Chapter 134 - The Dhandho Investor: The Low-Risk Value Method to High Returns
Today’s Chapter is based on the book “The Dhandho Investor: The Low-Risk Value Method to High Returns” by Mohnish Pabrai.
Mohnish Pabrai is an Indian-American businessman, investor, and philanthropist known for founding and managing Pabrai Investment Funds, a value-oriented investment firm inspired by Warren Buffett’s style which has achieved remarkable returns through disciplined value investing.
Here’s what I learned:
Dhandho Investing
“It follows from the above that risk is high when investors feel risk is low. And risk compensation is at a minimum just when risk is at a maximum. So much for the rational investor!”
— Howard Marks
Mohnish Pabrai’s main thesis from the book is the concept that high returns do not necessitate high risks. Instead, he advocates for a mindset that seeks asymmetric bets, those with significant upside potential but minimal downside risk. This principle, encapsulated in the phrase “Heads, I win; tails, I don’t lose much”, is a cornerstone of the Dhandho framework and reflects his belief that disciplined investors can achieve extraordinary results by carefully selecting opportunities with favorable odds.
As a matter of fact, Pabrai explains that “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. The stereotypical Patel naturally approaches all business endeavors with this deeply ingrained riskless Dhandho framework—for him it’s like breathing. Dhandho is thus best described as endeavors that create wealth while taking virtually no risk.”
To demonstrate the power of Dhandho, he mentions the story of how Richard Branson built Virgin Atlantic with zero capital. In fact, although the airlines businesses is known to be capital-intensive and highly regulated, Branson was able to identify a service gap and exploited it with minimal initial capital outlay, leveraging creativity over cash. The potential upside was building a global brand; the downside was limited because so little equity was risked upfront.
“My take on Virgin Atlantic is simply this: if you can start a business that requires a $200 million 747 jumbo jet and a boatload of employees in a tightly regulated industry for virtually no capital, then 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. Branson found a service gap and went after it. By the time that gap narrowed and British Airways and his other competitors woke up, he had already built a strong brand. Even today, Virgin Atlantic offers a very unique product in a very tough industry. The Virgin Atlantic business model is pure Dhandho. Heads, I win; tails, I don’t lose much!”
— Mohnish Pabrai
Pabrai explains that the reason why the Dhandho approach works is due to the fact that investors often confuse risk with uncertainty. He mentions that “Low risk and high uncertainty is a wonderful combination. It leads to severely depressed prices for businesses—especially in the pari-mutuel system-based stock market. Dhandho entrepreneurs first focus on minimizing downside risk. Low-risk situations, by definition, have low downsides. The high uncertainty can be dealt with by conservatively handicapping the range of possible outcomes. You end with the classic Dhandho tagline: Heads, I win; tails, I don’t lose much!”
As a matter of fact, Pabrai loves comparing investing in the stock market to the pari-mutuel system. As such, he encourages investors to adopt a probabilistic mindset, akin to Charlie Munger’s approach to betting at the race track. Pabrai mentions that “If you went to a horse race track and you were offered 90 percent odds of a 20 times return and a 10 percent chance of losing your money, would you take that bet? Heck Yes! You’d make that bet all day long, and it would make sense to bet a very large portion of your net worth with those spectacular odds. This is not a risk-free bet, but it is a very low-risk, high-return bet. Heads, I win, tails, I don’t lose much!”
The lesson here is clear: investors should seek opportunities where the downside is limited, and the upside is substantial, and be willing to act decisively when such opportunities arise. This approach requires a deep understanding of probabilities and a willingness to wait for the right moment, much like a seasoned gambler at the pari-mutuel betting system.
Bet Big!
“Opportunities come infrequently. When it rains gold, put out the bucket, not the thimble.”
— Charlie Munger
A cornerstone of Mohnish Pabrai’s Dhandho’s investment philosophy is the concept of “Few Bets, Big Bets, Infrequent Bets.” This principle challenges the conventional wisdom of broad diversification, instead advocating for a highly concentrated portfolio where an investor places significant capital only on a select few, deeply understood opportunities that present overwhelmingly favourable odds. This approach is heavily influenced by Charlie Munger who once said, “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.”
