Take-Home Lessons on Value Investing

Do you want greater investment returns? You need to assume more risk. So says academic finance, which rests almost entirely on the principle that reward necessarily entails and is commensurate with risk. Indeed this assumption has at least an element of truth to it, inasmuch as stocks are riskier than bonds, and also tend to deliver greater returns than bonds over longer (say, multiyear) periods of time.

Hedge fund manager and author of "The Dhandho Investor," Mohnish Pabrai, begs to differ with the academics. Like so many value investors who've come before him (and to whom he's duly deferential), Pabrai provides a framework for selecting unloved, overlooked, forgotten, and seemingly boring businesses that are selling at cheap enough prices to minimize risk and maximize returns.

Seeing Stocks as Living Businesses
Crucial to Pabrai's disagreement with the academics is his understanding of risk, which is permanent loss of capital or permanent business impairment rather than stock price volatility. Pabrai's approach to investing discourages viewing stocks as squiggly lines on a chart subject to short-term supply and demand pressure. Instead, he encourages understanding them as ownership units of living, breathing businesses with sales, expenses, manufacturing cycles, inventory, capital expenditures, and (hopefully) profits. "Dhandho" itself is the Indian word for business, making the translated title of the book "The Business Investor." This closely parallels the view taken by Warren Buffett; following his teacher Benjamin Graham, Buffett encourages any investor to think of himself as a "business owner."

Putting a Value on Cash-Generating Potential
If price volatility isn't a proper measure of risk, fluctuations can afford an investor the opportunity to purchase a business for less than it's worth, according to value investors like Pabrai. When the market smells trouble and sends a stock's price down, value investors smell a potential overreaction and get to work valuing the business. Pabrai uses basically the same approach to valuation that we use at Morningstar; he assumes a business is worth the present value of its future cash flows. Once Pabrai has a sense of how much cash a business will generate in the future, he discounts for risk and for what it could earn in a guaranteed investment such as a U.S. Treasury Note. This calculation reveals what that pile of cash is worth today. He divides this number by the amount of outstanding shares, and voil�, he has a valuation of each share of the business. The fancy name for this is "discounted cash-flow analysis," but if you can multiply and divide, you can discount a cash flow. (Go to the Stocks Curriculum at Morningstar's Investing Classroom for more information on discounting cash flows.)

Taking a Cue From Buffett's Past
Again using a method similar to the one we use at Morningstar, Pabrai thinks that moat quality, or competitive advantage, is crucial to evaluating a business. The more durable the competitive advantage, the more years the business should generate outsized returns on invested capital--and the more years of cash flows you can count toward the value of the business. (My colleague Justin Fuller's recent interview with Pabrai reveals Pabrai's broad agreement with the Morningstar approach to stocks.)

However, Pabrai's examples of stocks that he's bought in the past reveal that he'd perhaps prefer to buy a mediocre or decent business at a very cheap price than an excellent business at a mediocre price. In this, Pabrai resembles Warren Buffett as he functioned in the first part of his career, when he ran a private investment partnership. In Buffett's "second career" at  Berkshire Hathaway (BRK.B), we find him buying more outstanding businesses with wider moats at fair prices. Indeed, the writings Pabrai cites as influencing him most deeply are Buffett's letters to his partners in the 1950s and 1960s.

The Hallmark of Dhandho
Pabrai doesn't appear to spend much of his time analyzing behemoth, well-known, hugely profitable enterprises such as  Proctor and Gamble (PG) or  American Express (AXP)--both current Berkshire holdings--because they are what he calls "low uncertainty" businesses that are almost always fairly priced. Only in rare situations, such as when Buffett purchased American Express in the midst of a scandal, do they find themselves in the kind of low-risk, high-uncertainty territory--with the accompanying significantly reduced price tag--that makes them Dhandho investments.

The best situations, according to Pabrai, are those with low risk for permanent capital impairment but high uncertainty--that is, a wide range of possible outcomes. Wall Street hates uncertainty, even if the likely range of outcomes is mostly positive and the possibility of permanent loss is minimal. To overcome Wall Street's prejudices, Pabrai uses the Kelly Formula by which an investor tries to assign probabilities to a range of possible outcomes for a given investment. It would be difficult for anyone to divine exact inputs for the formula, given the risk and uncertainties inherent in nearly all investment situations. However, going through the formula can be a useful exercise, as it forces investors to think about their expectations and the probability of its downside risk.

