In the 1970s, a small Indian ethnic group named the Patels first began arriving in the United States as poorly educated people with no money to their name. Today, this group makes up 0.1% of the US population but owning >50% of all US motel assets worth >$50bn.
How? They outcompeted everyone using the principles of what Pabrai calls “Dhandho”: a low-risk, high-return approach to business stemming from the Gujarati word meaning “endeavors that create wealth”.
In 1991, Mohnish founded an IT services business named TransTech with $100k including $70k in credit card debt. 9 years later, he sold the company for several $mn. The year before selling, he started Pabrai Funds following the same principles and structure (no management fee) behind Warren Buffett’s early 1956-1968 partnership. With $1mn in initial capital backed by 8 families at inception, Pabrai Funds has since returned 13.3%/ year post-fees compared to the S&P 500’s 6%/ year as of the end of June 2019. Today, Pabrai Funds manages >$500mn. Pabrai Funds has no army of managers and analysts. Every investment decision is Pabrai’s.
In 2005, he concluted that poverty is driven by a lack of education. So he and his wife founded the Dakshana Foundation: a non-profit with the same principles that made him a successful value investor, using checklists and simple metrics to help educate Indians living in slums.
Back to the Patels. In the early 1970s, the US economy was hit by the Arab oil embargo, and the motel sector was hit especially hard, directly affected by disposable incomes and high gas prices. Many motels were selling at distressed prices, in some cases by banks that had foreclosed on them. No one wanted to buy motels.
This encouraged the newly-arrived Patels to acquire distressed motels at cheap prices. The families would live in the motel, eliminating any rent expenses, and since they’d worked where they lived, there was no need for a car. Everyone in the family worked doing all the cleaning, maintenance, and management.
This investment was a no-lose situation. If the motel went broke, they could work for several months to save up capital to make the bet once again because prices were so low, and since the Patels didn’t have any money to their name, the personal guarantee to the financing bank was meaningless. If it worked out, the rewards were huge.
The formula was:
- Cost control: They fixated on keeping costs low through intense zero-based budgeting. Competitors couldn’t compete as the Patels drove costs lower and lower until they became the lowest-cost operator in the industry.
- Lower rates: The intense cost control allowed them to charge much lower rates.
- Increase of occupancy: Lower prices meant increased occupancy and thus increased efficiency in operations.
- Cash flow deployment: The Patels would keep handing over motels to up-and-coming Patel relatives to run while adding more properties.
The Patels took a riskless bet with outsized reward potential and made the same bet over and over again. They patiently waited for the right deals and bet big when they arrived.
Pabrai introduces Dhandho arbitrage, where businesses earn above-normal profits for a limited time before competitors or substitutes enter and destroy these higher returns. He then goes on to introduce several companies where the Dhandho arbitrage lasted only a few months while others spanned decades. A short-lived arbitrage spread allowed a cable company named CompuLink to tap into the distribution chain by being one step ahead of their slower-moving, larger competitors by constantly introducing nimbler cables to vendors until competitors had to catch up with the innovation. He also mentions Geico which reaped a Dhandho arbitrage spread by being first at selling cost-effective insurance policies using inbound call centers and the Internet, giving it a dominant position in auto insurance.
Pabrai states that, due to brutal capitalism, all Dhandho arbitrage situations will eventually be eroded, but two important factors can allow investors to earn excellent returns in the interim: the size of the spread (determined by the moat), and its duration.
He writes that three investments done by Berkshire Hathaway—Blue Chimp Stamps, World Book, and The Buffalo News—had moats that evaporated, emphasizing:
This doesn’t mean these were bad investments. On the contrary, all three have been home runs for Berkshire. They had very robust business models for enough years for Berkshire to generate a spectacular return on its investment. See’s Candy was partially bought from the float dollars at Blue Chip Stamps.
Pabrai thinks the market tends to confuse the distinction between uncertainty and risk, which is why some stocks are discounted below intrinsic value for value investors to come in and reap the rewards. Whether its over-leverage as in the case of Stewart Enterprises, negative industry outlook as in the case of Level 3 Communications, or depressed shipping prices as in the case of Frontline, Pabrai walks the reader through 3 different market miscalculations due to risk being mistaken for uncertainty.
When extreme fear sets in, there is likely to be irrational behavior. In that situation, the stock market resembles a theater that is filled to capacity. Someone sees some smoke and yells “Fire, Fire!” There is a mad rush for the exits. In the theater called the stock market, you can only exit if someone else buys your seat – each share has to be held by someone! If there is a mass rush to leave the burning theater, what price do you think these seats would go for? The trick is to only buy seats in those theaters where there is a mass exodus well on its way to being put out. Read voraciously and wait patiently, and from time to time these amazing bets will present themselves.
He also argues that you should ignore the innovators and invest in the copycats run by people who have demonstrated their ability to repeatedly lift and scale. He mentions Ray Kroc, who purchased McDonald’s from the founding brothers and lifted and scaled the existing concept its the franchise model. Sam Walton at Walmart was a lifelong copycat of his competitors and ended up outperforming everyone. Microsoft took the idea of the computer mouse and graphical user interface (GUI) from Apple, Excel from Lotus, Word from Word Perfect, networking from Novell, etc. In each case, these entrepreneurs took a demonstratively successful idea, improved on it, and scaled it.
There’s a in-depth section on selling stocks. Pabrai compares entering a stock to the Indian story of Abhimanyu’s dilemma that’s about two families at war with each other. Their battle involved thousands of troops, swords, and elephants. One of the sides arranged their troops in a spiral formation, a Chakravyuha, which is designed like an Archimedes spiral wreaking havoc on the opposing army. The myth of the Chakravyuha was that if you could successfully enter its center, and successfully exit, it would lead to mass panic and disarray at the enemy’s leadership. But such a traversal would be virtually impossible.
Lord Krishna’s sister was the mother of the story’s protagonist, Abhimanyu. When Abhimanyu was in her womb, Lord Krishna explained how one enters a Chakravyuha and decimates it. She listened carefully to the first part of the story but fell asleep in the second part about exiting the Chakravyuha, so her unborn baby only heard half the story. Abhimanyu goes into the Chakravyuha, has great success slaying enemy warriors, and gets to the center but doesn’t know how to get out. In the end, he’s killed. Pabrai says that it’s only when you enter that the struggles or fruits present themselves.
Mohnish means you should avoid selling a stock if:
- It’s been <2-3 years since the purchase.
- You’re unable to estimate an updated intrinsic value with a high degree of confidence.
- The current price is below your initial conservative estimate of present intrinsic value.
If after three years the investment hasn’t reached intrinsic value, Pabrai argues you’re likely to be wrong about your estimate of intrinsic value and should therefore sell. And if the price rises to or above intrinsic value, you should exit the Chakravyuha to look for other opportunities.
Abhimanyu faced a difficult dilemma. As a valiant warrior he was left with no other choice than to enter the one formidable Chakravyuha in front of him. He could not time his entry to his advantage, and with no exit plan, his unfortunate fate was sealed. We have the luxury of choosing just a handful of Chakravyuhas from over 30,000 over an investing lifetime spanning several decades. Entering these carefully selected Chakravyuhas at times when the soldiers are asleep all but guarantees successful traversals and big rewards.