As mentioned previously, Pabrai loves to compare investing in the stock market to horse racing. However, there’s a huge advantage that an investor have in the stock market compared to the race track: the house takes a substantial cut. In fact, he mentions that “To be a consistent winner at the race track, a person has to overcome the staggering 17 percent frictional cost of placing a bet. According to Munger, there are actually a few people who are able to make a living by betting at the race track after paying the full 17 percent. These folks watch all the horses and races, yet place no bets. Then, when they encounter widely misplaced odds (in their favor) on a horse about which they know a great deal, they bet heavily on that one horse in that one race. After that, they go back to watching the horses and races indefinitely with no bets placed until another good opportunity shows up.“
“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.”
— Mohnish Pabrai
The implication is clear: true investment success comes not from frequent trading or widespread diversification, but from patiently waiting for those rare, “no-brainer” opportunities where the odds are overwhelmingly in one’s favor, and then betting heavily. Most of the time, the investor is observing, learning, and waiting. But when the stars align (i.e. when a simple business with a strong moat faces temporary distress, causing its price to plummet far below intrinsic value, creating a massive margin of safety and incredibly favorable odds), that’s the time to act decisively and allocate a significant portion of capital.
As Pabrai once said, “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.” Pabrai himself, in managing Pabrai Funds, typically concentrates his portfolio, often holding only 7 to 10 ideas that make up a significant portion of the portfolio, demonstrating his commitment to this concentrated betting approach.
This reminds me of what we have learned from Edward Thorp, who also understood the importance of betting big when you odds are in your favor. As such, he was known for betting bigger amount when he had a significant edge while playing blackjack and while investing in the stock market. This thought of betting big when odds are in your favor is the basis of the Kelly Criterion which is a mathematical formula to calculate what percentage of your money you should allocate in a bet or investment idea. The formula is based on two criteria:
Win Probability
Win/Loss Ratio
“Warren Buffett’s thinking is consistent with the Kelly Criterion. In a question and answer session with business students at Emory University, he was asked, in view of the popularity of Fortune’s Formula and the Kelly Criterion, to describe his process for choosing how much to invest in a situation. He and his associate Charlie Munger, when managing $200 million, put most of it into just five or so positions. Sometimes he was willing to bet 75 percent of his fortune on a single investment. Investing heavily in extremely favorable situations is characteristic of a Kelly bettor.”
— Edward Thorp
As such, considering the rarity of having an opportunity where odds are in your favor, Thorp learned that it isn’t worth it to be nit-picky in those situation. As a matter of fact, he believes that it isn’t worth to push the other party to their absolute limit when negotiating. A small gain is most likely not worth the risk of the deal breaking up. Similarly, it is ill advised to pass on an investment opportunity due to being stubborn on a set price:
“Here’s the idea. Suppose we want to buy 10,000 shares of Microsoft (MSFT), currently trading at, say, 71 bid for 50,000 shares, and 71¼ asked for 10,000 shares. We can pay 71¼ now and buy our 10,000 shares. Or, as our trader would do, we can offer to buy our 10,000 shares at 711⁄8 and see if we have any takers. If this works—and it does most of the time—we’ll save $1⁄8 × 10,000 or $1,250. This sounds good. Is there any risk? Yes. By trying to save $1⁄8 per share we may miss a big winner if the stock always trades at 71¼ or higher for however long we’re trying to buy. Those stocks we miss, which run away to the upside, would have given us windfall profits. Put simply, you might scalp $1⁄8 twenty times but lose $10 once. Do you like that arithmetic? I don’t.”
