The Dhandho Investor

The Dhandho Investor is a book about value investing.

I found The Dhandho Investor an average book with too much repetition. I can't hear his motto "Heads I win. Tails I don't lose much" anymore. I also found the stories about Dhandho investors a bit misleading. They were all about successful entrepreneurs whereas the book is mainly about investing in the stock market. And while I think the book is a good intro to value investing, there isn't much new in it if you are already familiar with the basic ideas from other value investing books or Warren Buffett's annual letters.

My notes

Patel Motel Dhandho

Dhandho (pronounced dhun-doe) is a Gujarati word. Dhan comes from the Sanskrit root word Dhana meaning wealth. Dhan-dho, literally translated, means "endeavors that create wealth". The street translation of Dhandho is simply "business".

We have all been taught that earning high rates of return requires taking on greater risks. Dhandho flips this concept around. Dhandho is all about the minimization of risk while maximizing the reward. [...] Dhandho is thus best described as endeavors that create wealth while taking virtually no risk.

Manilal Dhandho

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Virgin Dhandho

[...] virtually any business that you want to start can be gotten off the ground with minimal capital. All you need to do is replace capital with creative thinking and solutions.

Mittal Dhandho

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The Dhandho Framework

Never count on making a good sale. Have the purchase price be so attractive that even a mediocre sale gives good results.

The entrance strategy is actually more important than the exit strategy.

[...] the very best time to buy a business is when its near-term future prospects are murky and the business is hated and unloved. In such circumstances, the odds are high that an investor can pick up assets at steep discounts to their underlying value.

The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage. The products and services that have wide, sustainable moats around them are the ones that deliver rewards to investors.

If you buy an asset at a steep discount to its underlying value, even if the future unfolds worse than expected, the odds of a permanent loss of capital are low.

And that's the Dhandho framework:

• Invest in existing businesses
• Invest in simple businesses
• Invest in distressed businesses in distressed industries
• Invest in businesses with durable moats
• Few bets, big bets, and infrequent bets
• Fixate on arbitrage
• Margin of safety – always
• Invest in low-risk, high-uncertainty businesses
• Invest in the copycats rather than the innovators

Dhandho 101: Invest in Existing Businesses

There are six big advantages that the stock market offers versus the buying and selling of entire businesses:

• When you buy an entire business [...] there is some serious heavy lifting required. You either need to run it or find someone competent who can. This is no small task.
• When you buy a stock, you now have an ownership stake in the underlying business with one huge advantage – the business is already staffed and running. You can share in all the rewards of business ownership without much of the effort. The stock market enables you to own fractions of a few businesses of your choosing, over a period of your choosing, with full liquidity to buy or sell that stake anytime with a few clicks on your computer.
• When humans buy or sell whole businesses, both sides have a good sense of what the asset is worth and a rational price is usually arrived at. [...] The stock market operates like the pari-mutuel system in horse racing – prices are determined by an auction process. Like in horse racing, the auction process occasionally leads to a wide divergence between the value of a business and its quoted market price in a few stocks. We can do very well by only placing an occasional bet when the odds are heavily in our favor.
• Buying an entire business [...] requires some serious capital. In the stock market, you can hitch your wagon to the future prospects of any business with what you have in your wallet right now.
• There are thousands of publicly traded businesses in the United States, and you can buy a stake in any of them with a few mouse clicks. You can buy stocks in a plethora of other countries with ease as well. [...] In contrast, think about how many private businesses are on sale within 25 miles of your home at any given time.
• Even when you buy a tiny private business, transaction costs between the buyer and seller are usually between 5 percent to 10 percent of the purchase price, which doesn't include the considerable time and effort expended. You can buy or sell a stake in a publicly traded company for under $10.

Dhandho 102: Invest in Simple Businesses

[...] the intrinsic value of any business is determined by the cash inflows and outflows – discounted at an appropriate interest rate – that can be expected to occur during the remaining life of the business.

[...] while [the] definition of intrinsic value is painfully simple, calculating it for a given business may not be so simple.

Only invest in businesses that are simple – ones where conservative assumptions about future cash flows are easy to figure out.

[...] buy painfully simple businesses with painfully simple theses for why you're likely to make a great deal of money and unlikely to lose much. I always write the thesis down. If it takes more than a short paragraph, there is a fundamental problem. If it requires me to fire up Excel, it is a big red flag that strongly suggests that I ought to take a pass.

Dhandho 201: Invest in Distressed Businesses in Distressed Industries

Stock prices, in most instances, do reflect the underlying fundamentals. Trying to figure out the variance between prices and underlying intrinsic value, for most businesses, is usually a waste of time. The market is mostly efficient. However, there is a huge difference between mostly and fully efficient.

