To kick off chapter 14 of “The Dhandho Investor: The Low-Risk Value Method to High Returns,” author and hedge fund manager Mohnish Pabrai (Trades, Portfolio) returned to the story of the Patels. In 1976, B.U. Patel bought the “very modest 20-room” Dunes Motel in Anaheim, California and then went on to build a mini-empire. It was a true rags-to-riches story about a poor immigrant from the Gujarat state in India.
His secret to success, aside from hard work, discipline and business smarts, was due to what Pabrai calls Dhandho investing. That’s finding situations with low risk and high potential returns, as described in chapter one.
There was even less risk for the “scores” of other Patel families who arrived in America looking for opportunities as well. But rather than starting from scratch, these other families could follow Patel, learn how his model worked and apply it in a different region of the country. By the time Pabrai published this book in 2007, people with the last name of Patel dominated motel ownership in the United States.
The author wrote, “Innovation is a crapshoot, but investing in businesses that are simply good copycats and adopting innovations created elsewhere rules the world.” With that, he launched into three case studies to reinforce his theory.
Ray Kroc was a copycat. He loved the McDonald’s MCD business model so much, he bought the rights to it along with the name and went on to sell franchises. In other words, he copied an innovative business method and scaled it up beyond anyone’s wildest imagination.
Pabrai does not mention it here, but franchising is all about building a better mousetrap and then scaling it up relatively quickly. Whether a franchise business involves pouring concrete gutters or serving hamburgers quickly and efficiently, they all offer a relatively low-risk opportunity. The concept has already been proven and franchisors provide ongoing support (in most cases) to ensure the franchisee succeeds.
Nor does Pabrai discuss the wisdom of buying stock in franchising companies. While not all franchise operations succeed, they generally do well. In addition to a proven concept, there are also entrepreneurial actors on the front lines.
The author does recognize them in his discussion of how McDonald’s smartly adopted ideas from their franchisees and competitors. Big Macs and Egg McMuffins both originated with franchisees, as did the drive-through window.
The second case study looked at copycatting by Microsoft MSFT. According to Pabrai, Bill Gates (Trades, Portfolio) and Paul Allen promised IBM IBM an operating system for its new personal computer in 1980. They did not have one. However, they quickly bought all rights to the Quick and Dirty Operating System from another small Seattle company for $50,000.
They did the same with their graphical user interface and the mouse, which Gates had first seen in a mockup of the Apple Macintosh. Roughly two years later, Microsoft had its own operating mouse.
The company went on to develop several major products based on copycatting: the components of Microsoft Office; networking features that were based on features developed by Novell Netware and Unix; Microsoft Money, which was “inspired by” Quicken from Intuit INTU; the Pocket PC was based on work done by Palm Computing; and Microsoft Explorer, which evolved out of the Spyglass browser. Additionally, there were many other copycat products.
Pabrai added, “They have looked for customer validation of someone else’s innovation before embarking on their own. It is a very powerful strategy.” Ironically, when Microsoft has tried to lead on new products it has failed, but has done well when it copied the leaders, “Microsoft is an excellent lifter and scaler.”
For the third case study, the author discussed his own Pabrai Funds, the hedge fund operation he founded and managed. As he acknowledged, “Pabrai Funds also has been a shameless cloner.”
And from whom did he copy? Mostly Warren Buffett (Trades, Portfolio). Before starting his own firm in 1999, Pabrai had never worked in financial services. What he had done, though, was intensely study the Buffett Partnerships, the guru's first venture on his own. From Buffett, he copied several important ideas:
- The “very unusual” fee structure, in which he charged no management fees, just performance fees. Pabrai added, “It struck me that Mr. Buffett’s structure was very fair relative to the rest of the industry.” He also considered the guru's fee structure to provide a durable moat.
- The guru reinvested “virtually all” fees back into the partnership, unlike most mutual and hedge funds. As Pabrai points out, if he thought he could get better returns elsewhere, he should not be running his own fund.
- Staying tight-lipped about his investments; Buffett has argued that investing is not a spectator sport, so Pabrai followed along that path. He noted, “Independence of thought is fundamental to sound investing.”
- A concentrated portfolio. Unlike many mutual and hedge funds, Pabrai did not run a portfolio with 80 or more stocks. Instead, he focused closely on a much smaller number.
- Targeting families rather than big institutional investors. Buffett started the Partnerships with the capital of just eight families, all close friends or family, and let them become, in effect, his sales staff. Pabrai, too, started with eight families and that number had grown to about 400 by the time this book was published—with no institutional investors.
- A staff of one. Buffett ran the Partnerships by himself. Later, Charlie Munger (Trades, Portfolio) would become a close and influential advisor, but Buffett continued to make all significant decisions alone. Pabrai adopted this idea, noting that it helped avoid paralysis by failed consensus.
After studying these “nuances” of the Buffett Partnerships, Pabrai became convinced that they had delivered “three wonderful results for Mr. Buffett”:
- They gave him the right kind of long-term investor, because the investor base had been self-selected.
- Collectively, the nuances comprised a wide moat that Buffett’s competitors would never be able to cross.
- Professional money management became a “very relaxed, blissful career to follow.”
Finally, Pabrai had this recommendation for equities investors:
“In seeking to make investments in the public equity markets, ignore the innovators. Always seek out businesses run by people who have demonstrated their ability to repeatedly lift and scale. It is the Dhandho way.”
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:
- The Dhando Investor: Finding Low-Risk, High-Uncertainty Companies
- The Dhando Investor: Margin of Safety
- The Dhando Investor: 'Investing Is Just Like Gambling'
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