Note: While reading a book whenever I come across something interesting, I highlight it on my Kindle. Later I turn those highlights into a blogpost. It is not a complete summary of the book. These are my notes which I intend to go back to later. Let’s start!

It is these nine principles that constitute the Dhandho framework:

  1. FOCUS ON BUYING AN EXISTING BUSINESS

  2. BUY SIMPLE BUSINESSES IN INDUSTRIES WITH AN ULTRA-SLOW RATE OF CHANGE

  3. BUY DISTRESSED BUSINESSES IN DISTRESSED INDUSTRIES

  4. BUY BUSINESSES WITH A DURABLE COMPETITIVE ADVANTAGE—THE MOAT

  5. BET HEAVILY WHEN THE ODDS ARE OVERWHELMINGLY IN YOUR FAVOR

  6. FOCUS ON ARBITRAGE  
  7. BUY BUSINESSES AT BIG DISCOUNTS TO THEIR UNDERLYING INTRINSIC VALUE  
  8. LOOK FOR LOW-RISK, HIGH-UNCERTAINTY BUSINESSES  
  9. IT’S BETTER TO BE A COPYCAT THAN AN INNOVATOR

More notes:

  • Trying to figure out the variance between prices and underlying intrinsic value, for most businesses, is usually a waste of time. The market is mostly efficient. However, there is a huge difference between mostly and fully efficient. It is this critical gap that is responsible for Mr. Buffett not being a street corner bum

  • Markets aren’t fully efficient because humans control its auction-driven pricing mechanism

  • How do we get a list of distressed businesses or industries? There are many sources, but here are six to begin with:
    • If you read the business headlines on a daily basis, you’ll find plenty of stories about publicly traded businesses. Many of these news clips reflect negative news about a certain business or industry. For example, Tyco’s stock collapsed when the Dennis Kozlowski scandal was front and center. Martha Stewart’s prison sentence clobbered that stock
    • Value Line publishes a weekly summary of the stocks that have lost the most value in the preceding 13 weeks. It is another terrific indicator of distress. This list of 40 stocks routinely shows price drops of 20 percent to 70 percent over that period. The ones with the largest drops are likely the most distressed
    • There is a publication called Portfolio Reports (www .portfolioreports.com) that is published monthly. It lists the 10 most recent stock purchases by 80 of the top value managers. It gleans this information from the various filings that institutional investors are required by law to make. Portfolio Reports lists the buying patterns of such luminaries as Seth Klarman of Baupost, Lou Simpson of GEICO, Marty Whitman of Third Avenue, Peter Cundill of the Cundill Group, Bruce Sherman of Private Capital Management, and Warren Buffett
    • If you’d like to avoid the subscription price tag for Portfolio Reports, then much of that data can be gleaned by looking directly at the public filings (e.g., SEC Form 13-F) that institutional investors have to make
    • Take a look at Value Investors Club (VIC; www. valueinvestorsclub.com). It is a wonderful web site started and managed by Joel Greenblatt of Gotham Capital
    • Last, but certainly not least, please read The Little Book That Beats the Market by Joel Greenblatt
  • Between these sources, there are now a plethora of candidate distressed businesses to examine. How can we ever get our arms around all of them? Well, we don’t. We begin by eliminating all businesses that are either not simple businesses or fall squarely outside our circle of competence. What’s left is a very small handful of simple, well-understood businesses under distress

  • 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. It’s all about letting the Kelly Formula dictate the upper bounds of these large bets. Further, because of multiple favorable betting opportunities available in equity markets, the volatility surrounding the Kelly Formula can be naturally tamed while still running a very concentrated portfolio

  • Ford Motor Company’s primary innovation was the assembly line. This allowed the mass production of automobiles at vastly reduced costs. Not only was the assembly line adopted by every Ford competitor, but it became standard across virtually all manufacturers in all industries. The assembly line arbitrage spread closed for Ford many decades ago. General Motors’ innovation was the segmentation of the auto market by creating brands and models for every type of consumer. That arbitrage spread closed many years ago. It is no surprise both businesses have had a very hard time making any money for quite a while. Their founding arbitrage spreads are history, and Ford and General Motors are the successful ones. Thousands of auto companies formed in the early days of the automobile had very thin arbitrage spreads and quickly vanished from the scene

  • An enduring Dhandho arbitrage spread is what Warren Buffett called a moat when responding to a question at the 2000 Berkshire Hathaway annual meeting in Omaha, Nebraska: We like to own castles with large moats filled with sharks and crocodiles that can fend off marauders—the millions of people with capital that want to take our capital. We think in terms of moats that are impossible to cross, and tell our managers to widen their moat every year, even if profits do not increase every year. We think almost all of our businesses have big and widening moats

