Review of The Dhandho Investor

If anything can be described as the Holy Grail of trading and investment then following a low risk method that generates high returns is surely it.

For Mohnish Pabrai, the author of The Dhandho Investor, value investing is that method. I read this book on the recommendation of a colleague who was just getting started in the world of stocks. I am not a stock trader and have no real inclination to become one in the near future. So why did I decide to read the book anyway?

I have heard about value investing from many different quarters over the past few years. It has peaked my interest enough that I felt it might be worthwhile to know a little bit more about the world of value investing. After all, one of its biggest proponents is Warren Buffett, so there must be something to it!

Mohnish Pabrai is very much a Buffett follower, not in the sense that he copies Buffett trades, but that he follows rather closely the methods and practices that Warren Buffett uses in making his trading decisions.

Value investing is an approach where you attempt to identify securities whose shares appear undervalued as compared to your understanding of the fundamentals for that company. You are not necessarily looking to find a company for a bargain price, rather you are looking to buy into a company that is outstanding at a sensible price.

Pabrai often uses the following coin toss phrase throughout the book to describe the types of investments that he looks to make: “Heads, I win; tails, I don’t loss much!”

One of the main tenants of most stock investors is that diversification is key. This means that you buy stock in many different companies that are unrelated so that you do not expose yourself to risk in any one company or market sector.

Value investors shun this approach. Instead they look to find a few companies that are worth putting their money into. The book details how the Kelly Formula is often used to determine how much of your trading capital is to be used on any given trade or investment.

Pabrai seems to keep things even simpler. He just allocates 10% of his trading capital to any given investment that he is going to make. This obviously means that he is only ever interested in holding shares in a maximum of ten companies at any one time.

Investments are made irregularly and only after thoroughly researching the company in question and the market sector in which it belongs. A thorough understanding of the company and its fundamentals needs to be pieced together before the trade is placed.

The investment approach can be succinctly summed up as using few bets, big bets, infrequent bets.

When it comes to exiting from trading bets placed, an obvious profit target is reached when the stock price is no longer considered to be undervalued.

If the stock price goes against you then Mohnish Pabrai generally advocates holding onto that position as long as the fundamentals are sound and continue to point to the stock being undervalued. Only if the fundamentals turn against you should you consider exiting the trade for a loss. Pabrai recounts several trades he made that initially went against him, some for quite a long time, but he held onto to them as the fundamentals remained sound and he wanted to give the company time to realise their potential.

There is one other scenario that can force the exit of an existing trade and that is uncovering another value investment opportunity that offers substantially more reward and/or less risk than what is currently being held.

Like any trading or investment approach, if you want to be successful you need to put in the time and work to reap the rewards. Pabrai does an excellent job of detailing the research and legwork that he put into many of his investments.

I found the description of how Pabrai set up his investment fund to be fascinating. Once again he has followed Warren Buffett’s example in how he sets his fee structure. Instead of the 2/20 fee that most hedge funds use (where there is an annual 2% fee on the total trading capital being invested, along with a 20% fee on any monthly profits), Pabrai charges an annual fee of 25% on returns made that exceed 6%.

I like this approach as it eliminates the monthly volatility that can exist in returns. The 6% threshold is chosen to alleviate worries from investors that their potential profits will be eaten alive by fees if the fund does not make much during the year. The 6% level assures the investor that they will hopefully sees returns at least equivalent to risk-free investments such as treasury bonds which generally sees annual returns in the 4-6% range.

This fee structure also gives a nice incentive to the fund to generate the best return possible as they will receive a higher cut of the profits the better they do. There is no safety net equivalent to the 2% annual fee charged by most regular hedge funds. The fund manager must generate at least 6% in annual profits before they will see any income from fees.

Let’s look at a few quick examples of how this fee structure works. If the annual return is 10%, then the fee paid is (10 – 6) x 0.25 = 1%. If the annual return is instead 20% then the fee works out to be (20 – 6) x 0.25 = 3.5%.

This fee structure is extremely competitive when compared to regular hedge fund fees as well as mutual fund fees. Mohnish Pabrai sees it as a vital competitive advantage his Pabrai Investment Funds have over other managed funds.

The success of Pabrai Investment Funds means that its annual shareholder’s meeting is even turning into something similar to the Oracle of Omaha’s annual Berkshire Hathaway gathering.

There is also an interview with Mohnish Pabrai on The Motley Fool from earlier this year where he details how the assets under management for the fund have grown from $1 million at its inception in 1999, to over $400 million this year. The second part of the interview is here.

The Dhandho Investor clearly details the steps that Pabrai has taken to achieve value investing success. It is an enjoyable book to read, even for someone like myself who is not actively looking to get into value investing. It contains plenty of interesting stories and anecdotes that help to illustrate the concepts that are being showcased. Mohnish Pabrai shows that you don’t have to reinvest the wheel to find investment success. In many ways, Pabrai has just cloned the methods and strategies of Warren Buffett, making sure that they mesh with his personality and investment outlook.

If I ever have an inkling to do some stock investing then I shall certainly be returning to this book for help and guidance.