The Dhandho Investor- Review And Key Highlights


(Akshay Nayak) #1

The Dhandho Investor is a wonderful book written on the concept of Value Investing. The author Mohnish Pabrai, is an Indian American businessman investor and philanthropist. In the book, Pabrai talks about his investment style which he calls Dhandho investing which focuses on minimising downside and maximising upside to an investment

All students of finance (myself included) have always been taught that high risk = high returns and low risk = low return. Elementary logic would tend to agree with this philosophy. Pabrai takes this philosophy and turns it right on its head. In effect he says low risk = high returns, and this philosophy is at core of his investment style. But how does it all work out? Let’s take a look

Dhandho is a Gujarati word meaning business. Now, businesses are best run at low at low costs and low risks and our Gujarati friends are pioneers and thespians of this art. But how does a low cost, low risk style lend itself to investing?

Pabrai has always championed the cause of buying businesses and stocks at a significant discount to their intrinsic value. Now the intrinsic value of something, is nothing but its actual worth. So what Pabrai does is, buy a stock or a business worth say 100 rupees for 50 rupees or less.

The great thing about intrinsic value is that it can only go so low. So when you buy a stock at a significant discount to its intrinsic value, you’re automatically cutting the possible downside to your investment. And its a rule of nature that what is down today must recover tomorrow (whether the tomorrow comes in the next few months or years is another question altogether :wink: )… but the bottom line is if you’re patient enough you’re more than likely to make a hefty profit on your investment.

Pabrai further codifies his style through the use of nine tenets which he calls the Dhandho framework. The nine tenets are given below:

  • Invest in existing businesses

  • Invest in beaten down businesses in beaten down industries

  • Focus on Margin Of Safety (minimising downside and maximising upside)

  • Focus on Arbitrage

  • Invest in copycats rather than innovators (look for businesses with the ability to scale operations upwards)

  • Invest in businesses which are simple and easy to understand

  • Make few bets, big bets and infrequent bets (wait for the right stock, but once you find it, have the conviction to buy a truckload of it)

  • Invest in businesses with durable moats (strong and enduring competitive advantages)

  • Always buy a stock at a significant discount to its intrinsic value

When it comes to selling a stock Pabrai prescribes two simple rules. Firstly, sell a stock when the gap between its market price and intrinsic value is 90-95% covered. Secondly, if you have been holding a stock for three years or more, but are losing out on the investment, sell straight away.

The best thing about this book is the way Pabrai takes these seemingly incomprehensible concepts and explains them like it is child’s play.

As I close out this piece, I would like to remind you that what I have covered here is just the tip of the iceberg. So I implore all readers of this piece to grab a copy of The Dhandho Investor from their nearest bookstore or off the internet and spare a little time to read this book from cover to cover

Take it from me, because I myself have turned investor recently and have benefited immensely from reading this book.


(Agarwala) #2

It is a nice story like reading, written in historical perspective. When in early 70s Idi Amin drove out the Patels from Uganda, some of them settled in USA. They started acquiring the profitable businesses there, specially the motels, which were selling at a distressed rate. The rest is history. 35 years later, Patels were running more than 50 percent of motels in US. Nice read indeed and thanks Akshya for sharing this.


(Dhaliwal) #3

Pabrai has been successful in many of his investments. He also claims that his funds perform really good compared to peers (i haven’t verified it myself).

The book is a good read. It is difficult to find good stocks in overheated markets (as has been discussed many times on this forum in the past).

And, this forum is full of people who are performing research and sharing knowledge with others to make informed investment decisions. As I have noticed lot of messages here and you see that in majority of stocks discussed here, the valuations have gone up by 5 times or more.


(Pooja) #4

This is pretty interesting! Investing in a stock at the time of maximum pessimism …
Can you perhaps blog about a case study from your own experience that can help us understand how you determine the intrinsic value.


