Thursday, April 14, 2016

Low Risk High Value High Return Framework for Value Investing

In the book  The Dhandho Investor,  author and value investing  practitioner Mohnish Pabrai clearly explains how to follow the tenets of  value investing, and doing it  successfully too.
Mohnish Pabrai discusses India’s  savvy business community - Patel’s -  and their capital allocation framework  of this business savvy community.  Patels have flourished in the US.
Pabrai explains this model alongside simple methods and approaches described by Buffett, Graham and Charlie Munger.

Here are a few valuable investing concepts from the famous book The Dhandho Investor.

If you are investing in an existing business, you are in an advantageous position in terms of analyzing it in different cycles and getting the right information required to make sound investment decisions. This is why it is important to look for companies that have been in the business for long rather than searching for new start-ups or some fancy names, which are making headlines of late. These are fairly low-risk and predictable businesses because of their existence and ability to demonstrate performance over a period of time. Here the objective is to remove the risk that comes with new businesses, which may not have a proven track record. It is not new; it is the proven business that makes money. 

In line with the philosophy of not losing money, the other important thing that he outlines is to invest in simple businesses that are easy to understand and predict without much scientific work or expertise needed to analyze the operation. So if you have to choose between a railroad company and an aviation company, which one do you think has a simple business model? The objective here is to avoid risks. Instead, invest only in companies whose business you understand and read about the activities that influence these businesses. During the course of its operation, a number of companies go out of businesses for reasons that are often not known to investors because they never understood what drove the particular business. And when things go wrong, investors are left with nothing but losses. 

According to Pabrai, human behaviour and psychology impact share prices, much like a pendulum, which swings to the extremes in both directions. In investing, when the share price of a company goes very low, that is when investors must  invest in that stock. At this time, because of excessive fear, there is high probability of buying some of the cheapest stocks. Mohnish Pabrai quotes Warren Buffett who says: “Never count on making a good sale. Have the purchase price attractive that even a mediocre sale gives good result”.   

Again safety of capital is important and one of the things that protect businesses and investor capital is a moat. Moat is nothing but a sustainable competitive advantage that a company enjoys. If a company has a durable and sustainable advantage, there is a likelihood that the business will never go out of fashion. Companies which do not have a competitive advantage often die or get wiped out by competition before the companies actually make money for their shareholders. To cite an example, fixed line telephone services providers are today literally out of business with the mobile telephone capturing the entire market in India. 

It is one thing to be standing right at the top of the gold mine and other to actually be able to carry it. Therefore, the best thing to do is to load the truck when opportunity strikes and you know that the odds are in your favour. Investors like Warren Buffett and Charlie Munger simply do nothing for years. They hardly make any investment decision till the time they encounter a deal which is seriously  worth taking. For instance, Warren Buffett bought huge shares and invested heavily during the crash of 2008 and bought some of the banks, which were junked by the Street. 

When the risk is controlled or minimized, the focus is on returns and one of the tricks that the book discusses is finding some wide arbitrage in the market which are often available to investors due to mispricing of businesses. The book defines arbitrage as an attempt to profit by exploiting price differences in identical or similar financial instruments. The trick is to gain mispricing while remaining invested in a stock till the arbitrage shrinks or evaporates. They are often risk-free because of the nature of the underlying instrument.     

When you buy something at $50, which is worth $100, you have clinched a deal. This not only prepares you for future volatility in prices but also makes sure that if the prices reach its original value, you will earn handsome returns. Margin of safety is quite similar. This idea was espoused by Graham where he talked about buying businesses at low prices. You buy something below its intrinsic value and possibly at a substantial discount so that the possibility of something going wrong does not really impact you as most of the risk has already been factored in the price. So, the margin of safety is an important concept that Mohnish Pabrai dwells upon in the book both from the point of view of minimizing the risk while generating higher returns at the same time.

When fear rules the roost and there is huge uncertainty, people do not want to own that stock at any price. But if you are able to figure out that the possibility of the business going bust or permanent loss of capital then there is a huge deal to be made because prices will be so attractive that you can make huge returns over a period of time.

Pabrai does not believe in reinventing the wheel when it is not required. Most people refrain from recreating something that has already been created or proven successful. Pabrai says that Patels paved the way for the next generation and showed them the right path of doing business. What you need to do is simply copy the business. Similarly, apply this to investing too and copycat ideas that have already been successfully explored by other investors. So, if your neighbour is a great stock picker, you simply go out there and ask him which stocks he has invested in. Then, you do your homework and see if it makes sense to you, and follow if it does. He calls this cloning of ideas where you actually save a lot of time, energy and money.

As published in Nirmal Bang's Beyond market