Mohnish Pabrai (Trades, Portfolio) led off chapter 10 of “The Dhandho Investor: The Low-Risk Value Method to High Returns” with these odds on a $1 bet:
- An 80% probability, or chance, of winning $21.
- A 10% probability of winning $7.50.
- A 10% probability of losing everything (your $1 bet).
This looks like a promising game, but how much should you bet if you start with a $10,000 stake? You wouldn’t bet everything since there is a 10% chance of losing it all, and you wouldn’t bet just a dollar because winning would have no material effect on your stake.
To resolve this issue, Pabrai pointed to the work John Larry Kelly Jr. As a researcher at Bell Labs, Kelly devised a solution (the Kelly Formula) and published his results:
Edge/odds = Fraction of your bankroll you should bet each time.
The answer to the situation above? Bet 89.4% of your $10,000, or $8,940.
From the writings of Michael Mauboussin, Pabrai provided a second example: You are involved in a coin toss in which you win $2 for heads and lose $1 for tails. How much should you bet?
Since there is a 50% chance of winning and a 50% chance of losing with every flip, you would apply the Kelly Formula to the Mauboussin problem as follows:
$0.50 [(0.5 x $2) + (0.5 x -$1)] = 25% (of $2, which equals 50 cents)
In both cases, Pabrai was advising us to bet heavily when the odds are clearly in our favor. He quoted Charlie Munger (Trades, Portfolio) to back up his case:
“The wise ones bet heavily when the world offers them that opportunity. They bet big when they have the odds. And the rest of the time, they don’t. It’s just that simple.”
The use of the word “bet” may conjure up the notion of gambling or speculation, but Pabrai anchors his thinking about bets and betting to capital allocation. He wrote, “To be a good capital allocator, you have to think probabilistically.” For a real-life example of the connection between gambling and investing, he referred to Massachusetts Institute of Technology math professor Ed Thorp.
In the 1960s, Thorp used his university’s computers to analyze probabilities in blackjack and identified an optimized play, which he called “Basic Strategy.” At that time, casinos were not prepared for such a scientific approach to playing and Thorp used his card-counting knowledge to make a great deal of money at the blackjack tables (card counting worked then because casinos were dealing from just a single deck of cards.)
But the real assault on casino profitability began when Thorp published a book on the subject, “Beat the Dealer.” As Pabrai observed, casino owners also read the book and took measures that would return the edge them.
The then-organized crime owners of Nevada casinos may not have understood how Thorp was winning, but it was made clear to him that he should leave and never come back. Thorp, though, had his eye on a bigger casino, with better odds and no mobsters looking over his shoulder.
This new “casino” was the New York Stock Exchange and the “fledgling” options market. According to Pabrai:
“The Black-Scholes formula is, effectively, Basic Strategy for the options market. It dictates what a specific option ought to be priced at. Because he was one of the only players armed with this knowledge, Thorp could buy underpriced options and sell overpriced ones—making a killing in the process.”
Thorp founded a hedge fund called Princeton-Newport Partners, which went on to produce 20% annual returns for 20 years. Actor Paul Newman reportedly asked Thorp how much he could make playing blackjack full time; Thorp responded that it could be $300,000 a year. When Newman asked Thorp why he wouldn’t do it full time, Thorp responded he could make $6 million a year in the options market—with very little risk.
Pabrai recommended that investors approach equity markets with the same mindset. Find a publicly traded company with a simple business model and a durable moat—and in temporary distress. If the current stock price is less than half of its expected intrinsic value in two or three years, then bet on it.
Then it is a matter of waiting for the stock price to increase or, as we might say, revert to the mean. How stock prices return to their intrinsic value is not fully understood. When Benjamin Graham was asked in 1955 why cheap stocks would recover, he said, “That is one of the mysteries of our business and it is a mystery to me as well as to everybody else. But we know from experience that eventually the market catches up with value.”
What Pabrai called “dislocating events” offer investors opportunities to find temporarily distressed companies. He provided a list of nine events (prior to 2007, when the book was published) where there had been immediate double-digit drops in the Dow Jones Industrial Average, and recoveries within a few months:
- The fall of Free France in 1940.
- The start of the Korean War in 1950
- U.S. bombing of Cambodia in 1970.
- Arab oil embargo in 1973.
- Nixon resignation in 1974.
- Hunt silver crisis in 1980.
- Financial panic of 1987.
- Asian stock market crisis in 1997.
- Russian-LTCM crisis in 1998.
Pabrai wound up the chapter with these words:
“Investing is just like gambling. It’s all about the odds. Looking out for mispriced betting opportunities and betting heavily when the odds are overwhelmingly in your favor is the ticket to wealth. It’s all about letting the Kelly Formula dictate the upper bounds of these large bets. Further, because of multiple favorable betting opportunities available in equity markets, the volatility surrounding the Kelly Formula can be naturally tamed while still running a very concentrated portfolio.”
Read more here:
- The Dhando Investor: Distressed Businesses and Businesses With Moats
- The Dhando Investor: Common Stocks as Existing Businesses
- The Dhando Investor: Pabrai's Investing Framework
Not a Premium Member of GuruFocus? Sign up for a free 7-day trial here.