(Akshay Nayak) #5

@Pooja First off, thank you so much for your valuable feedback. Your support and appreciation makes all the time and effort I put into these posts worthwhile. Coming to your request for an example, I’m really sorry for not including an example in my post as I felt it would make an already long post even more lengthy. But I will meet your request now.

Consider the following information taken from the annual report of Graphite India Limited for 2017 (all figures in crores):
Net Cash Flow from Operations = 250.16
Interest expenses = 6.5
Tax Rate = 30%
Post tax interest expenses = 4.55 (6.5 - 30%)
Net Capital expenditure = 80.44

Now, FCFF = Net cash flow from operations + Post Tax interest expenses - Net Capital Expenditure

Therefore FCFF = 250.16 + 4.55 - 80.44 = 174.57. This is the value of the FCFF today. Let’s call it Year 0

Now, let us hypothetically assume that Graphite India Limited has a cost of capital capital of 10% and cash flows are expected to grow by 5% every year. Assuming you have a three year investment horizon the free cash flows are calculated as follows:
Year 1: 174.57 + 5% = 183.3
Year 2: 183.3 + 5% = 192.46
Year 3 (Terminal Cash Flow) : 192.46 + 5% = 202.48

Now that we have estimated the FCFF figures, we discount the future FCFFs to their present values at the appropriate discounting rate, which is the cost of capital, which is 10%. Doing this we get:

Year 1: 183.3 x 0.909 = 166.62
Year 2 : 192.46 x 0.826 = 159.09
Year 3 (Terminal Cash Flow): 202.48 x 0.751 = 152.06

Now we add up all the present value cash flows to get the Net Present Value or NPV. Doing this we get:
NPV = 166.62 + 159.09 + 152.06 = 477.77 crores

Now, the market cap of Graphite India Limited is currently 13,875.57 crores. A comparison with the NPV clearly shows that Graphite India Limited is clearly overvalued on an intrinsic basis given our assumptions and investment horizon.

Hope you find this example useful.

If you want further clarity on some of the concepts discussed here, you can always have a look at my post titled ‘Valuation 102: True Beauty Is Always Intrinsic’


(sandeepayachit) #6

Well explained! Thanks.


(phreak) #7

Am afraid this is highly incorrect. You stopped at Year 3 because your investment horizon was 3 years? So if your horizon was 1 year, you would value the company at 1 year’s FCF? That way every single company will be overvalued by a country mile. You have ignored the terminal value of the business. Graphite India being a cyclical business is unfit for DCF unless you are covering the entire cycle in a forecast period. Am afraid there are too many problems in this calculation.


(Akshay Nayak) #8

@phreakv6 Sorry for the wrong calculation. Here is a better one. I will be expanding on the Graphite India Limited example with the assumption that the company will ultimately be going into liquidation.

Continuing with the same data where Graphite India Limited has a present free cash flow of 174.57 crore with a free cash flow growth rate of 5% per annum, assuming a 10 year investment period, we get the following cash flows:

Year 0 (today): 174.57
Year 1: 174.57 + 5% = 183.3
Year 2: 183.3 + 5% = 192.46
Year 3: 192.46 + 5% = 202.90
Year 4: 202.90 + 5% = 212.20
Year 5: 212.20 + 5% = 222.80
Year 6: 222.80 + 5% = 233.94
Year 7: 233.94 + 5% = 245.63
Year 8: 245.63 + 5% = 257.91
Year 9: 257.91 + 5% = 270.81
Year 10: 270.81 + 5% = 284.35

Further discounting these cash flows at the cost of capital which is 10%, we get the following following present value cash flows:
Year 0 (today): 174.57
Year 1: 183.3 x 0.909 = 166.61
Year 2: 192.46 x 0.826 = 158.97
Year 3: 202.90 x 0.751 = 151.76
Year 4: 212.20 x 0.683 = 144.93
Year 5: 222.80 x 0.620 = 138.13
Year 6: 233.94 x 0.564 = 131.94
Year 7: 245.63 x 0.513 = 126
Year 8: 257.91 x 0.466 = 120.18
Year 9: 270.81 x 0.424 = 114.82
Year 10: 284.35 x 0.385 = 109.47

Now, adding these present value cash flows we get an NPV of 1537.38 crore.

The present book value per share of Graphite India Limited is 94.78. Assuming that Graphite India Limited goes into liquidation at the end of the 10 year period, with no significant change in book value per share, we get the following liquidation value:
94.78 x 19.53 crore shares outstanding (this figure has been obtained from Graphite India Limited’s 2017 annual report.) which gives us a liquidation value of 1851.05 crore. Discounting this liquidation value to present value we get:
1851.05 x 0.385 = 712.65

Adding the discounted liquidation value to our cash flow NPV we get:
1537.38 + 712.65 = 2250.03 crore

This value compared to Graphite India Limited’s current market cap of 14778 crore clearly shows that Graphite India Limited is intrinsically overvalued at this point of time.

Hope you find this explanation helpful.


(Dinesh Sairam) #9

Why assume Graphite India will go into liquidation at the end of Year 10? And why use the Book Value as the Terminal Value? IIRC, regardless of what anyone’s investment horizon is, a stock should always be valued at the PV of all the cash flows it will produce in its lifetime.

In fact, valuing for a specific holding period sounds weird. Even the best of investors don’t know when a stock will meet its intrinsic value requirements. They just calculate the Value, purchase at a discount to the value and hold on to however long it takes to achieve the returns.


(Vasu) #10

Agree there is no right way to value a stock especially in dcf ,however your assumptions and valuation methodology doesn’t make logical sense. Too many simplistic assumptions were made for the simplicity in your caluation. Refer to ashwath damodarans blog for better valuation assumptions which you can incoporate.


(Akshay Nayak) #11

@dineshssairam @vistag Assuming that the company will go into liquidation, is just one of the assumptions which can be made for the purpose of valuation. And yes a terminal value after a certain number of years can also be found without assuming that the company goes into liquidation. The formula for the same can be given as follows:

Terminal Value = [FCFFn (1+g)]/(r-g)

Where,
FCFFn - Free Cash Flow To The Firm for the nth year basically the last year of our investment period
r - Discount Rate converted into decimals
g - Free Cash Flow Growth Rate converted into decimals

When we use this formula we are assuming that the company will continue to exist and cash flows will continue to grow at the end of our investment period.
So, if this is applied to our Graphite India Limited example, we get the following terminal value:
FCFF in year 10 = FCFFn = 284.35
Discount rate in decimals = r = 10% or 0.1
Free Cash Flow growth rate in decimals = g = 5% or 0.05
Therefore,
Terminal Value = [284.35 (1+0.05)]/ (0.1-0.05)
= [ 284.35 * 1.05]/ 0.05
= 298.56/0.05
= 5971.35 crore

So adding this to the earlier calculated cash flow NPV of 1537.38 crore we get a final result of 5971.35 + 1537.38 = 7508.73 crore. Compared to the current market cap of 14778 crore, Graphite India Limited is still overvalued.

Remember not to use the discounted value for the FCFFn figure, because the discounting will be done when we apply the Terminal Value formula.

Hope you find this explanation more logical and helpful


(Kritesh Abhishek) #12

The Dhandho investor by Mohnish Pabrai is one of my favorite books on investing. His ideology of “Heads I win, Tails I don’t lose much” is worth following.

The book is quite simple to read and complex investing principles are simplified in an easy-to-understand manner. The Dhandho framework mentioned in the book helps in investing in low-risk businesses with high returns.

Overall, it’s a great read. Highly Recommended.

P.S. I have also written a detailed review of this book which you can find here: http://www.tradebrains.in/the-dhandho-investor-book-review/

Cheers!