The Dhandho Investor: Distressed Businesses and Businesses With Moats

'Every once in a while a business with a secret sauce for enduring outsize profits emerges'

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Apr 29, 2019
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As Mohnish Pabrai (Trades, Portfolio) continued to explain his approach to investing, he covered the topics of distressed businesses, preferably in distressed industries, as well as businesses with strong moatd. He called his approach “Dhandho investing,” which refers to finding low-risk, high-return opportunities. Or as he frequently said, “Heads I win; tails I don’t lose much.”

It’s also in his book, “The Dhandho Investor: The Low-Risk Value Method to High Returns,” published in 2007.

Pabrai led into the "distressed businesses in distressed industries" chapter by going after the proponents of Efficient Market Theory (EMT), who argue that essentially all known information about a company is available to all investors and is reflected in the market price.

One of the implications of the theory is that there is no point in trying to assess a firm’s intrinsic value, and, with transaction costs considered, stock picking is bound to be a negative-sum game. Pabrai, a very big fan of Warren Buffett (Trades, Portfolio), responded with a couple of stick-it-in-your-eye quotations from Buffett:

  • “I’d be a bum on the street with a tin cup if the markets were always efficient.”
  • “Investing in a market where people believe in efficiency is like playing bridge with someone who has been told it doesn’t do any good to look at the cards.”

Pabrai conceded that the market is “mostly efficient.” But there is a difference between mostly efficient and fully efficient: “It is this critical gap that is responsible for Mr. Buffett not being a street corner bum.”

That gap arises because markets are subject to human emotions and drives, including Buffett’s famous distinction between fear and greed. As a result, share prices are more volatile than intrinsic values. That led Pabrai to Benjamin Graham’s creature, Mr. Market, with his constant buying and selling, sometimes driven by fear and sometimes driven by greed.

The author wanted readers to recognize that there is an important distinction between the way Mr. Market arrives at prices and the way business people determine the prices of whole businesses.

And, with that, he arrived at the issue of buying distressed businesses. Unlike the buyers of whole businesses, such as motels or steel mills, stock market investors need not wait very long. Out of the many thousands of stocks trading daily, many opportunities can be found at any time. Pabrai wrote, “All we need do is to first narrow the universe of candidate businesses down to ones that are understood well and are in a distressed state.”

After providing a list of sources for finding distressed businesses, he said there should be a “plethora of candidate distressed businesses to examine.” To sort out those businesses, he recommended eliminating any listings that are not simple businesses or are beyond an investor’s circle of competence. Then, apply “the rest of the Dhandho framework” to those that are left.

In chapter nine, Pabrai moved on to businesses with durable moats, with this insight:

“Capitalists strive hard to capitalize on any opportunity to make outsize profits. The irony is that, in that pursuit, they usually destroy all outsized profits. But, every once in a while a business with a secret sauce for enduring outsize profits emerges.”

To illustrate, he offered the example of his favorite restaurant, Chipotle (CMG, Financial). Even though he was living in Southern California, and had access to many other Mexican food restaurants, he stuck with Chipotle because of its fresh ingredients, taste, ambience and the ability to choose ingredients. While other operators might have wanted to challenge Chipotle, they had not been able to make a serious dent in its revenues and profits.

Thus, Pabrai believed the restaurant chain had a durable moat, allowing it to earn “supernormal” profits, and (in 2007) he expected it to enjoy such profits for 10 years or more. He gave examples of other companies with deep moats:

He also pointed to five companies with shallow moats or no moats at all:

  • General Motors (GM, Financial)
  • Cooper Tires (CTB, Financial)
  • Tellingly, the other three companies he listed in 2007 are no longer listed

The author observed that there are companies with hidden moats, including Tesoro (TES, Financial), an oil refiner in a commodity business; it controlled neither the price of its input (crude oil) nor its output (gasoline). How, then, could it have a moat? Well, the company operated on the West Coast and in Hawaii, where there is little competition. In 2007, a new refinery had not been built in the U.S. in 20 years, while roughly a third had gone out of business despite the demand for oil products increasing 2% per year.

That was a specific example, but Pabrai also had his eye on the bigger picture, “In the overwhelming majority of businesses, the various moats are mostly hidden or only in partial view. It takes some digging to get to the moat.”

To find companies with durable moats, you must look in the financial statements. As the author noted, good businesses with good moats produce high returns on invested capital (ROIC).

Pabrai thought that while moats were great things for a company to have, you cannot count on companies to survive forever, even if they have durable moats. Thus, he recommended never extending a discounted cash flow analysis more than 10 years into the future.

Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.

Read more here:Ă‚

The Dhandho Investor: Common Stocks as Existing BusinessesÂ

The Dhandho Investor: Pabrai’s Investing FrameworkÂ

The Dhandho Investor: Why the Patels Owned So Many MotelsÂ

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