  • Always look for arbitrage opportunities. They allow you to earn a high return on invested capital with virtually no risk. Exploit these Dhandho arbitrage spreads for all they are worth

  • Graham’s genius was that he fixated on these two joint realities:
    • The bigger the discount to intrinsic value, the lower the risk
    • The bigger the discount to intrinsic value, the higher the return  
  • In the fall of 2000, as I was looking at Value Line’s listing of stocks with the lowest price-to-earnings (P/E) ratios, something jumped out at me. Week after week, there were two stocks that I’d never heard of that were showing up as the lowest P/E stocks in the entire Value Line universe. They were Service Corp. and Stewart Enterprises. Both were sporting P/E ratios under three. I’ve looked at these Value Line lists for several years and seeing a business in their 1,600-stock universe trade at under three times earnings is a rarity. Further, I noticed that both these businesses were in the funeral services business. It sounded like a simple business, so I decided to dig deeper  
  • I recalled reading an interesting article in the Chicago Tribune in the mid-1990s. The article delved into the rate of business failure by industry. Of particular interest was a table that listed rates of business failure by SIC code. I found it interesting that the lowest rate of failure of any class of business was funeral homes. When I thought about it, it made perfect sense: • Families want the last rites of their loved ones to be done right. They don’t go shopping for the low bid. They are likely to follow tradition and use the services of the same funeral home that the family has used in the past. • I don’t know any teenagers who aspire to become tycoons in the funeral business. The morbid nature of the business also serves to keeps upstarts down to a trickle. • As Warren Buffett has succinctly stated, industries with rapid change are bad for the investor. The choices that most humans consider for their last rites are pretty set and slow to change over hundreds of years. Even the growing preference for cremations over burials is a gradual shift that existing players have easily adapted to. • The population of the United States continues to grow and is expected to keep increasing over the coming decades, leading to an increasing revenue stream for years to come. • While increased life expectancy puts a damper on near-term revenue, pre-need sales counterbalance this trend. Pre-need sales make up about 25 percent of the total revenue for many operators. How would you like to be in a business where your customers pay you today for a service you might not deliver for 40 years! With these characteristics, funeral homes ought to trade at very high premiums and double-digit P/E ratios. Their cash flow has a very high degree of certainty. And yet, here was this bulletproof business being discarded by the Street   
  • I recalled reading an interesting article in the Chicago Tribune in the mid-1990s. The article delved into the rate of business failure by industry. Of particular interest was a table that listed rates of business failure by SIC code. I found it interesting that the lowest rate of failure of any class of business was funeral homes. When I thought about it, it made perfect sense: • Families want the last rites of their loved ones to be done right. They don’t go shopping for the low bid. They are likely to follow tradition and use the services of the same funeral home that the family has used in the past. • I don’t know any teenagers who aspire to become tycoons in the funeral business. The morbid nature of the business also serves to keeps upstarts down to a trickle. • As Warren Buffett has succinctly stated, industries with rapid change are bad for the investor. The choices that most humans consider for their last rites are pretty set and slow to change over hundreds of years. Even the growing preference for cremations over burials is a gradual shift that existing players have easily adapted to. • The population of the United States continues to grow and is expected to keep increasing over the coming decades, leading to an increasing revenue stream for years to come. • While increased life expectancy puts a damper on near-term revenue, pre-need sales counterbalance this trend. Pre-need sales make up about 25 percent of the total revenue for many operators. How would you like to be in a business where your customers pay you today for a service you might not deliver for 40 years! With these characteristics, funeral homes ought to trade at very high premiums and double-digit P/E ratios. Their cash flow has a very high degree of certainty. And yet, here was this bulletproof business being discarded by the Street. There was no clear answer in July 2000 as to how Stewart was going to pay down its debt load and avoid default. Wall Street assumed the company would have to declare bankruptcy when it defaulted on its debt and tanked the stock. At the time, Stewart had about $700 million in annual revenues and owned about 700 cemeteries and funeral homes in nine countries, with the bulk of them in the United States. Stewart’s tangible book value was $4 per share. It was thus trading at half of book value. Since book value included hard assets like land at cost, it was likely understated. Stewart’s earnings and operating cash flow for the six months ended April 30, 2000, was about $38 million, or about $0.36 per share. On an annualized basis, it was producing free cash flow of about $0.72 per share. The stock was trading at less than three times cash flow. It was also trading at about one-quarter of annual revenue  
  • On the exterior, there was no visible change after these hundreds of mom-and-pop funeral homes were acquired. The names were maintained since these small funeral homes had tremendous brand equity in their communities, but the back end, merchandising, selling pre-paid funerals, and such were streamlined and corporatized. Each underlying funeral home was an excellent business with lucrative and predictable free cash flow characteristics. The weak balance sheet of the parent company was the culprit. By the time the debt came due, the company would generate over $155 million in free cash flow, leaving a deficit of under $350 million. I concluded that there were five possible scenarios for Stewart over the next 24 months: 1. Each individual funeral home is a distinct standalone business. Stewart was a roll-up that had bought hundreds of family-owned funeral homes. Each had kept the same name. Most customers did not know that ownership had even changed hands. Thus, to raise cash, Stewart could elect to sell some of its funeral homes. Presumably, many of the previous owners might buy them back. The company had typically paid eight or more times cash flow for each funeral home. I figured that it should be able to sell boatloads of these back to the original owners for at least four to eight times cash flow. Thus, 100 to 200 homes might be sold to take care of the debt. Odds I ascribed to this scenario playing out 25 percent 2. Stewart’s lenders or bankers could look at the company’s solid cash flow and predictable business model and extend the loan maturities or refinance the debt—especially if the company offered to pay a higher interest rate (e.g., 200 basis points higher than present). Odds I ascribed to this scenario playing out 35 percent Equity value in 24 months if this scenario played out >$4 per share 3. Stewart could look for another lender. With the robust cash flows, it was likely to find many takers— especially if it offered 100 or 200 basis points more than it was presently being charged. Odds I ascribed to this scenario playing out 20 percent Equity value in 24 months if this scenario played out >$4 per share. 4. Stewart goes into bankruptcy. In a bankruptcy reorganization like Stewart, the judge would order that some of the businesses be sold and cash proceeds be used to repay defaulted debt. In a distress sale, these funeral homes should still go for at least five to seven times cash flow due to competition among buyers. A few hundred businesses (at most) get sold and the company emerges clean from bankruptcy. Odds I ascribed to this scenario playing out 19 percent 5. A 50 mile meteor comes in or Yellowstone blows or some other extreme event takes place that takes Stewart’s equity value to zero. Odds I ascribed to this scenario playing out 1 percent Equity value in 24 months if this scenario plays out $0 per share It is clear that there is much uncertainty about how this might play out. The risk of a permanent loss of capital is under 1 percent. It is a textbook example of a situation with ultra high uncertainty and ultra low risk. If presented with such a scenario, Wall Street will irrationally collapse the quoted value of the business. Always take advantage of a situation where Wall Street gets confused between risk and uncertainty. The results will usually be quite acceptable   
  • Innovation is a crapshoot, but investing in businesses that are simply good copycats and adopting innovations created elsewhere rules the world