— Edward Thorp
Copycats
“If I have seen further [than others], it is by standing on the shoulders of giants.“
— Isaac Newton
Mohnish Pabrai’s final lesson is a counterintuitive one: investors should favor investing in businesses that copy and scale proven models rather than those that innovate from scratch. Innovation, while celebrated, is inherently risky, whereas copying successful models reduces uncertainty. As Pabrai explains, “Innovation is a crapshoot, but investing in businesses that are simply good copycats and adopting innovations created elsewhere rules the world.”
He uses the example of Microsoft as a case study to illustrate this principle. In Pabrai’s opinion, Microsoft’s success lies in its ability to adopt and scale innovations pioneered by others, effectively neutralizing competitive threats. He mentions that “Microsoft repeatedly has reacted to innovation outside its walls by acting quickly and intensely to nullify the threats. They have looked for customer validation of someone else’s innovation before embarking on their own. It is a very powerful strategy.”
“Microsoft is an excellent lifter and scaler. It has had 90 + percent success in annihilating the “enemy product” it has gone after. It is an open question how the battle of Google versus Microsoft will finally play out. With over sixty thousand employees, Microsoft is now, unfortunately, the bureaucracy it has always despised. If I were given just two investment choices of Google or Microsoft at present prices, it is a no-brainer decision for me. I’d pick Microsoft all day long. It is a battle between an innovator versus a cloner. Good cloners are great businesses. Innovation is a crapshoot, but cloning is for sure.”
— Mohnish Pabrai
As a matter of fact, Pabrai argues that copycat businesses, when run by capable managers, often outperform innovators because they avoid the pitfalls of untested ideas. He once said that “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.”
However, this approach is not about stealing ideas, but about recognizing and scaling proven concepts. Pabrai points to Sam Walton’s Wal-Mart as an example. He mentions that “Sam Walton was a lifelong student (and lifter) of other retailers’ models. Most of Walmart’s business model was lifted from Kmart. If you carefully study the most successful businesses around, you’ll notice that much of it has been lifted and scaled by great executers.”
As we have previously learned from Sam Walton, he was never content with the status quo. He believed that complacency was the enemy of progress and that continuous experimentation was essential to stay ahead of the competition. As he once said, “I think my constant fiddling and meddling with the status quo may have been one of my biggest contributions to the later success of Wal-Mart.”
One way for Walton to overcome this status quo was to be constantly seeking to learn from others. As a matter of fact, he was a voracious student of the retail industry, constantly visiting competitors’ stores and studying their methods. He wasn’t afraid to borrow ideas and adapt them to his own business, always seeking to improve and to refine his approach. Sam Walton was famous for always bringing with him a yellow legal pad in order to write notes when visiting other retail stores. He mentions, “I probably visited more headquarters offices of more discounters than anybody else—ever. I would just show up and say, ‘Hi, I’m Sam Walton from Bentonville, Arkansas. ... and I’d like to visit with Mr. So-and-So’ ... about his business.” One of Sam Walton’s biggest influence is Sol Price, often known as the father of the retail industry.
“I guess I’ve stolen—I actually prefer the word ‘borrowed’—as many ideas from Sol Price as from anybody else in the business.”
— Sam Walton
However for Walton, learning from others was not limited to learning from his competitors. In his opinion, he could learn from everyone and everything. He viewed every experience as an opportunity for growth and innovation. As he once said when he first started into the retail business, “It was a real blessing for me to be so green and ignorant, because it was from that experience that I learned a lesson which has stuck with me all through the years: you can learn from everybody.”
As such, one thing that Walton emphasized in the company was the significance of listening to employees and customers during the innovation process. He understood that great ideas often came from those who interacted with the products and services daily. this collaborative spirit fostered an innovation environment at Wal-Mart, where employees felt empowered to contribute ideas.
“We always said that the best ideas come from the people on the front lines. They know what works and what doesn’t.”
— Sam Walton
Beyond the Book
Read "Standing on the Shoulders of Giants" by Farnam Street
Read "The Indispensability of Risk" by Howard Marks
Read "How Good Gamblers Think" by Farnam Street
Watch "The Dhandho Investor By Mohnish Pabrai | Heads I Win (TIP517)" on YouTube
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