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The Dhandho Investor: Common Stocks as Existing Businesses

- By Robert Abbott

Previously in "The Dhandho Investor: The Low-Risk Value Method to High Returns," author Mohnish Pabrai (Trades, Portfolio) laid out a nine-point framework for what he called "Dhandho investing." By Dhandho, he meant low-risk and (potentially) high-return investing. Or as he often put it, "Heads, I win; tails, I don't lose much."

Among his examples were the extended Patel families and their low-cost approach to buying and operating American motels. Another was Lakshmi Mittal in Pakistan, who bought up distressed steel mills, streamlined their operations and made them powerhouses in the industry (now part of ArcelorMittal (MT)).

Among all existing asset classes, the author recommended common stocks: "There are a plethora of asset classes you could choose to invest in--CDs, U.S. Treasuries, bonds, stocks, real estate, private businesses, gold, silver, platinum, oil futures--the list is endless. If you examine returns from the broad stock market indexes over the past one hundred years, it is pretty clear that stocks do better than virtually all other easily accessible asset classes."

He went on to argue that there are six compelling reasons to go to the stock market rather than buying and selling whole businesses.

  1. There is a great deal of work required if you buy an existing business. Citing the example of the Patels, he noted it required "tremendous energy and dedication from his whole family for several years to make it work." Not only did the family need to manage the business, they also had to work in it, changing the linens and cleaning the rooms, doing all the maintenance themselves, having family members at the front desk 24 hours a day and seven days a week and so on.
  2. Owning a stock means owning a piece of a business without any other obligations (except, perhaps, for voting occasionally). As Pabrai put it, "Humanity has given you a marvelous asset compounding machine that's vastly superior to virtually all other alternatives and made it all amazingly cheap and easy to use." That's the opposite of owning your own motel.
  3. The stock market platform is a more-level playing field than that provided in private buy and sell transactions. Both buyers and sellers on the stock market have roughly equal access to all the relevant information available, though one side may decide to work harder on that information than the other. In private business deals, the buyer often lacks the insider information available to the seller. The private seller also has a timing advantage since they pick the time to put the business on the market.
  4. Lower capital requirements are needed to get into business through stocks (or mutual funds), in some cases less than $100. As Pabrai observed, serious capital is needed to buy even a small neighbourhood gas station of a laundromat. What's more, you could start investing in stocks or mutual funds with practically nothing and keep adding to your pool with miniscule amounts each month.
  5. The breadth and depth of businesses available to stock market investors is truly astonishing. With a few mouse clicks, you can buy stakes in a few of literally thousands of opportunities. On the other hand, how many private businesses are for sale within 25 miles of your home?
  6. You waste less on frictional costs when dealing with the stock market. Entering into a private business transaction means giving up 5% to 10% of the sale price (think brokers, lawyers, etc.). On a $100,000 deal, that means losing $10,000 up front, while you could buy that amount of stock for less than a $1,000 (assuming you're not buying too many companies). The author also pointed out the difference in time requirements. Buying stocks involves far less time and effort than buying a stand-alone business.

Pabrai summed up the chapter by writing, "buying stakes in a few publicly traded existing businesses is the no-brainer Dhandho way to go."

In the following chapter, chapter seven, he expanded on his second rule: investing in simple businesses.

It revolves around establishing intrinsic value and he used the work of John Burr Williams to define it. The intrinsic value is the net total of cash flowing in and cash flowing out, discounted at an appropriate interest rate for the expected life span of the business.

So far, so good. It may not, however, be so simple when applying it to individual stocks. Pabrai did an analysis of Bed Bath & Beyond (BBBY). At the time (late 2006), the company had a market cap of $10.7 billion, based on the stock market price of $36 per share. Using both conservative and aggressive assumptions, he came up with intrinsic values of $9.6 billion on the low side and $19 billion on the high side. (As a side note, Bed Bath & Beyond hit a high of more than $77 a share in 2013, but has since slipped back to $16.91 per share and a capitalization of $2.19 billion as of April 25.)

That was a broad range, too broad for Pabrai's liking. He wrote, "There isn't that much upside and a fairly decent chance of delivering under 10 percent a year. For me, it's an easy pass."

Turning to a company like Google (now Alphabet (GOOG)(GOOGL)), the uncertainty is even higher, making discount rates hard to establish. Pabrai's solution?

"The Dhandho way to deal with this dilemma is painfully simple: Only invest in businesses that are simple--ones where conservative assumptions about future cash flows are easy to figure out. What businesses are simple? Well, simplicity lies in the eye of the beholder."

Unfortunately, Pabrai did not share the names of stocks he considered simple enough to provide relatively certain discount rates. And while we don't have access to the names he held when he published the book, we know he is a great admirer of Warren Buffett (Trades, Portfolio). Thus, we might look at Berkshire Hathaway (BRK-A)(BRK-B) stocks for ideas.

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: Pabrai's Investing Framework
  • The Dhando Investor: Why the Patels Owned So Many Motels
  • Buffett on Financial Statements: Which of These 3 Retailers Has the Best Moat?

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This article first appeared on GuruFocus.