What was Sam Saying in 1977?

Over the last couple weeks, I’ve spent some time getting acquainted with the “young” Sam Walton. Walmart’s website reproduces annual reports going back to 1972, and some of the early ones include letters from the entrepreneurial Chairman. Let’s take 1977 as a case study.

In their fiscal year 1977, Wal-Mart increased its store count from 125 to 153 (or 22.4%), while at the same time growing sales from $340 million to $479 million (40.9%) and earnings from $11.5 million to $16.5 million (43.5%)—more stores, producing even more sales, and even better earnings.

If those look like outstanding numbers, you need not make an appointment with your optometrist. As Walton narrates, “your Company again achieved record highs…” [notice the possessive] Comparable same store sales increased 19%–“to my knowledge, no other general merchandise retailer in the United States came close to equaling this figure.” And expenses remain low, “… classified as one of the lowest in the industry.” Since 1974, the total expense structure fell from 21.1% of sales to 20.8%.

Yet, even with Wal-Mart’s rapid growth, dividends increased 25%, from .08 to .1 per share. And this should be the norm, for “our Board of Directors has a stated policy of continuing to increase dividends proportionate to our increase in earnings.”

Rest does not find the able though, for ambition demands activity. In the year ahead, Wal-Mart “will be striving to achieve our sales goal of $100 per square foot of gross store space. Last year, we hit a new high of $88 a square foot in sales, which was well above the industry average.” So continues the challenge of “developing Wal-Mart into one of the leading retailers in the United States.” I wonder whether Sears Roebuck got a copy of the letter?

Of course, the investor’s question remains. Would you want to be partners in the discount retail business with the ambitious Arkansan? The trends look promising—consistently selling more, and earning more, with relatively meager capital investments. If you’re game, what would you pay to partner with Walton? By January 1977, he’s using assets with a book value of $66.2 million and earning $16.5 million. For an average business, one might pay 10x earnings plus book value. But a discount retailer who just grew earnings 43.5%?

In early 1977, that partnership would have cost you less than $12 per share—a price that implied Walmart’s value to be $163 million. More recently, the market values the founder’s business near $188 billion.

Disclosure: No position

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Finding the Next Sam Walton

We’ve banked a few posts for the upcoming week, so expect a more regular schedule again for a while.

For today, enjoy some of Charlie Munger, discussing “The Art of Stock Picking.”

There he provocatively highlights the stunning success of one Sam Walton:

“It’s quite interesting to think about Wal-Mart starting from a single store in Bentonville, Arkansas against Sears, Roebuck with its name, reputation and all of its billions. How does a guy in Bentonville, Arkansas with no money blow right by Sears, Roebuck? And he does it in his own lifetime ‑ in fact, during his own late lifetime because he was already pretty old by the time he started out with o­ne little store….

He played the chain store game harder and better than anyone else. Walton invented practically nothing. But he copied everything anybody else ever did that was smart ‑ and he did it with more fanaticism and better employee manipulation. So he just blew right by them all.

He also had a very interesting competitive strategy in the early days. He was like a prizefighter who wanted a great record so he could be in the finals and make a big TV hit. So what did he do? He went out and fought 42 palookas. Right? And the result was knockout, knockout, knockout 42 times.

Walton, being as shrewd as he was, basically broke other small town merchants in the early days. With his more efficient system, he might not have been able to tackle some titan head-on at the time. But with his better system, he could destroy those small town merchants. And he went around doing it time after time after time. Then, as he got bigger, he started destroying the big boys.

Well, that was a very, very shrewd strategy.”

Later Munger opines that “were [he] a young man,” he might concentrate his investing energies of finding great companies with stellar management when they are just starting out.  In that vein, we’ll be doing a little research on the young Sam Walton and his retailing tricks over the next few weeks.  If you have any resources you’d recommend, or would like to contribute, please pass them along.

Disclosure: I, or persons whose accounts I manage, own debt of Sears at the time of this writing.

Buffett’s Berkshire Letter for 1991

1991 saw Scuds and Patriots battle over desert skies. Cracks became fissures, and the brittle Union of Soviet Socialist Republics finally dissolved. In the stock market, the S&P 500 launched from the gate—rising from 325 to 380 in the first quarter—only to chortle along for the remainder, and close with a two week sprint to 417. Including dividends, the 500 gained 30.5% for the year.

Over at Berkshire, net worth rose to $2.1 billion, or 39.6% YOY. In its most recent 27 years (i.e., since present management took over), per-share book value has grown from $19 to $6,437, or at a rate of 23.7% compounded annually. “Look-through earnings” declined from $602 million in 1990 to $516 million.

For Buffett, the goal of each investor should be to create a portfolio that will deliver the highest possible look-through earnings a decade from now. Successful investing requires the investor to think about long-term business prospects rather than short-term stock market prospects. It is crucial then that an investor competently distinguish companies with long-term “economic franchises” from mere businesses, those companies with wide moats from those with none.

An economic franchise “arises from a product or service that: 1) is needed or desired; 2) is thought by its customers to have no close substitute and; 3) is not subject to price regulation.” These conditions enable a company to “regularly price its product or service aggressively and thereby to earn high rates of return on capital. Moreover, franchises can tolerate mis-management. Inept managers may diminish a franchise’s profitability, but they cannot inflict mortal damage.”

A mere “business” earns exceptional profits “only if it is the low-cost operator or if supply of its product or service is tight. Tightness in supply usually does not last long. With superior management, a company may maintain its status as a low-cost operator for a much longer time, but even then unceasingly faces the possibility of competitive attack. And a business, unlike a franchise, can be killed by poor management.”

In Berkshire’s stock portfolio in 1991, Coca Cola, Gillette, and Guinness PLC meet Buffett’s definition of an economic franchise. Only a few years prior, The Washington Post Company and Capital Cities/ABC would have also sat in this class. However, in recent years, “the economic strength of once-mighty media enterprises continues to erode as retailing patterns change and advertising and entertainment choices proliferate.” By 1991, newspaper, television, and magazine properties now resemble businesses more than franchises in their economic behavior. GEICO and Wells Fargo represent mere businesses, albeit ones which are some of lowest cost providers in their industry. Each has superior management—as Buffett often notes—but were mismanagement to arrive, costs could quickly escalate, and their moats erode.

Given Buffett’s lecture, one may be surprised to find that Berkshire acquired another “business” in 1991—H.H. Brown Company, a shoe manufacturer. Candor reigns, for “shoes are a tough business… and most manufacturers in the industry do poorly. The wide range of styles and sizes that producers offer causes inventories to be heavy; substantial capital is also tied up in receivables. In this kind of environment, only outstanding managers like Frank Rooney and the group developed by Mr. Heffernan can prosper.”

What distinguishes H.H. Brown’s management? For one, their compensation system is one of the most unusual Buffett has encountered: “key managers are paid an annual salary of $7,800, to which is added a designated percentage of the profits of the company after these are reduced by a charge for capital employed. These managers therefore truly stand in the shoes of owners.” Unlike most compensation schemes which are “long on carrots but short on sticks,” the system at Brown has served both the company and managers exceptionally well, for “managers eager to bet heavily on their abilities usually have plenty of ability to bet on.”

Ultimately, the best investments are those with favorable long-term economic characteristics, honest and able management, and a fair price. With H.H. Brown, Buffett shows that two out of three is sufficient to pass his tests.

In light of our contemporary economic environment—with new government equity stakes in highly competitive industries with questionable economics—Buffett offers a final and interesting coda. Recall that a few years back, Berkshire bought convertible preferred stock in a notoriously bad “business”—US Air. On Berkshire’s balance sheets, Buffett and Munger valued this stock at a significant discount to its par value, to reflect the risk that “the industry will remain unprofitable for virtually all participants in it, a risk that is far from negligible.”

1991 was a “decimating period” for airlines, as Midway, Pan Am and America West all entered bankruptcy. Continental and TWA followed some months later. And the risk to the entire industry was further heightened by the fact that “the courts have been encouraging bankrupt carriers to continue operating. These carriers can temporarily charge fares that are below the industry’s costs because the bankrupts don’t incur the capital costs faced by their solvent brethren and because they can fund their losses—and thereby stave off shutdown—by selling off assets. This burn-the-furniture-to-provide-firewood approach to fare-setting by bankrupt carriers contributes to the toppling of previously-marginal carriers, creating a domino effect that is perfectly designed to bring the industry to its knees.”

[If history serves as precedent, keep an eye out for GM and Chrysler promotions in the months and years ahead. And you really thought Ford could survive?]

Disclosure: I, or persons whose accounts I manage, own shares of Berkshire Hathaway at the time of this writing.

[Also, check out our other posts in our Berkshire Hathaway Letters Series.]

Buffett’s Eye on Google’s Moat

Some recent fussing over Google has followed from an unlikely source—the Berkshire Hathaway annual meeting. During a Sunday press conference, Charlie Munger quipped that “Google has a huge new moat. In fact I’ve probably never seen such a wide moat.”

Unfortunately, Charlie’s brevity and the reporters’ lack of curiosity leave the reader to surmise what he really means. Warren Buffett kindly filled a bit of the gap when he added that Google’s search-linked advertising is “incredible.”

At a basic level, their observations are hard to dispute. Any time a brand name enters our common lexicon, one can assume that their product has attained sufficient “share of mind” to command pricing power. Even the most ardent Yahoo-er would not be so uncouth as to “yahoo” the web for an answer.

As if seeking confirmation, many leapt to conclude that Buffett and Munger now find Google a great investment. Yet a wide moat does not a great investment make. And I can think of no better criteria for an investment than those which have served Buffett and Munger so well over the years, and which are annually reproduced in Berkshire’s annual reports. An investment must have: 1) demonstrated consistent earning power, 2) earn good returns on equity while employing little or no debt, 3) have honest and able management, 4) operate in simple businesses, and 5) be available at a fair price (somewhat below its intrinsic value, to provide a margin of safety).

Given these criteria, Google couldn’t pass as a viable investment for two reasons—it is too difficult (likely impossible) to forecast what the “search” market will look like in ten years, and Google’s equity currently sells at a premium price. One only needs to look back ten years ago to see a Google with no “share of mind.” For Buffett and Munger, Google’s moat—like Microsoft’s—is extremely wide, but its durability is unknowable.

Disclosure: I, or persons whose accounts I manage, own shares of Berkshire Hathaway at the time of this writing.

Buffett’s Berkshire Letter for 1986

1986 saw seven million people join hands in Hands Across America–a well-publicized, but unsuccessful attempt to raise $50 million to alleviate famine in Africa.  Later in the year, the Iran-Contra Affair features on the public page, revealing that the United States had sold weapons to Iran in exchange for the release of 7 American hostages held in Lebanon.  And the stock market had drawn its share of helium, with S&P soaring from its open near 165 to close the year near 210.

Over at Berkshire, net worth increased by $492.5 million, or 26.1%, and for those keeping score (be assured the Chairman is), that signifies an increase of 10,600% over 22 years, from $19.46 to $2,073.06 per share.

The good news for Berkshire’s owners is that they own a grove of money trees; the bad news is the fruit of their grove has not found fertile ground to grow tomorrow’s trees.  In the stock market, where Buffett and Munger had previously found abundant fertile ground, the terrain now looks sterile and barren. The best available alternative in 1986 then was to pay off debt and stockpile cash. Though “neither is a fate worse than death, they do not inspire us to do handsprings either. If we were to draw blanks for a few years in our capital-allocation endeavors, Berkshire’s rate of growth would slow significantly.”

After some obligatory back-slapping and “atta-boys” for Berkshire’s managers, Buffett talks the business. At Buffalo Evening News, they have attained both the highest weekday and Sunday penetration rates (near 83% on Sunday) of the top 50 papers in the country. At Nebraska Furniture Mart, net sales increased 10.2% to $132 million, and the only logical explanation for their success is “that the marketing territory of NFM’s one-and-only store continues to widen because of its ever-growing reputation for rock-bottom everyday prices and the broadest of selections.” At See’s Candies, their “one-of-a-kind product ‘personality’” derives from “a combination of [their] candy’s delicious taste and moderate price, the company’s total control of the distribution process, and the exceptional service provided by store employees.” More than any other metric, See’s manager Chuck Huggins “measures his success by the satisfaction of our customers, and his attitude permeates the organization.”

The big news of the year are Berkshire’s acquisitions of Scott Fetzer (which includes World Book and Kirby) and Fechheimer, a uniform manufacturing and distribution business. In the case of Fechheimer, its Chairman Bob Heldman had concluded that their company fit Buffett’s criteria for desired acquisitions: “1) large purchases (at least $10 million of after-tax earnings), 2) demonstrated consistent earning power, 3) businesses earning good returns on equity while employing little or no debt, 4) management in place, 5) simple businesses, and 6) an offering price.”

And Heldman was right. As Buffett recounts, “Fechheimer is exactly the sort of business we like to buy. Its economic record is superb; its managers are talented, high-grade, and love what they do; and the Heldman family wanted to continue its financial interest in partnership with us… the circumstances of this acquisition were similar to those prevailing in our purchase of Nebraska Furniture Mart: most of the shares were held by people who wished to employ funds elsewhere; family members who enjoyed running their business wanted to continue both as owners and managers; several generations of the family were active in the business, providing management for as far as the eye can see; and the managing family wanted a purchaser who would not re-sell, regardless of price, and who would let the business be run in the future as it had been in the past.” For those curious, Fechheimer earned $8.4 million pre-tax in 1986, and the purchase price valued the entire business at 6.5x pre-tax earnings.

Lastly, over at the insurance businesses, prices have firmed and premiums boomed, likely making Berkshire “the fastest growing company among the country’s top 100 insurers.” Not only that, but the cost of their insurance float fell, with Berkshire’s combined ratio falling from 111 in 1985 to 103 in 1986.

Despite Berkshire’s performance, they were no match for their partially-owned competitor GEICO. Under the leadership of GEICO’s Chairman Bill Snyder and with the investing acumen of Lou Simpson, GEICO’s moat grew considerably. As Buffett observes, “the difference between GEICO’s costs and those of its competitors is a kind of moat that protects a valuable and much-sought-after business castle. No one understands this moat-around-the-castle concept better than Bill Snyder, Chairman of GEICO. He continually widens the moat by driving down costs still more, thereby defending and strengthening the economic franchise. Between 1985 and 1986, GEICO’s total expense ratio dropped from 24.1% to the 23.5% mentioned earlier and, under Bill’s leadership, the ratio is almost certain to drop further.”

All told, the businesses performed well in ’86, but the stock markets offered few bargains. As a temporary home for Berkshire’s growing piles of cash, Buffett begrudgingly took some positions in merger arbitrage, for “common stocks, of course, are the most fun. When conditions are right that is, when companies with good economics and good management sell well below intrinsic business value – stocks sometimes provide grand-slam home runs. But we currently find no equities that come close to meeting our tests.”

Disclosure: I, or persons whose accounts I manage, own shares of Berkshire Hathaway at the time of this writing.

[Also, check out our other posts in our Berkshire Hathaway Letters Series.]

Be the Dumber Guys in the Room

Business, most simply, is the practice of persuasion with the aim of making money. And the wise, worldly investors like Charlie Munger have done well in large part because of their familiarity with basic incentives and common methods of persuasion. One of Munger’s favored guides in his study has been Dr. Robert Cialdini, and in particular, his book Influence: Science and Practice, now in its 5th edition [see our previous discussions here, here, and here].

Dr. Cialdini, with Noah Goldstein and Steve Martin, has recently co-authored a shorter, more accessible account of social psychology’s established findings on human persuasion, entitled Yes! 50 Scientifically Proven Ways to Be Persuasive (Free Press, 2008). All told, it offers 50 brief vignettes that describe effective tactics of persuasion. Though the reader will find some reprises from Influence, I found much of interest and use.

For example, the authors describe the danger of being the brightest person in the room, or in one’s field. James Watson and Francis Crick are well-known as the discoverers of the double helix structure of DNA, even though Rosalind Franklin was the most intelligent scientist working on the problem in those days. Presumably like Franklin, Watson and Crick had clearly identified the most important problem to probe, dedicated their minds fully to its pursuit, and were passionate about their work. Yet, their advantage was their collaboration. Whereas the most brilliant tended to work alone, Watson and Crick sought advice and insight from all resources.

And more recently, behavioral scientists Patrick Laughlin and his colleagues have confirmed the value of collaboration, finding that “the approaches and outcomes of groups who cooperate in seeking a solution are not just better than the average member working alone, but are even better than the group’s best problem solver working alone” (100). Multiple minds working together stimulate more creative solutions and command wider knowledge and perspectives. Further, multiple actors can work on specialized tasks, expediting progress and enabling “parallel processing.” However, despite these benefits, Goldstein et al. argue that decisions made completely by committee are “notorious for sub-optimal performance” (101). Hence, their ultimate recommendation is that information be gathered and accessed collectively, but that decisions are made by a leader.

What lessons can we take from this knowledge of our patterned behavior? In investing, collaboration has clearly produced unprecedented returns for the team of Buffett and Munger. Yet, neither is shy in admitting that Buffett makes most of the buying decisions—at times, not even consulting Munger. Practically speaking, as one gathers information about a potential investment, there is a temptation to myopia, particularly if one is initially inclined to buy or sell. Data that confirms our inclination stands bold; disconfirming data melts into the mess. Crucial then is the intentional act of building and weighing the case against the proposed action. For each security one buys, he must achieve equal fluency in the case for selling. And vice versa. Only amid the trial of contending voices can the decisive agent invest intelligently.

Disclosure: I, or persons whose accounts I manage, own shares of Berkshire Hathaway at the time of this writing.

Retailing and Moats

Few retailers benefit from an enduring economic moat because many goods stocked on their shelves reside at their competitors. Seemingly the only thing to distinguish their goods is the price. Hence in retail, the widest and best moat is found around the business that consistently offers the lowest price. As Charlie Munger observes, “retail is a very tough business. [Warren and I] realized that we were wrong. Practically every great chain-store operation that has been around long enough eventually gets in trouble and is hard to fix. The dominant retailer in one twenty-year period is not necessarily the dominant retailer in the next.”*

Though only fools would dare position themselves contrary to Munger, it is striking, when one surveys the American retail space, how many retailers appear to thrive. Of course, Circuit City and Linen ‘n Things have recently taken the fall, but the majority still remain, even amid this dire economic environment. Yet, when I survey the survivors, it is hard to discern any economic moat, much less a wide one. The washing machines at Lowe’s, at Sears, and at Best Buy appear virtually indistinguishable; the same Dockers line the walls of Sears, Kohls, and JCPenney. Yet, more of our family’s dollars find their way to Target than any other, even though Wal-Mart often offers better prices. Are we doubly fools, or does Target offer something which its competitors do not?

Looking at the numbers, Target has 351,000 employees, which produce 64.95 billion in sales, at a gross margin of 28.6% and an operating margin of 6.78%. