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The Investor's Podcast (We Study Billionaires) - The Investor’s Podcast Network
TIP714: Bet Big, Bet Rarely: The Dhandho Investing Playbook w/ Kyle Grieve
01:09:09
Kyle Grieve dives deep into Mohnish Pabrai’s The Dhandho Investor, unpacking its nine core principles.
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Kyle Grieve
You're listening to Tip Mohnish Pabrai has significantly influenced me ever since I first heard him speak and read his book. He's held several incredible multibaggers while staying humble and admitting his mistakes in a refreshingly open manner. So today I'm excited to discuss one of the best resources I think he ever created, which was his book the Dendo Investor. I've always wanted to dive deeper into this book and share some of my biggest takeaways, so that's exactly what I'll be doing today. We'll examine some of the unique people that Mohnish admires for their business acumen and success. One thing I like about Mohnish is how he uses his roots in Indian culture to find what we in the west would consider esoteric investing mentors and influences. We'll examine motels and gas stations and determine why these seemingly boring businesses have been key to building significant amounts of wealth for certain people. I'll cover Mohnish's nine investing core principles, ranging from making big concentrated bets on simple low risk businesses to embracing distressed industries and the power of cloning. I'll also share a few areas where Pabrai's thinking has kind of evolved over the years, and a few areas of his investing philosophy that I tend to diverge from. We'll examine some of his wins and losses after the book's publication, drawing lessons from each One of my favorite parts about Mohnish is just how simple he makes investing. He's not trying to complicate investing just to, you know, raise assets under management. I think he genuinely wants to give back to the investing community and does a lot of work to spread the gospel of value investing, I think this episode will help investors of all experience levels enrich their own investing. So whether you're managing your portfolio or just curious about what it takes to invest successfully, this episode will give you some very practical takeaways, some thought provoking ideas, and maybe even a few mental models that you haven't heard before. Now let's jump right into the Dendo Investor and learn why the most profitable path is sometimes simply the most obvious one. Since 2014 and through more than 180 million downloads, we've studied the financial markets and read the books that influence self made billionaires the most. We keep you informed and prepared for the unexpected. Now for your host, Kyle Grieve. Welcome to the Investors Podcast. I'm your host Kyle Grieve and today we'll be discussing one of the books that influenced my investing journey the most. This book is the Dundo Investor by Mohnish Pabrai. Now it's pretty easy to see why Mohnish has been one of my most significant mentors who doesn't even know who I am, since he's shamelessly cloned many ideas from both Warren Buffet and Charlie Munger, who I consider two of the most significant influences on top of Mohnish Pabrai on my own investing education. But Mohnish is interesting because he approaches it from a slightly different angle and has various experiences from his upbringing in India and his engineering background. Today we're going to cover his book in a little more detail where we're going to explore some of the book's central themes based around his own investing principles. These principles have mostly stayed true, but I'll discuss a few principles that may have diverged as well from when he wrote this book. So the book is based around nine core principles. They are Number one, invest in existing businesses. Number two, invest in simple businesses. Number three, invest in distressed businesses in distressed industries. Number four, invest in businesses with durable moats. Number five, make few and infrequent bets. Number six, fixate on arbitrage. Number seven, always invest with a margin of safety. Number eight, invest in low risk and high uncertainty businesses. And number nine, invest in the copycats, not the innovators. Now the first principle is to invest in existing businesses and this point is so vital that I think it's also touched on throughout his investing framework and other principles. Now the crux is that starting a business venture from scratch is just a risky endeavor. The Dendo investor opts instead to purchase a proven existing business that is already generating cash flows. This basically acts to de risk the business venture. So even if you don't necessarily improve the business, you're still going to be cash flow positive. But if you're a good business person, you should be able to do things like cut costs, which increases cash flows even more into the future. Now let's go over an example here that Mohnish gives which is about someone he calls Papa Patel. So Papa Patel was an outstanding businessman who saw the motel business as a great opportunity when he came into America. After saving up a few thousand dollars, he bought a 20 room motel. Now the point here that's pretty crucial is about financing. So Papa Patel knew that the seller or a bank would finance up to 90% of the purchase price of the motel. So this meant that yes, Papa Patel would be in a little bit of debt. But the pros outweighed the cons in his view so let's go over what some of those pros might be. So he had the cash required to put a down payment on the motel. Now the seller or bank would finance the rest of it specifically because they could put a lien on the property. Further cost cutting could happen because he could live in the motel with his family rent free. He wouldn't require a vehicle because his home and his workplace were in the same location. So he could save money there. He could reduce employee costs by using himself and his wife as well as his children as labor. And since he was able to minimize expenses, he could offer the lowest possible rates while maintaining a very healthy profit margin compared to, you know, localized competitors. And because of this low cost nature of the location that he was going to open, he was able to increase occupancy and steal market share from other competitors as well, who just didn't have the same competitive advantages. Now let's examine this motel investment through a slightly different lens. We'll consider it a bet and we'll use expected value to determine whether it's a good decision. I like using a bear base and bull thesis in my investing when I'm evaluating my own investments. And Mohnish uses a very similar strategy here. So for the bull thesis, we're going to assume a couple things. We're going to assume that the economy holds up. We're going to assume that the initial investment is about $5,000 and that this is going to yield an annual return of 400%. So we assume the hotel is generating about $20,000 in annual return. That's how we get to that 400% number. We assume that this lasts for the next 10 years. So we assume the business is sold for the same price it was bought for, which was $500,000. And then lastly, we think in bond like terms. So if we look at this investment, we're essentially getting about a 300% coupon every single year. And then we get our principal back after that 10 year time period. And this equates to a 21 bagger in 10 years, which is well over 50% compound annual growth rate. Now for the base thesis, we get a little bit more bearish here. So we're going to assume that the economy goes into a severe recession and then the business has a few bad years. We're going to say it has five years of just zero returns. Because of the macro environment, Papa Patel is able to negotiate the interest on his loans to get a little bit better terms. But the final five years, the economy ends up Rebounding and the returns are about $10,000 per year. The business is sold for the same price it was bought for $500,000 after 10 years. And in this case we have bond like returns of 0% for the first five years and then it goes to 200% for the next five years. After the final year we get our principal back and this ends up as still being a seven bagger with annualized returns of 40% per annum. So a very, very good investment. Now we go to the bear side. So in the bear thesis we assume that the economy goes into a severe long term recession for 10 years, which in real life doesn't happen. But you know, why not just plan for the worst, right? So then we assume that Patel is unable to make payments on this investment. The assets are therefore transferred to his debtors and his return is negative 100%. He loses all of his money and in this worst case, of course, the investment goes to zero and he makes zero return and ends up in the hole by $5,000. So then we have to assign probabilities to each of these. So Mohnish assigns 80% to the bull case, which in kind of the way that he worded it in his book is just kind of a base case. He kind of had a base case, then a bear case, then an ultra bear case. But just bear with me here. So let's just say he assigned 80% to the bull case and 10% each to the base and the bear thesis. So even when we factor in these odds, the probability weighted expected returns are over 40%, which means it's an incredible investment. And so I think this is what Mohnish means when he says invest in no brainer investments. If you can bet on investments like this as often as possible, you're going to do very, very well. Now there's a beautiful thing about investing in the stock market. So unlike Papa Patel, the market offers very, very unique advantages to buying privately. So the first one is that there isn't any manual labor involved with owning shares of a business. If Papa Patel's business was traded publicly, he would do all the work while we just observe and reap the benefits as shareholders. It actually sounds kind of unfair when I say that. But public markets exist so that the businesses have access to funding when required to operate or grow. And that's kind of the trade off. Now the second advantage is that we can pick and choose how much of the business we want to own. Since the stock market offers fractional ownership of a company, we can choose to own A fraction of a fraction of a percent of a business, or if we have a lot of capital, larger percentages of a business. So this means that we are in complete control of how much money we are risking, which is just not a luxury you get if you fully own a business privately. Third, public markets in the short term are a voting machine. When a company gets a lot of votes, its price goes up, offering unfortunately, lower returns and elevated risks. But companies also get voted down. In that case, the price ends up going down, which offers higher returns and lower risk. In private transactions, buyers and sellers tend to be better informed, and therefore the purchase price is less likely to diverge as much from value. Because of the structure of public markets, large discrepancies happen in price and value very, very regularly. And a good value investor will take advantage of that fact and buy when the business is cheap, just like a Dundo investor. Fourth, because we can own fractional shares of a business, we don't have large capital requirements compared to owning a private business. You know, not everyone can buy a private business for a million dollars. However, nearly anyone can buy a share or even a fractional share of a public business. Fifth, the stock market offers a massive variety of businesses that can be bought nearly instantaneously through just your phone or a web browser. Suppose you were trying to match the amount of companies that are available in the public markets to the private businesses within, say, 25 miles of you. In that case, you're going to have way more opportunities in public markets compared to private markets. And lastly, there's frictional costs involved with any type of transaction. A tiny private business is still going to cost, you, say, 5 to 10% in transaction costs on top of the purchase price. Stock investing brokers offer minimal fees, and many platforms offer zero trading fees. I won't go into the nuances of zero trading, but let's just realize here that trading fees are becoming less and less of an issue due to improved technology. With private transactions, you just don't get that benefit. Now, while I personally do get some crazy ideas for starting my own businesses, I just continue to be very, very attracted to investing in public existing businesses because the only work involved in doing that is just determining whether the business will create shareholder value above my benchmarks. If I were to invest in a private business, there's certain things I have to do. I have to maybe write a business plan. If I'm creating it from the start. I have to get funding, I have to find buyers, I have to find suppliers, I have to find employ management accountants. And partners. Then I have to buy an office or a manufacturing plan, I have to pay leases. I have to deal with angry investors that I might have if they're still private investors who are investing alongside me. And, you know, with public investing, I just find a business I like, I think that I can understand and I let the company do its thing. It's just a wonderful experience and requires a lot less work. While Mohnish prefers businesses with very long and stable cash flows, he will also take a position in companies that might be very clear for shorter periods of times in terms of their cash flows. So a very good example here is ipsco. So IPSCO was a Canadian steel manufacturer. The investment thesis was very straightforward. So the business traded around $42 a share, and each share had about $14 in cash and zero debt. So the company had visible earnings streams for the next two years, and they reported they would make about $15ish per share in free cash flow for each of the next two years. This meant that after two years, Mohnish would effectively receive all the money invested in the investment back. But it's important to remember that after that two year forecast period, the business did experience a lot of uncertainty. And I think that's why it was so cheap and that's why Mohnish thought it was so cheap as well. Now, after he owned it for about a year, they had an additional year of visibility where they'd make another $14. So the market started catching up on this and the shares went up in price pretty fast to about $90. Eventually it was bought out by a Swedish company for about $160 per share and ended up selling at around $155 per share. Now, I bring up this example for two main reasons. The first one is that I resonate a lot with this style of investing because it integrates safeguards against my own stupidity. So I prefer to tell myself I'll only hold a specific investment for a few years and I want to let it prove to me that it deserves to be held longer. Doing this gives me the freedom to let go of an investment rather than stubbornly cling on to a sinking ship, which unfortunately I have done in the past. So the second point here is that it highlights the importance of just simple investments. I love these types of investments where there's kind of this short one to two year period where profits or cash flows are super obvious. Many of these businesses over a long period of time are very volatile, just like the IPSCO example. So you must understand the underlying business in the industry pretty well. I've made about two investments into these types of companies, and I made out with a minor loss on one, while the other is up 45% in a little over a year. And even the one where I experienced a loss was more because I think I made a big mistake and I should have probably exited it earlier, in which case I would have had a double rather than having a slight loss. So, lesson learned. Now this example of a simple investment leads directly into Mohnish's next lesson, which is on simplicity. So Leonardo da Vinci once said that simplicity is the ultimate sophistication. And I think the same thing rings true in investing. So let's start with simplicity in valuing a business. Mohnish agrees with Buffett that the best way to value a business is still the discounted cash flow that John Burr Williams popularized back in the 1930s. Simply put, the value of a business is the cash flow it will produce over the lifetime of that asset, which is discounted then to a present value. So the cool part about using a discounted cash flow is that you can easily compare stocks with bonds. You can look at a stock that pays off steady cash flow as sort of an equity bond. This equity bond will pay a coupon each year, and after, say, 10 years, you get your principal back plus your yearly coupons. Mohnish uses a simple example of owning a gas station. Let's say the gas station is purchased for $500,000, generates about $100,000 in free cash flow annually, and can be sold for about $400,000 after 10 years. We use a discount rate of 10%, which is a rate of return for the S&P 500 over a multi decade time period. In this case, the gas station has an intrinsic value of about $774,000. So buying it for $500,000 is a discount to intrinsic value, which obviously all value investors like this is a great example that displays many attributes of a simple business. So a gas station, for instance, is simple because the cash flows are relatively predictable. If you compare this to a cyclical business, like, let's just say a gold miner, you're going to get just wild fluctuations in cash flows. Sure, you're going to have some boon years where cash flows increase rapidly. But on the other hand, you can easily run into negative cash flows for multi multiple time periods, which can obviously be very hard if you have any debt that you have to pay back. But you know, I think for the average person, these types of investments that are highly cyclical are probably squarely outside of their circle of competence. And they're better taking a pass on those unless they have some degree of competency in those areas. So the way I see it, there are kind of three very significant advantages of using simplicity in your investing. So the first one is that simplicity just reduces risk. A business with a straightforward business model is less likely to experience negative surprises. A motel, for instance, earns very stable rates, has stable occupancy, and therefore you should favor this company that has fewer paths to ruin over something that might be more complicated. The second one here is that simplicity helps you avoid industries with rapid changes. Yes, you can make good returns by investing in evolving industries, but you must have insights into those industries that few others have or are unwilling to make. Simple businesses and industries don't require leaps of faith to make an investment thesis work. A railroad is a simple business that will probably be around for centuries, if not longer. The same cannot be said for the hottest new SaaS business. And third here, simplicity offers greater predictability. If we subscribe to Pabrai and Buffett's points about cash flow, we obviously want businesses with high probabilities of steady cash flow over long periods of time into the future. If you can successfully predict a business's cash flow, then evaluating it becomes very, very easy. All three of these points work together, and I'd like to touch on them a little bit on as to how they relate to one of Warren Buffett's most famous investments into See's candies. When Warren and Charlie were looking at See's, part of the investment's allure was the business's simplicity. The business just sold chocolate. It had a small geographical footprint and a long track record of success. It was very unlikely to be toppled by a competitor. And it had been around for decades, displaying a high degree of robustness. The simplicity helped reduce risk. Now the chocolate industry is pretty straightforward and resistant to change. No technology alive is going to alter how we feel when we eat a delicious piece of chocolate. Humans will always cherish food, mainly when it's associated with positive emotion. This is not an industry that can be disrupted now. Since seas had been around for so long, had a strong brand, and had a good product, Buffett knew that the probability of it being around in the future was very, very high. Therefore, it was pretty easy for him to see see value. He understood how much pieces of chocolate could be sold, what it would cost to make it, and what he could sell it for. And just knowing those three variables meant that he could value a business like See's very easily. Now See's wasn't a distressed business or in a distressed industry, but Warren Buffett had many successes investing in those businesses. And this brings us to the next principle, which is based on the importance of distressed investing. So Mohnish prefers investing in distressed industries or businesses. These can be highly lucrative or unfortunately punishing, and Mohnish has experienced both. But let's first go over why Mohnish prefers distressed firms or sectors. His first point is that the stock market is usually efficient. And since it's typically efficient, many investing academics will have us believe that there's just no point in trying to beat the market since all the information is already priced into the stocks that make up the market. But I think there are some examples of people who consistently beat the market that this theory has some very, very big holes in it. Now to take advantage of these holes, we have to understand Ben Graham's very, very famous Mr. Market analogy. Let's take a quick break and hear from today's sponsors.
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Kyle Grieve
Back to the show. The Mr. Market analogy is very simple. Stock prices in the short run are guided by the market's mood. If the market is depressed, it will be more willing to sell a business at a low price, and if the market is euphoric, it will be more willing to buy businesses at higher prices. Now the critical point is that if we fully grasp what Mr. Market is thinking, we're going to be offered just many, many great opportunities in our investing lifetime. If Mr. Market is depressed, then buying is a great option. And when the market is feeling euphoric, it's usually a good time to sell or just do nothing. Mohnish has definitely improved his art of doing nothing throughout the years. I think he spent quite a lot of time beating himself up over some of the mistakes that he's made selling winners early. So naturally when markets are depressed, it's a good time to swoop in and pick up cheap shares when you have a variant perception. One great example is Mohnish's investment in Fiat Chrysler, which offers just multiple lessons. So Kreisler at one point declared bankruptcy and Fiat was there to take control of the business. So once Fiat took control, the company was just plain cheap. So Mohnish points out that the business was doing $140 billion in revenue on a $5 billion market cap. Now granted this is a business that has low margins, so you know you're not going to get a one time price of sales, but still it's, it's a pretty big discrepancy. So Fiat Chrysler, which I'm going to refer to here as FCA CEO Sergio Marchione, projected that in 2018 the company would have a net income that surpassed the entire market cap of the business. So this is one of these mythical price to earnings ratios of 1 that Mohnish really likes to talk about. Now, after studying FCA for three months, Mohnish liked what he saw in Marchionne and invested about 70 million in his fund. Eventually he turned that investment into 300 to 350 million of very, very good return. Now these types of investments coming out of bankruptcy can just be ripe for the taking. Think of it from the aspect of someone who held Chrysler shares before the merger happened. So these people were probably not very happy with the state of the business and might be in a pretty big rush to just cut their losses and get out. On top of that, they may not have much trust that a merger would actually help create much value after being part of a narrative that probably destroyed value. Now you mix that in with the perception of the market that Chrysler wasn't a good business, and you start running pretty low on people who are willing to buy the stock. Now this is the kind of distress that Mohnish is looking for. And that's usually what's required to pick up shares of a business that are trading below a forward price to earnings ratio of 1. So we're going to go on a slight tangent here and mention a big mistake of omission that Mohnish made on this investment. So inside FCA was an 80% stake in Ferrari. Now the business was hidden inside of FCA's assets. And while Mohnish liked the brand, he underweight just how good a company Ferrari was once Ferrari was spun out. I believe he held his shares for a short period. I don't know, it might have been a couple years. I couldn't find exact numbers, but he did end up selling and regretted it. So it was interesting because during this time he actually bought a Ferrari and he actually tested out the experience of owning one and how good that experience was. And he learned a lot. So I had three keys that he learned here. So the first one was that the process of buying a car from Ferrari was just different than most other car companies. You don't just really walk into a Ferrari dealership and then leave the lot driving out a brand new Ferrari. It just doesn't work that way. So when you go in, you're put on a wait list and generally speaking, your car arrives within two years. Now, Mohnish had some connections and was able to expedite that process. But for the average person, that's what the waiting period is. And because of this, cars are built specifically for their owners, which is really interesting because there's just no excess inventory. So if there's a car being built, it's already got someone who's going to be buying it. So the second point here is in relation to what happened when he picked the car up. So he said when he came and picked the car up, the dealer actually offered him $100,000 in cash to just walk away without the car. And so Mohnish was kind of gobstruck on wondering why they could do this or why they were doing this. And so the reason was that there was a lot of very impatient customers who wanted Ferraris and if they wanted to get a Ferrari earlier, they could end up paying more money to the dealership and I guess he would have pretty significant markup. So even with his hundred thousand dollar expense, he still made a good profit for selling the cars to people who wanted them without waiting a two year time period. And the last one here was really interesting, was that Mohnish ended up going to this Ferrari driving school and learning about the types of people who own Ferraris and just how much they were willing to spend on the brand. In one of his talks, he was talking to some of the other people that were in his course and asking which Ferrari they had. And he said they all looked at him all strangely and he found out that it was because he was asking the wrong question. The right question was actually how many Ferraris do you have? So a lot of these people just had multiple Ferraris and, and that was how they, that, you know, that's how they spent their money. That was his point, that rich people spend their money by buying a lot of cars. And he thought that that was A good business to be in. Now, Mohnish points out that selling Ferrari was definitely a mistake. His spun out shares were worth about $16 million and he ended up selling them at about 70 to 80 million. So obviously a great return. But as of 2023, they would have been worth what, a half a billion dollars. So the big lesson to pay attention to here is, you know, what specifically can be spun out in distressed assets? You know, obviously there's going to be a lot of spin offs that are just financial engineering, but some spin outs can be exceptionally value accretive, just like this one. So you have to be willing to do the work into what you own. And when a spin off happens, don't necessarily just default to selling shares, because sometimes these spinoffs can be very value accretive and sometimes there can be a company inside of a business that is just hidden value. So it's up to you to do the right amount of work to understand which of those businesses that are being spun out should be held or should be sold. Now the chapter on distressed assets ends with Mohnish discussing a few of the resources that he uses to find distressed industries and distressed businesses. So they're pretty simple. You know the news value line, he likes looking at public filings like 13F's Edgar, NASDAQ.com, value Investors Club, a little book that beats the market. And speaking of Joel Greenblatt, he also mentions magicformulainvesting.com he mentions another resource that no longer exists. So I left that out. But I also want to add a couple resources that I've used that I think anybody can take advantage of. So places that I like to look actively, Number one, Twitter. So, you know, it's, it's very, very simple. I'll go on Twitter and I'll search for a cash tag. And so what a cash tag is, is you just put the dollar sign in front of a ticker symbol, hit search, and you're going to get a bunch of people who are talking about it. So that is just the beginning of the work. Obviously you want to click on that hashtag and see what people are saying. Then look for people who are talking about that business in an intelligent way and then, you know, give them a follow. And then the way to find other ideas is just see what other ideas are talking about. The second one here is using substack. So there's tons and tons of really good high level investors that are using substack to share their ideas with the world. If you just search for an Interesting stock on Google and this add substack to your search query, you're probably gonna find some people who are writing about it pretty much the exact same as Twitter. So similar to Twitter, again, you're just going to find people who are intelligently talking about these businesses and then just take a look at what else they're writing about and see if you can find some ideas there. The other two here are ones I don't find as effective, but other people do. So there's just stock screens. You know, I'm not crazy about these, but if you run out of ideas, you can just throw up a screen and you can often find a couple names that maybe are interesting. And the last one here is Datoroma. If you're a cloner like Mohnish is, or you know, like looking at 13 Fs, this is like the best possible resource. It's basically a cheat code for finding what other really, really good investors are buying and selling. And it also shows the specific stocks that many of these investors are buying and selling, which I think can help you find new ideas or maybe prompt you to dig a little bit deeper into a specific idea and try to put yourself in other people's minds. So all the resources here that I mentioned from Mohnish Perai's book and the ones that I like are really good jump off points, but they, they are just the start of where investors should learn from before hitting the buy button. So one area of emphasis for every business that you should look for is durability, and more specifically, how long and how certain that durability can last. Now to answer this question, you should focus on learning why a business is as good as it is and why competitors will have difficulty competing with them. This leads to Mohnish's next lesson, which is that all investors should invest in businesses with durable moats. Mohnish mentions Chipotle as a business that he enjoys going to and eating their products. So superficially, you know, when you look at a restaurant, just pretty much any restaurant, it's hard to see a moat. You know, a business like Chipotle, obviously they sell kind of Mexican food, but you know, anyone can open a Mexican restaurant right next to a Chipotle if they really wanted to. But you know, Chipotle has gone from one restaurant in 1993 to 3,726 as of the end of 2024. So it's pretty clear that Chipotle is doing something to continue growing its store count at such an astronomical rate. And I think a Restaurant must have something special to do this. And that special sauce is composed of a durable moat. So a moat can be different things. It can be brand, it can be intellectual property, it can be scale economies, it can be network economies, switching costs, or even counter positioning. Mohnish makes a great point in the book that sometimes a company's moat can be hidden. Or perhaps a company will have a moat that's not hidden. Maybe it'll have something like a brand. And then when you dig into the business and start understanding it more and more, you realize that it has aspects of other moats that further strengthen the competitive position versus competitors. So one of my favorite points that Mohnish made in one of his previous interviews was when he said that a company that is complaining that it has no competitive advantage to regulators is usually a very powerful indicator that it actually does have pretty extreme competitive advantages. Now this makes me think of a mental model that I've been looking at lately in the biological realm called aggressive mimicry. So aggressive mimicry is simply when a predator disguises itself as something non threatening to get close to its target. Now I think a business like Amazon is a great example of this. So the business has numerous moats that we can rattle off today in 2025. You know, it's got a strong brand, it's got network effects, it's got economies of scale. But these advantages were obviously built over time. You know, if we looked at the late 90s when Amazon was brand new, I don't think anyone would have ascribed these competitive advantages to Amazon. Bezos used his perception of his business to his advantage in a few ways. So when Amazon was just an unprofitable small business, it allowed competitors to kind of underestimate how much market share Amazon could steal. A competitor like Barnes and Noble might have felt that Amazon wasn't as significant of a threat because it just couldn't turn a profit. And who knows if it would even be around in the next year. However, underestimating them allowed Amazon to make massive strides to secure its advantages. And then on a regulatory note, Amazon didn't really appear as a monopolistic superpower that it is today from its inception, which is to be expected. But you know, kind of piggybacking along that theme of not making money, I think because of that, it stayed at a lot of regulators crosshairs. And this allowed Amazon to build up product lines and services such as Amazon Web Services, kind of discreetly. And it also helped keep attention away from it from some of its biggest competitors. Now one additional Moat that isn't often mentioned is what Hamilton Helmer calls counter positioning. Now this is when a business can't necessarily clone a competitor's business model because it would damage their existing business model too much. And I think Amazon actually had part of this in its hidden moat. So during Amazon's initial expansion, they specialize in getting books to their customers as fast and as cheaply as possible. This disrupted traditional brick and mortar stores like Barnes and Noble. While Barnes and Noble are still around today, the business has lost many, many customers to Amazon simply because retail experience is just different than the E commerce experience. While Barnes and Noble eventually did turn to E commerce sales, the margin of the total businesses are going to be inferior to a digital competitor. And because of the difference in these margins, Amazon was able to invest in other areas of the business grow very rapidly. While Barnes and Noble has grown its top line by about 3% annually since 1995. Another example of moats can be found in commodity type businesses. Now, it's kind of weird to think that a commodity business can have a moat, but let me explain here. So Mohnish discusses a business called Tesero Corp in the book. So this business used to refine oil, which obviously is a commodity. But the interesting part about it was that the business was on the West Coast. And Mohnish points out that a new refinery hadn't been built on the west coast or I think in America in the last 20 years. Additionally, during that time, refineries had decreased from 220 to about 150, all while oil demand was actually increasing by about 2% annually. And another very good part about this business was that they were running at 90% capacity. So any surge in demand meant rising margins. Now, most refineries have to service very specific geographies. For instance, a refiner in California would be able to service California markets, whereas a refinery in Texas would not be able to service California's market. And the reason for this was that the formulations that they would be able to produce wouldn't match the regulations for a specific state. So this moat makes it very difficult for other refineries, even in the same country, to compete with them. Another more recent example of a hidden moat that I think Mohnish has pursued is in coal. He's discussed coal a little bit, but not at too much length. And I believe the reason for this is that he doesn't necessarily want to share all the reasoning that he has for making some of these investments. But as a investor in Coldplay myself, let me share what I think he might be seeing. So Mohnish obviously loves these boom and bust cycles. He mentions how supply demand changes based on commodity pricing. So for instance, when pricing goes up, people get really happy, they increase capacity, and unfortunately, that increased capacity eventually reaches the market, which then drops prices. And when a lot of these commodity prices drop, a lot of the suppliers end up going insolvent because of the decreased demand. And then we look at coal as an industry. You know, coal's just, it's a dirty industry. People don't like it, ESG hates it. The average person in public dislikes it because of the amount of carbon dioxide that it produces. And so because of that, investor sentiment towards the industry just isn't very high. And I think this leads to distressed price levels for businesses that are still, you know, good class flowing, generative businesses. And then on top of that, you know, existing coal mines that were built years ago are going to be much cheaper than building a coal mine today. On top of that, if you want to find funding for a coal mine, good luck, because it's just seen in a very poor light to lend for that purpose. So similar to the Tesaro case study, new coal mines are just not proliferating. So supply is actually being taken offline and not replaced. So this means that existing mines will probably be able to raise prices in the future. And then on top of that, if you think of the economy being in kind of an inflationary period, that's a tailwind because obviously these mines already exist and they don't need to buy extra assets at inflated prices to continue their operations. And then my last point here was that many of these mines like amr, which Mohnish has invested in, have asymmetric upside. So the downside is protected by the business's assets. For instance, AMR is trading right around book value. And if the company were liquidated, equity owners would be paid a fair share because AMR pretty much has negligible debt. So that leaves upside in the business's future cash flow streams, which Mohnish clearly thinks offers a very good upside. So while a business like AMR doesn't appear to have a moat, to the untrained eye, it has some very clear advantages. And if a company can't be competed with, it has some sort of moat. As an investor, it's your job to determine what that moat is, how strong it is, and how long it will last for. The next principle is based on Mohnish's preference for concentration. I will note that Mohnish heavily references the Kelly Criterion in the book. But in later interviews he's admitted that he would actually omit this from the book. So I'll briefly cover it for those of you who are curious. So the Kelly Criterion is a formula that helps you decide how much money to bet or invest in something risky to maximize your long term growth while avoiding going broke. So it works by balancing risk and reward. If a bet has a good chance of winning, you bet more, and if it's a risky bet with low odds, you bet less or don't bet at all. So there's a formula. It's F equals your edge divided by odds, where F is a fraction of the money to bet. Edge is how much you expect to win on average, and the odds are how much you get paid for winning. If the formula tells you to bet 0% or less, you just don't take the bet. The key idea here is that betting too much can wipe you out, while betting too little means you're not growing your money as fast as possible. Now, Mohnish said, you know, the Kelly Criterion, it's still very, very valid, especially in gambling terms. But he overlooked a caveat when he wrote the book, and that's that it only works when you're making a lot of bets. If you're going to the casino and, you know, making a bet every couple minutes, it's very, very valid. But obviously this is not the case in the world of value investing. In value investing, we only, you know, one, two bets a year in order to be successful. So Moni said the stock market doesn't offer the ability to make these repeated bets with well known odds. And therefore the Kelly Criterion just isn't as useful for the use of investing. But let's get back here to bet sizes. So Mohnish prefers a kind of 10x10 approach, which means he's making about 10 bets at about 10% concentration levels, which is definitely quite concentrated. But it's a method that works for him and it's a method that I've also been attracted to. While I may go slightly above or below that number at times, I would say 10 bets is my North Star, just like Mr. Pabrai. Now, the core idea of this chapter is that most investors are just too diversified because of this. Their bets are too spread out, making it nearly impossible to achieve outsized returns. Pabrai thinks investors should emphasize three key areas to combat this. One, make fewer investments. Two, bet big when the odds are in your favor, and three, be patient and only strike when the opportunity is right. Now These three principles will move investors towards concentration, patience, and asymmetry. Mohnish Pabrai has emulated these three attributes from his two investing icons, Warren Buffett and Charlie Munger. Concentration and patience are pretty straightforward, but let's look at asymmetry more to see how investors can exploit it. One of the best examples of this is the case study Mohnish used in his book on Warren Buffett and American Express. So Berkshire Hathaway right now owns a significant state in Amex, but this actually isn't Warren's first ride owning the business. So if we go all the way back to Warren's Buffett partnership days, he had 40% of the fund's assets at one point in American Express, because specifically, it was just an asymmetric opportunity. So the thesis here was simple. Amex had a thriving business in travelers checks and charge cards, but they gave a lousy loan. And because of this, the business was being punished, even though its main money making part of the businesses was fully intact. So once Warren examined the downside risk and realized that Amex wouldn't just suddenly cease operating because of this one bad loan, he knew that the downside was very, very minimal. But he also knew that the upside was very high because the share price had been punished. Now, this is just a bet where heads you win big and tails you lose nothing. And if you can make an investing career based on making these types of bets, you're going to retire a wealthy person. Pabrai references a great Buffett quote that essentially says the partnership will invest in bets with the appropriate risk reward profile. Now, while a bet like this might offer less upside than some sort of moonshot, the fact that you can't lose much means it's something that Warren could put a lot of money behind. Let's take a quick break and hear from today's sponsors.
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- [45:02]
Kyle Grieve
Right, back to the show. When I look at investments, I think of two primary frameworks that can protect my downside. So the first one is asset based downside protection and the second one is future earnings stream downside protection. Now I've had minor successes with asset based downside protection investments, but generally they just haven't worked out super well for me. So my preference is actually to search for businesses where I have A high certainty that the business is earning stream will be higher than it currently is in the near future. If you find a company that will double per share earnings in, let's say, three years, has little to no debt, and isn't trading at egregious price levels, it's very, very doubtful that you're going to lose money. I've actually yet to lose money on any business that has done this successfully. Now I'll leave this topic with a great quote from Mohnish. 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. Now this topic of asymmetry leads nicely into our next chapter on arbitrage. I want to focus on what Mohnish calls the Dundo arbitrage. Now this is arbitrage at a business level. He has a case study on a company called Compulink and I think it was fantastic. So Compulink was founded in 1980 by just two 20 year olds. And the business was started because one of the founders needed a 20 foot cable and the cable only came in seven foot lengths. So when he went to buy the cable, the seller basically said that the workaround was to just daisy chain the three of them to get the necessary length. Now the founder went back and thought about this and then had an idea. So he went back to the PC store and he offered to make the cables in various length. The store owner said that he'd had numerous requests exactly for this offering and therefore he had his first customer. So then the founders just went to work. They bought about 300ft of cable, they cut it into odd lot lengths. Now the economics were incredible for this. So each piece costs about two to three dollars to make and then they ended up selling it to the store for $16. The store would then market up to about $30. And you know, everyone was pretty happy. And due to the success of this one store, they began selling to other retailers as well. But then something terrible happened. Sales just started falling off a cliff. So what happened was that retailers notified CompuLink that they no longer needed their cables because the incumbents, these bigger brands had, you know, better brands and packaging were able to, you know, copy pretty much exactly what they were doing. So feeling defeated, they went back to the drawing board. But they realized something very interesting. They realized that the PC and printer manufacturers were constantly updating their hardware and that the incumbents were always about six months behind on these technological upgrades. So they played just an arbitrage here where they would actually quickly pivot once their product was no longer selling and they would just move on to the next big thing. Now, using this exact strategy, they became an Inc. 500 company just simply due to this arbitrage. Now, I find other forms of arbitrage fascinating. There was one that wasn't mentioned in this book, which is called long horizon arbitrage. I first learned about this from Robert Hagstrom, who I interviewed back on tip 635. Now, this type of arbitrage relies on an investor's conviction in an idea and patience, and having enough patience to allow the business to compound its intrinsic value over time. So when Buffett began investing, we all know he used short term arbitrage. He would buy these cigar butt businesses that were lousy businesses, but they traded at a fraction of liquidation value. So once the market rerated the business and the price and value closed, he would sell. And it worked very, very well for him while he was managing small sums of money. But once he scaled up, these opportunities just failed to materialize. And this is where his search for long horizon arbitrage began. So finding good businesses meant a business could compound its intrinsic value. Now, when you find a business like this, you can simply hold it and wait. The arbitrage opportunity comes from the public markets generally searching for businesses that will do well in the next quarter or two, Right? So the fact a company might be worth more than five years doesn't matter if the share price is likely to drop in the next quarter. Now, you can probably see here that there's obvious benefits to this long horizon arbitrage. If you're willing to hold on to a really, really good business over a long period of time and willing to go through the bumps and bruises and the volatility, you can just do very, very well. Now let's shift gears here and discuss a vital value investing concept that Mohnish writes about. And this is the margin of safety. So Benjamin Graham originally formulated the margin of safety in his legendary investing book, the Intelligent Investor. The idea is super simple. Buy assets below their intrinsic value to protect against the downside and avoid analytical mistakes. Now, the margin of safety principle is vital to value investors for multiple reasons. So the more significant a discount to intrinsic value you buy an asset, the lower your risk is going to be. And then the more significant discount to intrinsic value you buy an asset, the higher your upside will be. Let's break these things down on a stock that most listeners will be familiar with a Business called Costco. So if I look today at Costco, I see virtually no margin of safety. Over the last decade, Costco has had the following growth metrics. Revenue, 9%, earnings per share, 13%. And net margins have grown from 2% to 2.9%. Now, it's really good to see that margin growth. That's pretty incredible to increase it by 50% over that period of time. But to me, the valuation despite this, still just doesn't make any sense. So let's go over why I think this way. So let's assume over the next three years that Costco can maintain its historical EPS growth rate of about 13%. In this case, the business's earnings per share in 2028 is going to be about $25. Now, that's a solid EPS growth rate. But now we must price the business. So what kind of multiple does Costco deserve? If we go according to the market, it's a massive premium. Costco's PE multiple has expanded from about 25 times in 2015 to about 52 times today. A business growing at 13% with a price to earnings of 52 times seems very, very rich to me. So let's just meet in the middle and let's say Costco in three years will have a multiple of about 37 times. So we just multiply EPS by that 37 times multiple and we get a share price of about $925. The current share price is $902. So we essentially make negligible returns in this case. Now, if my assumptions are correct, the business will generate less than 1% returns compounded annually. And this assumes that everything goes perfectly with execution and that they can maintain historical growth rates. It's obvious that the business is not trading at a discount to intrinsic value in this case, and using my assumptions. But let's pretend we're in an alternative universe and all things are equal here. But now Costco's trading for $300, so now our compound growth rate is actually 46%. And even if we use Costco's old multiple of 25 times, we still generate returns of 28%. Now, we definitely have a massive margin of safety. And it's very clear that Costco is cheap in this scenario compared to the first one. This is what marginal safety is all about. The concept's importance is that you may come across businesses that you believe are widely undervalued and the market just doesn't believe the same thing. I found it surprising when I run numbers on some businesses and I can see the types of returns I think are possible at the current stock price. Usually the market might disagree with my assumptions, otherwise the opportunity wouldn't exist. For instance, maybe they believe the business's profits will be eroded by competition. Maybe they believe they won't grow as fast as I'm assuming. Or maybe they think that the business has made a new acquisition and it just won't integrate well. Or maybe they overpaid for it. There's just endless possibilities. This is why it's so important to accept simplicity in your investing. When you have simple investments with high levels of certainty that your assumptions are correct, it strengthens your evaluation of a business. You make big bets when you see significant discrepancies between price and value. An interesting part of the margin of safety concept is that while most investors are aware of it, it's unlikely that many investors actively integrate it into their investing strategy. Now why is this? Charlie Munger, of course, has an opinion. So he said very few people have adopted our approach. Maybe 2% of people will come into our corner of the tent and the rest of the 98% will believe what they've been told, which is that markets are totally efficient. Now, this is an essential realization for many people. If markets are efficient, stock picking ceases to be lucrative. However, as numerous investors have shown us over decades, there's numerous inefficiencies in the market. And people actively seeking these opportunities can make incredible returns when they find the right opportunity. I think the easiest way to take advantage of the margin of safety is to just value businesses that you want to own. So whether you do a discounted cash flow or whether you're using the simple method that I used previously, you should know what a business is worth. Then you can discount its value to present value to come up with a price that you want to pay. Many businesses will not be below what you want to pay. And in that case, you just watch it and you make sure the business is getting better and wait for events that can happen that'll maybe hopefully drop the share price. As part of your analysis of a business, you can even brainstorm specific adverse events that maybe could happen but wouldn't harm your thesis. Some examples might be maybe a business can have a bad quarter due to temporary rise in their input costs, or maybe they have reduced profits due to increasing growth capex that won't be realized for maybe, you know, six to 12 months into the future. These types of events happen very often, and if you watch good businesses closely, you can find opportunities where the price and value diverge. Pretty considerably. You just need to have patience and have some cash ready to deploy. Now, earlier in this episode, I spoke about Mohnish's investment into ipsco. Now, part of the reason that investment was so attractive was that the business had a large margin of safety. Within two years, Mohnish would have had earnings and cash that equal the business's market cap. It's hard to lose money on bets like this, and this is what a margin of safety is all about. Another thing I mentioned with IPSCO is how uncertain its earnings streams were when you went out two plus years in the future. So this brings us to the next lesson. Mooney shares, which is to invest in low risk, high uncertainty businesses. Wall street does not like uncertainty. If a business is going to do well over the next five years, but the next quarter's earnings will decrease, Wall street will exit that investment in droves. And this is precisely because of the near term uncertainty embedded in the business. Mohnish thinks investors should take advantage of this. Now, it's important to note that Mohnish specifically says low risk and high uncertainty. If you are uncertain about a business, but there is a risk that the investment can drop significantly or even go to zero, that's an unacceptable risk that you just simply should not take. So the key to these high uncertainty bets is to have a large margin of safety in case things just don't go your way, which happens very, very often. If we look at ipsco, about a third of the price was in cash. Then you add the two years of earning streams and you get a PE in two years of one when you decrease the cash on the share price. So pretty much the only way you lose money on this is if the company goes bankrupt. And I couldn't find the financials for ipsco, but he did say that IPSCO had no debt. So in that case, if the company went bankrupt, you'd get your $15 in cash and then you'd get whatever amount of cash you could get for the assets back. And I would assume that those assets were worth a decent amount of money. So, so let's imagine a hypothetical situation where the assets were worth $30 a share. In this case, Mohnish would get 15 plus 30, $45 back, which was his initial investment, and therefore he took no risk. Now, I have no idea if that's the actual case or not, but I'm just spitballing here. Now let's focus here on the fact that IPSCO also was bought out for $160. So Mohnish points out that it seemed kind of odd for a business to take IPSCO private at this massive premium when they could have had it for a fraction of that price just a few years earlier. But I think this really just proves the point that businesses, even in the same industry, crave certainty. Would the takeover business have made any offer two years before the takeover bid? You would assume if they did, they could have gotten shares for a significant discount on what they paid. But then they would have to deal with uncertainty, even though Mohnish thought there was no uncertainty until you reached that two year mark. Now, when I reflect on some of the potential investments that I passed on, I see that a major reason for this was having uncertainty. If I didn't understand the business well enough to know what it's worth or thought it could maybe get through some temporary headwinds, I might be more inclined to just take a pass on the business. And I think that's perfectly fine because there's only so many hours in a day and you want to look at investments that just smack you on the side of the head with how obvious they are. Another area where this principle matters is managing current investments. It's vital to key in on the value of your businesses and whether it's shifting. In the best case scenario, your businesses are increasing in intrinsic value while widening their moat. This scenario can happen, yet the share price can still drop. In this case, the two best possible actions are 1 do nothing, or 2 buy more shares. Now, in the worst case scenario, your business's mode and intrinsic value are shrinking. In this case, selling is generally the right thing to do. The trick is to not confuse these two scenarios. An excellent business with a widening moat and increasing its intrinsic value can and does go through rocky periods all the time. Let's just say a company has to invest in its future, which would result in a drop in its free cash flow as long as this new investment will produce a good return. This is a natural part of a business cycle. But the market often will punish these types of business for doing this. I own two where this scenario pretty much happened exactly, which was dinopolsk and Aritzia. And because I understood the investments were necessary for future growth, I was okay with the fact that short term numbers might suffer and I took advantage of this to pick up cheaper shares and I've been well rewarded. Now the last principle that Mohnish outlines in the book is the importance of investing in copycats rather than in innovators. While investors seem to obsess over the latest shiny object, Mohnish thinks that investing in well established, boring and predictable businesses is just far superior. Mohnish writes about the the first few Patels who figured out the wonderful motel ownership business economics in the United States were the trailblazers. The thousands upon thousands of Patels who could simply