The Kelly Formula's ultimate purpose is to tell an investor what percentage of his capital to invest in a particular stock, given the odds the investor ascribes to the various possible outcomes. If the prospects for success are great and the possibility of loss is small, the formula tells you to load the boat with an investment. In many of the situations Pabrai discusses, the formula encouraged him to invest huge amounts of capital. In fact, Pabrai rarely invests more than 10% of his capital in a particular stock, often rejecting the more aggressive encouragement of the formula; but being forced to handicap his odds for each situation still serves to limit his investments to the few opportunities that provide truly mouth-watering upside potential with limited risk of capital impairment.

Does Pabrai Follow His Own Advice?
A concentrated portfolio of an investor's best ideas is the royal road to returns that many index-hugging mutual funds refuse to follow, according to Pabrai, who reserves praise only for the Third Avenue and Longleaf fund families and Bill Miller at Legg Mason. Oddly, Pabrai neglects to mention the extreme differences among these successful investors regarding valuation methods. For example, Third Avenue's Marty Whitman prefers to choose securities with ample assets backing up their value instead of running a discounted cash-flow analysis, famously labeling the securities he likes "safe and cheap," partly because of their solid balance sheets.

This neglect isn't so bad on its own, given that Pabrai isn't writing a book about mutual funds, but a problem related to it emerges in his discussion of his own investments. First, when Pabrai discusses a successful bet on funeral parlor owner  Stewart Enterprises  at a time when it and its competitors were facing a liquidity crunch, he (properly) gears the analysis toward the company's balance sheet and whether it would survive its liquidity crisis, but he doesn't provide much of a discounted cash-flow analysis, and he doesn't discuss the company's competitive advantage or moat (indeed, Morningstar currently classifies Stewart as a no-moat business). There's nothing wrong with Pabrai's asset-based approach, but we'd like to see Pabrai include additional support for this bet, especially after his defense of the moat-oriented discounted cash-flow approach.

Moreover, Pabrai never says what distinguished Stewart from one of its competitors that went bankrupt. His case for Stewart's continued viability in the midst of a cash crunch is persuasive as he presents it, but it's incomplete without a comparison to the industry peer--Loewen--that didn't make it. Pabrai thought that Stewart could sell assets to remain solvent until profitability improved, which it did; but he never says why Loewen couldn't or wouldn't do the same thing.

Second, when Pabrai discusses his purchase of  Level 3 Communications  convertible bonds--another distressed situation in which the balance sheet and the firm's immediate viability were the major issues--he mentions that the firm did a private convertible bond offering to Buffett, Bill Miller, and the Longleaf funds, who injected the company with cash. Unfortunately, Pabrai doesn't say whether that was crucial to the company's survival. When he (Pabrai) bought the debt, he had no knowledge that the company would be able to find more liquidity. Indeed, Pabrai mentions that he believed CEO Jim Crowe, who repeatedly argued that the company would never run out of cash.

Pabrai makes much of the management team at Level 3, whom he says he trusted implicitly. One could say that getting involved with great management helped in this instance, and that's the lesson to learn. However, even honest management can't always make liquidity materialize precisely when the firm most needs it. Virtue doesn't always find itself in a position to make a difference, leading the reader to wonder whether Pabrai didn't just get lucky on this one.

Summing up Pabrai's Best Lessons
One the whole, "The Dhando Investor" offers readers several pieces of valuable advice. The following are gleaned from our favorites:

• make a few large bets infrequently
• be fanatical about assessing the downside of any investment
• don't mistake risk of permanent capital impairment for uncertainty
• question the dictum that more risk is required for greater return
• resist being charmed by businesses that seem to be innovators

Expanding on the last point, Pabrai believes that shameless copycats wind up making the surest investments. He ought to know, as this book repackages and successfully executes the lessons of Graham, Buffett, and others. However, Pabrai gives credit to his sources of inspiration, and despite the book's shortcomings, we think Pabrai's reformulation of basic value investing principles is eminently readable and instructive.