  • Following in the tradition established by Bill Gates, I’d like to confess that Pabrai Funds also has been a shameless cloner. Prior to starting Pabrai Funds in 1999, I had never worked in the financial services industry. I had, however, spent some time studying the 1950s Buffett Partnerships and contrasted it to the way money was (and is) managed by the majority of mutual funds and hedge funds. I made some useful observations

  • I consider Mr. Buffett’s fee structure to be a sustainable competitive advantage. Fidelity Investments cannot go to zero fees below 6 percent annualized without putting their very existence at risk—there is too much infrastructure and staff that needs to be paid. The cloner in me figured that if I could somehow set up a fund with Mr. Buffett’s fee structure, two things were likely to be true. First, it ought to be very appealing to a good number of mutual fund and hedge fund investors due to the superior economics. Second, it was not a fee structure that could be adopted by most mutual funds and hedge funds—even if they recognized the competitive advantage it would bring. Having a moat that your competitors can see in broad daylight but never ever cross is just fantastic—and a rarity. So I shamelessly cloned Mr. Buffett’s fee structure   
  • Value investing is fundamentally contrarian in nature. The best opportunities lie in investing in businesses that have been hit hard by negativity. Even the pundits of the efficient market theory, Eugene Fama and Ken French, concluded that stocks in the lowest decile of price/book ratios outperformed stocks in the highest decile by over 11 percent a year from 1963 to 1990. If you had invested $10,000 consistently in stocks with the highest price/book ratios (the Googles of the world) in 1963, it would have grown to about $72,000 by 1990. Not bad. However, if you had invested those same dollars in the cheapest businesses, you’d have $915,000 by 1990. I’d say that’s a statistically significant difference   
  • Here are seven questions that an investor ought to be thinking about before entering any stock market chakravyuh: 1. Is it a business I understand very well—squarely within my circle of competence? 2. Do I know the intrinsic value of the business today and, with a high degree of confidence, how it is likely to change over the next few years? 3. Is the business priced at a large discount to its intrinsic value today and in two to three years? Over 50 percent? 4. Would I be willing to invest a large part of my net worth into this business? 5. Is the downside minimal? 6. Does the business have a moat? 7. Is it run by able and honest managers? One should only consider buying if the answer to all seven is a resounding yes.

  • Let’s imagine that toward the end of 2006, a neighborhood gas station is put up for sale and the owner offers it for $500,000. Further, let’s assume that the gas station can be sold for $1,000,000 after 10 years. Free cash flow—money that can be pulled out of the business—is expected to be $100,000 per year for the next several years. What is the intrinsic value of this gas station assuming a 10 percent discount rate? Its intrinsic value is $1,000,000. The gas station is being offered to us at just $500,000. What a deal! Now, we know its intrinsic value today ($1 million). Discounted Cash Flow (DCF) Analysis of the Gas Station Year Free Cash Flow ($) 2007 100,000 2008 100,000 2009 100,000 2010 100,000 2011 100,000 2012 100,000 2013 100,000 2014 100,000 2015 100,000 2016 100,000 2017 Sale price 1,000,000 Total Present Value ($) of Future Cash Flow (10%) 90,909 82,645 75,131 68,301 62,092 56,447 51,315 46,650 42,410 38,554 385,543 1,000,000 (rounded) and that we’d be buying at 50 percent off, which is terrific. We make the investment. Two years roll by and someone offers us $950,000 for the business. What should we do? We would run another intrinsic value calculation. Assuming that cash flows have remained steady, the intrinsic value is still $1 million. Moreover we’ve enjoyed getting dividends of $200,000 in the past two years. With the offer being at 95 percent of intrinsic value, it is a no-brainer to sell. The final economics look like this: Funds invested $500,000 Total proceeds $1,150,000 Annualized return Over 50 percent Buying at the steep discount to intrinsic value enabled us to get a 50 + percent annualized return on the investment, even though the gas station was only generating a 10 percent return for us based on the cash invested.

  • The only time a stock can be sold at a loss within two to three years of buying it is when both of the following conditions are satisfied: 1. We are able to estimate its present and future intrinsic value, two to three years out, with a very high degree of certainty. 2. The price offered is higher than present or future estimated intrinsic value.  
  • While valuations of public companies can go through dramatic change in a matter of a few minutes, real business changes takes months, if not years. The gas station has seen dramatic drop-offs in cash flows and the future is murky. We need to allow enough time for the clouds to clear. In two to three years, it should be quite clear whether oil prices are likely to stay permanently at $150 a barrel or higher, whether the government has stepped in to help, whether consumer conservation patterns were temporary or permanent, whether the business model can be transformed to emphasize other products or services, and so on. Once two years have passed and cash flows are still at $20,000 a year, you ought to be open to a sale at $200,000 or higher if you have a compelling investment alternative for the proceeds. Once three years have passed, all the shackles are off. At this point, I would be open to selling at any reasonable price—even if it means a big loss on the investment. Markets are mostly efficient and, in most instances, an undervalued asset will move up and trade around (or even above) its intrinsic value once the clouds have lifted. Most clouds of uncertainty will dissipate in two to three years  
  • The three-year rule also allows us to exit a position where we are simply wrong on our perception of intrinsic value. If we didn’t have an out and always waited for convergence to intrinsic value, we may have an endless wait. There is a very real cost for waiting. It is the opportunity cost of investing those assets elsewhere. Hence, there is a balance between allowing a sufficient time frame for a stock to find its intrinsic value and waiting endlessly

  • Why two to three years? Why not two to three months or five to six years? I don’t have a rigorous proof for why this period should be two to three years. We know that a few months can be inadequate. Real business change does take time. If a CEO were looking to make certain key hires or enter or exit certain markets, it takes months, if not a year or longer to accomplish the same. Similarly, our gas station is dealing with a shock to its business model. We need to allow some time for the clouds to lift or at least thin out. Waiting 5 to 10 years for the clouds to lift or business changes to become visible is too long. There is a very real cost of waiting. If we hold on to the gas station for 10 years and eventually get back our $1 million including dividends, then reinvest the proceeds in another investment that gets us an annualized return of 12 percent for the next 10 years, our total assets after 20 years are about $3.1 million. Alternately, if we sell the gas station for $700,000 after two years, then invest the proceeds at a 12 percent annualized return for the next 18 years, we’d have nearly $5.4 million. In fact, if we sold the gas station at anything over $400,000 after two years, we do better than holding it for 10 years and selling it for a million. It is very hard to make up the lost non-compounding years. We must be patient, but not wait endlessly. My conclusion is that two to three years is just about the right amount of patience for losers to fix themselves

