturally mitigated by adopting a concentrated portfolio.
**04 Seven Questions That Must Be Considered** The Patels likely did not know the probabilities calculated by the Kelly Criterion, but they instinctively realized their investment had a high probability of doubling their money, with a very low chance of losing it. This is the ultimate strategy for successful Dhandho investing that Pabrai summarizes: "Heads, I win a lot; tails, I don't lose much."
However, risks and uncertainties are hidden behind this ultimate strategy. Wall Street dislikes uncertainty and shows its aversion by discounting a company's stock price. In this context, several investment combinations can lead to depressed stock prices: 1) High risk, low uncertainty. 2) High risk, high uncertainty. 3) Low risk, high uncertainty. 4) Low risk, low uncertainty. Wall Street favors the fourth combination the most. Companies in this category often trade at high multiples. Pabrai advises avoiding investments in such companies.
For "low-risk, high-return" Dhandho investing, the only combination of interest is the third: "low risk, high uncertainty," because it yields the most desired outcome, akin to a coin toss: heads, make money; tails, don't lose much.
Companies like American Express and Procter & Gamble are examples of low-uncertainty businesses. Their stock prices rarely fall to bargain levels. Once their future shows uncertainty, as happened with American Express in the 1960s, the stock price plummets rapidly. The future development is uncertain, but the risk of a total loss is less than 1%. In such situations, Wall Street often irrationally discounts the company's market value. When Wall Street is confused by risk and uncertainty, investors can exploit this moment, usually with quite good results.
Savvy investors like Buffett and Graham have skillfully exploited the stock market's weaknesses for decades, reaping substantial returns. As long as one finds low-risk, high-uncertainty investment opportunities, they can profit from Wall Street's weaknesses. Such investment opportunities almost always carry no danger of failure but possess immense potential for success. This is a classic "Heads, I win; tails, I don't lose much" investment model. As long as the chance of success exceeds 50%, even if things turn sour, the outcome is merely breaking even or making a small profit.
Of course, this investment model has prerequisites. These prerequisites form the "buy or don't buy" questions. Pabrai lists seven questions that must be clearly considered: 1) Is the industry one I understand well—within my circle of competence? 2) Do I have a reasonably accurate understanding of the company's current intrinsic value and how it might change over the next few years? 3) Is the company's current market value, and its likely market value in the next two to three years, significantly below its intrinsic value, even by more than 50%? 4) Am I willing to invest a substantial portion of my net worth in this business? 5) Is the possibility of the business performing poorly minimized? 6) Does the business possess a competitive advantage? 7) Is the business run by managers with ability and integrity?
Only when all seven questions receive affirmative answers should an investor consider buying. If you encounter a stock of a company you understand, trading at less than half its estimated intrinsic value two to three years from now, and the possibility of the business performing poorly is extremely low, then you can buy. Otherwise, avoid such companies, as there will be better investment opportunities in the future.
To be a successful investor, one must purchase assets whose market price is consistently below their intrinsic value while being extremely careful to minimize the potential for permanent loss. As Buffett famously said, "Rule No. 1: Never lose money. Rule No. 2: Never forget Rule No. 1."
Although the market price of a public company can change dramatically within minutes, changes in the business itself typically take months or even years. Markets are usually efficient; in most cases, once the situation clarifies, market-discounted assets will rise in price, and the stock price will settle around its intrinsic value level. The clouds of uncertainty usually dissipate within two to three years. This two-to-three-year time principle can help us exit a stock if our intrinsic value estimate proves wrong. If we do not exit, always hoping for an adjustment to intrinsic value, we can fall into an endless wait. Waiting has a very real cost—the opportunity cost of not investing elsewhere. Therefore, there must be a balance between allowing sufficient time for a stock to adjust to its intrinsic value and waiting indefinitely based on a flawed premise.
Joel Greenblatt, in "The Little Book That Beats the Market," proposed the "Magic Formula" stock selection model. He suggests holding all selected stocks for a full year. The calculations show that whether the stock price falls or rises, if you buy stocks from the Magic Formula list, you should not sell them for one year. The stocks provided by the Magic Formula are essentially deep value stocks. Most are companies that have been through turmoil, and their stock prices have already fallen. The effectiveness of the Magic Formula lies in the fact that for most of these stocks, the panic subsides within a year, rationality returns, and these stocks generally end up performing much better than the market on an annualized return basis.
One year is a good holding period. However, if you understand the company well before buying, Pabrai believes holding for a longer period can also ensure returns. For companies you understand well, the holding period can certainly be longer. The "low-risk, high-return" model only invests in simple, well-understood companies. It does not involve boundless expansion. According to this requirement, 99% of potential investment choices can be eliminated, avoiding interference from any factors outside one's circle of competence.
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