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The Dhandho Investor: Chapter 6-7

August 30, 2009
Saj Karsan

Saj Karsan

20 followers
Mohnish Pabrai is an Indian-American businessman and investor. For a number of years, he turned heads with the performance of Pabrai Investment Funds since its inception in 1999. Pabrai has high regards for Warren Buffett and admits that his investment style is copied from Buffett and others. Over the next few weeks, we'll be exploring the topics in his book about value investing.

The Dhandho Investor: Chapter 6

Mohnish Pabrai is an Indian-American businessman and investor. For a number of years, he turned heads with the performance of Pabrai Investment Funds since its inception in 1999. Pabrai has high regards for Warren Buffett and admits that his investment style is copied from Buffett and others. Over the next few weeks, we'll be exploring the topics in his book about value investing.

Of all of the asset classes that investors have the option in which to invest, Pabrai argues that common stocks have proven to offer the best returns. While investors also have the option of buying (and selling) individual businesses, Pabrai offers the following advantages of the stock market:


1. With an entire business, you have to run it, or find someone who can. To be successful, this requires an enormous amount of dedication.

2. In the stock market, you're buying a business that is already staffed, yet you still get to share in the earnings.

3. With whole businesses, often the sellers know a lot more about the business than the buyers, and furthermore the prices offered are not usually as attractive as they can be in the stock market.

4. Buying an entire business requires a large investment. In the stock market, however, you can start with just a tiny amount of capital, and add to that capital over the years - a tremendous advantage.

5. The selection offered to buyers of private businesses does not compare to that offered by the stock market. With a few brokerage accounts, the investor has the option to purchase from 100,000 companies worldwide. On the other hand, how many private businesses are for sale with a 25 mile radius of the investor?

6. In the purchase of a private business, transaction costs can add a good 5 to 10% to the price of the transaction. The frictional costs in the stock market, however, even for an extremely active investor, are extraordinarily low.


As long as investors follow the "Dhandho" approach to investing (as described in the previous and subsequent chapters), the stock market offers the best potential for realizing excellent returns on investment.

Now that Pabrai has established that the best place to look for returns is in the stock market, he turns his attention to discussing why investors should restrict their investments to simple and predictable companies.

A stock will sell on the market for a particular value. The investor must compare this selling price to the actual worth of the underlying business. The worth of the underlying business is determined based on the business' future cash inflows and outflows.

To demonstrate this, Pabrai takes the reader through a quick valuation of Bed, Bath and Beyond in 2006. While the stock sells with a market value of about $11 billion, the estimate of the worth of the underlying business conducted by Pabrai reveals the company is probably worth between $8 billion and $20 billion. As such, this investment should not excite the reader much.

By changing the expected estimates of the cash inflows and outflows of a business, however, its valuation can change dramatically. It is for this reason that it is of utmost importance to stick to simple and easy-to-understand businesses. If a business' future can be predicted, an investor can calculate its intrinsic value with more accuracy. In turn, this allows the investor to know that he is buying a company at a discount.

The Dhandho Investor: Chapter 7

Now that Pabrai has established that the best place to look for returns is in the stock market, he turns his attention to discussing why investors should restrict their investments to simple and predictable companies.

A stock will sell on the market for a particular value. The investor must compare this selling price to the actual worth of the underlying business. The worth of the underlying business is determined based on the business' future cash inflows and outflows.

To demonstrate this, Pabrai takes the reader through a quick valuation of Bed, Bath and Beyond in 2006. While the stock sells with a market value of about $11 billion, the estimate of the worth of the underlying business conducted by Pabrai reveals the company is probably worth between $8 billion and $20 billion. As such, this investment should not excite the reader much.

By changing the expected estimates of the cash inflows and outflows of a business, however, its valuation can change dramatically. It is for this reason that it is of utmost importance to stick to simple and easy-to-understand businesses. If a business' future can be predicted, an investor can calculate its intrinsic value with more accuracy. In turn, this allows the investor to know that he is buying a company at a discount.

Saj Karsan

http://www.barelkarsan.com/

(Editor Note: GuruFocus features proprietary research on Predictable Companies, a list of which is available to here(premium membership is required, but 7-day free trial is available).

About the author:

Saj Karsan
Saj Karsan founded an investment and research firm that is based on the principles of value investing. He has an MBA from the Richard Ivey School of Business, and an undergraduate engineering degree from McGill University.

Rating: 2.9/5 (10 votes)

Comments

kfh227
Kfh227 premium member - 4 years ago
I think that you duplicated some of the text of this article in the Ch 6 and Ch 7 section.

"the company is probably worth between $8 billion and $20 billion"

One question. How did he come up with a range for IV?

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