The Dhandho Investor: Chapter 11-12

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Sep 14, 2009
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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.

Chapter 11

Pabrai advises investors to "fixate on arbitrage", especially those situations where downside risk is eliminated, even if upside potential is limited. He discusses the following types of arbitrage, with particular emphasis on the last one:
1. Traditional: Buying gold on one exchange and selling it for a higher price on another

2. Correlated: Buying shares of a Class B stock while shorting the Class A if there's a price/value discrepancy

3. Merger: Buying a company about to be bought-out by another. It's important to note that this type of arbitrage is generally not risk-free.

4. Dhandho Arbitrage

Dhadho arbitrage is the central theme of this chapter. Dhandho arbitrage allows businesses to earn above normal profits for a limited time, before competitors or substitutes enter and destroy these higher returns. An enduring Dhadho arbitrage is what Buffett would call a moat.

Pabrai goes on to describe the Dhandho arbitrage spreads of several businesses. Some have spreads of just a few months, while others have spreads that span decades. While Pabrai argues that the "Dhadho arbitrage spreads" of all businesses will eventually be eroded, two important factors can allow investors to earn excellent returns in the interim: the size of the spread (or moat), and its duration.

To that end, Pabrai describes a couple of businesses owned by Warren Buffett that no longer have moats, Blue Chip Stamps and World Book. Nevertheless, the "aribitrage spread" earned by these companies over the years has made Buffett a lot of money - for example, Buffett's purchase of See's Candy was partially bought by money earned from Blue Chip. Pabrai advises investors looking for superior returns to invest in companies with wide and durable Dhandho arbitrage spreads

Chapter 12

This chapter stresses the importance of only purchasing investments with a healthy margin of safety. Once again, Pabrai quotes Buffett to back up this point:

"Make sure that you are buying a business for way less than you think it is conservatively worth."

Pabrai also refers to the writings of Ben Graham in The Intelligent Investor (which we've summarized here) by pointing out that Graham discussed the following joint benefits of employing a margin of safety: lower downside risk, and higher upside potential.

The entrepreneurs described at the beginning of Pabrai's book had likely never read the writings of Graham. Nevertheless, it is clear to Pabrai that their decisions were always taken with the idea of risk minimization in mind. Business schools, on the other hand, teach that reward comes from risk, and do a great disservice to their students, Pabrai argues.

The idea that higher rewards can only be achieved through higher risk is a common argument made by those who believe that the market is efficient, and therefore that it does no good to look for low-risk, high-reward situations. On this topic, Pabrai quotes Buffett again:

"We are enormously indebted to those academics: what could be more advantageous in an intellectual contest - whether it be bridge, chess, or stock selection than to have opponents who have been taught that thinking is a waste of energy?"

Saj Karsan

http://www.barelkarsan.com/