Markets aren't fully efficient because humans control its auction-driven pricing mechanism. Humans are subject to vacillating between extreme fear and extreme greed. When humans, as a group, are extremely fearful, the pricing of the underlying assets are likely to fall below intrinsic value; extreme greed is likely to lead to exuberant pricing.

Stock prices move around quite a bit more than the movement in underlying intrinsic value. Human psychology affects the buying and selling of fractions of businesses on the stock market much more than the buying and selling of entire businesses.

If you read the business headlines on a daily basis, you'll find plenty of stories about publicly traded businesses. Many of these news clips reflect negative news about a certain business or industry.

Dhandho 202: Invest in Businesses with Durable Moats

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.

How do we know when a business has a hidden moat and what that moat is? The answer is usually visible from looking at its financial statements. Good businesses with good moats [...] generate high returns on invested capital. The balance sheet tells us the amount of capital deployed in the business. The income and cash flow statements tell us how much they are earning off that capital.

There is no such thing as a permanent moat.

Dhandho 301: Few Bets, Big Bets, Infrequent Bets

Kelly calculated that the optimal fraction of your bankroll to bet on a favorable bet is: Edge/odds = Fraction of your bankroll you should bet each time.

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.

To be a good capital allocator, you have to think probabilistically.

In investing, there is no such thing as a sure bet. Even the most blue-chip business on the planet has a probability of not being in business tomorrow. Investing is all about the odds [...].

Dhandho 302: Fixate on Arbitrage

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Dhandho 401: Margin of Safety – Always!

When we buy an asset for substantially less than what it's worth, we reduce downside risk.

The bigger the discount to intrinsic value, the lower the risk.

The bigger the discount to intrinsic value, the higher the return.

It is during times of extreme distress and pessimism that rationality goes out the window and prices of certain assets go well below their underlying intrinsic value.

Dhandho 402: Invest in Low-Risk, High-Uncertainty Businesses

A high dividend yield is sometimes indicative of a stock being undervalued. So, like low P/E or 52-week low lists, it's a worthwhile screen.

Fear and greed are very much fundamental to the human psyche. As long as humans drive buying and selling decisions in equity markets, pricing will be affected by these fear and greed attributes. When extreme fear sets in, there is likely to be irrational behavior.

Dhandho 403: Invest in the Copycats rather than the Innovators

Innovation is a crapshoot, but investing in businesses that are simply good copycats and adopting innovations created elsewhere rules the world.

Value investing is fundamentally contrarian in nature. The best opportunities lie in investing in businesses that have been hit hard by negativity.

If you carefully study the most successful businesses around, you'll notice that much of it has been lifted and scaled by great executers. 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.

Abhimanyu's Dilemma – The Art of Selling

A critical rule [...] is that any stock that you buy cannot be sold at a loss within two to three years of buying it unless you can say with a high degree of certainty that current intrinsic value is less than the current price the market is offering.

As a corollary, the only time a stock can be sold at a loss within two to three years of buying it is when both of the following conditions are satisfied:

1. We are able to estimate its present and future intrinsic value, two to three years out, with a very high degree of certainty.
2. The price offered is higher than present or future estimated intrinsic value.

The key to being a successful investor is to buy assets consistently below what they are worth and to fixate on absolutely minimizing permanent realized losses.

The three-year rule also allows us to exit a position where we are simply wrong on our perception of intrinsic value. If we didn't have an out and always waited for convergence to intrinsic value, we may have an endless wait. There is a very real cost for waiting. It is the opportunity cost of investing those assets elsewhere.

If you have a very high degree of conviction on underlying intrinsic value, feel free to hold on to losers for longer than two to three years, but always be cognizant of the time value of money. It is very hard to make up the lost non-compounding years.

Don't hesitate to take a realized loss once three years have passed. Such losses are your best teachers to becoming a better investor. While it is always best to learn vicariously from the mistakes of others, the lessons that really stick are ones we've stumbled through ourselves.

To Index or Not to Index – That Is the Question

The Magic Formula is a very good place to go hunting for fifty-cent dollar bills.

Arjuna's Focus: Investing Lessons from a Great Warrior

We must remain squarely in our circle of competence and not even be aware of all the noise outside the circle. Within the circle, read pertinent books, publications, company reports, industry periodicals, and so on. Every once in a while something about a business will jump out at you. If there appears to be some meat on the bone and you sense that the business might be underpriced compared to its intrinsic value, it is time to hone in. At that point, you need to become ultra-focused [...]. All you should see is this one business. Shut everything else out. Nothing else exists on the planet. Drill down and see if it truly is an exceptional investment opportunity.