  • After three years, if the investment is still underwater, the cause is virtually always a misjudgment on the intrinsic value of the business or its critical value drivers. It could also be because intrinsic value has indeed declined over the years. Don’t hesitate to take a realized loss once three years have passed. Such losses are your best teachers to becoming a better investor. While it is always best to learn vicariously from the mistakes of others, the lessons that really stick are ones we’ve stumbled though ourselves. Over time, learning from your stumbles, you’ll begin to notice a diminishing number of unsuccessful chakravyuh attempts

  • Within three years of buying, there is likely to be convergence between intrinsic value and price— leading to a handsome annualized return. Anytime this gap narrows to under 10 percent, feel free to sell the position and exit. You must sell once the market price exceeds intrinsic value. The only exception is tax considerations. If you’re looking at short-term gains as a result, you should hold on until long-term gains can be realized or the price is enough of a premium over intrinsic value to cover the extra tax bite

  • The mantra always is “few bets, big bets, infrequent bets”—all placed when the odds are overwhelmingly in your favor. The Kelly Formula is an excellent guide to figuring out how many stocks to own. A “quarter Kelly” is a good way to go. If you can get to holding 5 to 10 diverse, well-understood value stocks in your portfolio, you’re well on your way to trouncing the markets and decimating one chakravyuh after another

  • The Magic Formula is a very good place to go hunting for fifty-cent dollar bills. We could keep it very simple, only analyzing Magic Formula stocks day in and day out, and become quite wealthy over time

  • Here are nine other ponds where we are likely to find more of these fifty-cent dollars
    • The Value Investors’ Club (VIC) web site is open to the public, and it is loaded with a plethora of fifty-cent dollars. Anyone can view these write-ups on individual stocks on www.valueinvestorsclub.com
    • Subscribe to Value Line (or review it at a library). Study their “bottom lists” every week. They list stocks that have lost the most value in the preceding 13 weeks, ones trading at the widest discounts to book value, lowest P/E, highest dividend yield, and so on. It is a wonderful treasure trove to dig in and discover
    • Look at the 52-week lows on the New York Stock Exchange (NYSE) daily. This is published in many newspapers, including the Wall Street Journal, as well as readily available on the Internet. Barron’s publishes a weekly list of stocks that have hit a 52-week low during the week
    • Look at the 52-week lows on the New York Stock Exchange (NYSE) daily. This is published in many newspapers, including the Wall Street Journal, as well as readily available on the Internet. Barron’s publishes a weekly list of stocks that have hit a 52-week low during the week
    • Subscribe to Outstanding Investor Digest (OID; www .oid.com) and Value Investor Insight (www.value investorinsight.com). Both carry detailed interviews and write-ups with some of the best value money managers in the United States 
    • Subscribe to Portfolio Reports. It is published by the same people as OID, and it lists the recent buying activity of some of the best money managers in North America. Alternately, you can get close to the same data on Nasdaq.com
    • Another web site that is free and can partly replace Portfolio Reports is Guru Focus (www.gurufocus.com)
    • A sister publication of Value Investor Insight is Super Investor Insight. It too tracks the 13-F filings of the super investors of our time. This is another worthwhile subscription to get. 8. Subscribe to the major business publications— Fortune, Forbes, the Wall Street Journal, Barron’s, and BusinessWeek—at a minimum. A tremendous amount of research and brainpower goes into every page of content in these publications. It is presented in an easyto-digest format at a super value price. The more you read up on the different companies, people, and industries in these publications, the better you’ll get at securities analysis. That’s the long-term benefit   - Attend the biannual Value Investing Congress (www .valueinvestingcongress.com)
    • If an investor runs a portfolio of 5 to 10 stocks and holds them for one to three years, he or she needs to come up with an investment idea or two just every few months. The combination of Magic Formula, VIC, Value Line, OID, Value Investor Insight, Portfolio Reports, Super Investor Insight, Guru Focus, and the various business publications are all likely to drop a few fifty-cent dollars right into your lap

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