Mohnish Pabrai (Trades, Portfolio), a GuruFocus guru and the founder and manager of Pabrai Funds, is also the author of “The Dhandho Investor: The Low-Risk Value Method to High Returns.” Published in 2007, he said the book was “a synthesis of ideas I’ve encountered in my readings, interactions with friends and various experiences, both visceral and direct.” Or, more simply, the methods he used to generate excellent returns for several years.
Because he runs a hedge fund, not a lot of details are available about his performance. In the description of his book, however, Pabrai reported generating an average of 28% per year, after fees and expenses, between 1999 and 2006. It also claimed his funds had, “outperformed all of the major indices and over 99% of other managed funds.”
However, “outperformed” is hardly the description of what his funds have done in more recent years. As the following TipRanks chart shows, his funds have seriously “underperformed” when compared to the S&P 500 and his hedge fund peers:
Note, that’s just 10.18% over six years, just barely staying above water. This book was written before the decline began.
In speaking about his readings, interactions and experiences, Pabrai is referring in particular to Warren Buffett (Trades, Portfolio), Charlie Munger (Trades, Portfolio) and his own family. Without Buffett, he said, there would have been no Pabrai funds.
The author, born in India, set the framework by explaining how the extended Patel family, immigrants originally from the state of Gujarat in India, came to dominate the [RA1] American motel industry. The key, he said, was a business philosophy called Dhandho, which means “endeavors that create wealth”; the word is pronounced dhun-doe. More specifically, it referred to the low-risk, high-return approach of the Patel family.
The first Patel family to come to the United States, via Uganda, arrived in 1972. As refugees from Uganda, the family had few language skills and practically no savings. They arrived at a particularly bad time as Americans were trying to deal with a serious economic downturn, one made worse by the Arab oil embargo.
The motel sector may have been suffering more than most since it is directly affected by the availability of disposable income and travel. Both had taken a beating in the early 1970s, and many motels were selling at distressed prices, in some cases by banks that had foreclosed on them.
Papa Patel, who may be an archetype, thought they might have to settle for two minimum-wage jobs (one for Patel and one for his wife), which was hardly enough to raise a family with three teenagers.
Fortunately, he discovered a 20-room motel for sale at a very low price and considered the possibilities. First, he thought the bank or seller would be motivated to sell and probably finance between 80% and 90% of the purchase price. The family would live at the motel, thus eliminating any rent expenses. Since they will live and work in the same place, they would not need a pricey car. And, the family, including the three teens, can do all the cleaning, maintenance and management. It looked like a no-lose situation, so with a few thousand dollars of their own cash and a few loans from relatives and friends, the family bought the motel.
Because they had no paid staff and kept expenses to a minimum, they became the lowest-priced motel in the area. That allowed them to offer the lowest prices while remaining as profitable as other motels. In turn, they enjoyed a higher occupancy rate and made above-average profits. So with rates of $12 or $13 per night, and occupancy of 60% or less, they brought in annual revenue of about $50,000.
From that $50,000 came interest expenses of about $5,000, principle payments of $5,000 and a further $5,000 to $10,000 in operating expenses and taxes (amounts of taxes are not discussed). According to the author, “The annual return on that $5,000 of invested capital is a stunning 400 percent ($20,000 in annual returns from the investment—$15,000 in cash flow and $5,000 in principal repayment).”
If, on the other hand, the motel had failed, the loss from their personal guarantee would have been less than $5,000, which would have been unfortunate but not life-changing. As Pabrai put it, “If a Patel cannot make the motel run profitably, no one can.” So the lender would have to be very hard-pressed to foreclose.
He also listed three potential scenarios after 10 years: First, the family continues to earn 400% on their $5,000 investment and after 10 years they sell it for the purchase price: $50,000. During this time, they will have had a bond-like asset that throws off 300% per year for nine years, with a tenth-year interest payment worth 900%.
Second scenario: For several years after they buy the motel, the economy is in bad shape, so the lender works with the Patels to renegotiate the terms of the loan. For five years, the family earns nothing on their investment, but in the second five years, the economy recovers and they sell the motel for $50,000. Ultimately, this works out an average annual return of more than 40% over the 10 years.
Third scenario: The economy does not recover after year five and goes on for another five years with the family unable to make payments. They are foreclosed and lose their investment. This represents a negative return of 100% (but they will have lived rent-free, if nothing else).
The author looked at the likelihood of the three scenarios and assumes there is an 80% chance the first, and best case, occurs. He also attributes a 10% likelihood to the second (mean) case and a 10% probability that the third and worst-case scenario unfolds.
Based on the scenarios, Patel estimated there was a 10% chance of losing everything, a 90% chance of winding up with more than $100,000 after 10 years and an 80% chance of winding up with more than $200,000 after a decade. The author noted that these numbers do not include an increase in the motel’s value and no room rate increases for 10 years.
He also wrote, “This is not a risk-free bet, but it is a very low-risk, high-return bet. Heads, I win; tails, I don’t lose much!”
As it turned out, the big bet worked out for the Patels, and soon they had a thriving business and lots of cash flow, allowing them to buy a house of their own and an even bigger motel. Even then, they stuck with the basic business model of ultra-low costs, charging lower rates than competitors and bringing in lots of cash.
Soon, they could afford to buy more motels, which they handed over to other Patel families to run. As the author noted, a snowball effect was developing and by 2007, the Patels owned half of all the motels in America.
In summary, Pabrai is preparing us for a look at his investing approach by letting us know he uses a low-risk, high-return approach. As he frequently proclaimed in the book, “Heads, I win; tails I don’t lose much!”
Read more here:
- Buffett on Financial Statements: Which of These 3 Retailers Has the Best Moat?
- Buffett on Financial Statements: When to Buy and When to Sell
- Buffett on Financial Statements: Valuations in 5 Steps
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