copy the model did not actually innovate. They simply lifted and scaled a proven idea. Now Moniz truly lives by this rule. If you listen to his conversations, you'll notice he constantly stresses the importance of cloning. He likes to clone other investors and business models. If a business model works well in one geography, it can often work well in another geography as well. Most businesses he's invested in are boring, slow moving industries with little exposure to technological disruption. Now Monish uses Microsoft as a great case study in the book about a business that simply cloned the ideas of others and then just scaled them up. So there are a couple of areas that Microsoft cloned to become a dominant business. The first story was in Ms. Dos, which was Microsoft's operating system that they promised to IBM. The problem was when they promised this operating system, IBM, it didn't actually exist. So to solve that problem, they bought the rights to Quick and Dirty Operating Systems, or qdos, from Seattle Computer Products. Next came the integration of a mouse for computing. So Gates ended up visiting Apple in 1981 and saw the mouse for the first time. A few years later he had his engineers create a working wired mouse, and he essentially observed the idea from someone else and then scaled it himself. And when most people think of Microsoft, Excel is probably the first thing to come to mind. But the earliest version of Excel was not owned by Microsoft. It was something called VisiCalc. And Microsoft was observing this business and seeing that it was growing very rapidly. So they basically wanted to get some exposure to spreadsheets. So Excel is what it is today because it basically cloned many of its features from both VisiCalc and from Lotus 1, 2, 3. And then, you know, you can look at the Xbox, they just clone that from Sony or Nintendo. Now many of the great Chinese tech business are also clones of US competitors. So Tencent has a messaging app called qq, and this was directly a clone of icq. It was initially actually called oicq, but was forced to change its name due to legal action. Now I love this mental model of cloning and scaling because it draws its power from just having validated ideas. The problem with innovation is that an idea starts as just an idea with zero validation, but if the concept has already been validated, it can be improved by others. Simply by cloning it and then scaling it up, just like we talked about in some of these examples. One concept that I've been following closely is the use of automation in legacy industries. I believe many manufacturing companies have seen the success of automation in the last century. And as technology is now being developed, it opens up more and more opportunities for businesses that had no use case for automation previously to now adopt it. One business doing this very well is a business I don't own called ADF Group. They manufacture steel products needed in the infrastructure industry. They have successfully transformed their business through the use of automation and the proof for that transformation is just in their incredible margin improvement. So if you go back to 2018, their net margins were negative 4%. It wasn't even a profitable company. You go to 2024, it's up to 17%. So you know, if you find business in these low tech areas that are now starting to employ automation, I think you're going to find some pretty incredible massive value creators. We'll continue to probably see this theme as automation advances and becomes more and more embedded in the manufacturing process of a variety of different industries. Now, the final part of the Dunndo investor that I want to explore is the art of selling. When Mohnish wrote this book, I believe his selling framework was deeply embedded in Benjamin Graham selling framework of selling. When price approaches intrinsic value, Mohnish writes about a hypothetical business that he bought for $500,000 but was worth a million dollars. He wrote, Two years went by and someone offers us $950,000 for the business. What should we do? We would run another intrinsic value calculation. Assuming cash flows have remained steady, the intrinsic value is still just a million dollars. Moreover, we've enjoyed getting dividends of about 200 grand in the last two years. With the offer being 95% of intrinsic value, it's a no brainer to sell. Now this is an area where I think Mohnish has evolved. While this principle might apply to lower quality businesses with little gross prospects, I think he actually ignores this principle if it's on the right company. So Mohnish has spoken about after reading the chapter on Nick Sleep and Case Zakaria in William Green's richer, wiser, happier book, he began to see the strength of hold just genuinely great, great businesses. So Sleep and Zakaria did incredibly well in their fund because they just bought Costco, Amazon and Berkshire Hathaway and then just did nothing with their shares. Now if you go back and think about it and just observe what would have happened with the prices of these businesses, you can just ask yourself something. Did the price of these business ever exceed intrinsic value? And I would say yeah, it probably did. But you know, they both held firm because they knew and understood the business as well and could continue compounding for years into the future. And because of this, they could close their fund down with incredible annual returns of 21%. Now, because of reading this and understanding the framework better, Mohnish realized that a great business should not be sold when the price exceeds intrinsic value. Instead, he thinks you should sell when the fundamentals of a company are weakening. And absent of that, you should sell only when shares are egregiously overvalued. Now, what egregious overvaluation means is kind of up to your own discretion. It may mean the price is pulled forward five years, 10 years, 15 years. I remember Mohnish saying that Charlie wouldn't sell Costco at 50 times earnings, but if it got to say, 80 to 90 times, he would probably have sold shares. So this is a great mental model to help you understand the staying power of a great business. I've learned that keeping good businesses in my portfolio is much more critical than just taking profits. One such example is a microcap business I have that rents surveillance towers. The business has SaaS like numbers and demand for its products is greater than it can supply to the market. They are rapidly increasing their tower count and the growth is more likely to accelerate than slow down over the next few years. Thoughts have definitely entered my head on whether or not I should sell, simply because the price of the business has actually gone up five times since my lowest entry price in just 18 months. But using this principle of holding great businesses has kept me invested. I estimate the business can increase to about 10,000 towers from its current 1400 towers within about five years. So while the company's shares are definitely, definitely expensive on a trailing basis, when I consider what the company will be worth when it has 10,000 towers, it's going to be significantly higher than the current share price. So I hold the hard part about investing is figuring out what businesses you own will be the most attractive in, say, five to 10 years. But you only need a few companies that can win big to generate incredible returns. So if you have a high certainty that you have one of these businesses in your portfolio, hold onto them and don't let go. That's all I have for you today. If you want to interact with me on Twitter, please follow me Rational mrks or on LinkedIn under Kyle grief. If you enjoy my episodes, please Feel free to let me know how I can make your listening experience even better. Thanks again for tuning in. Bye bye. Thank you for listening to tip. Make sure to follow we study billionaires.
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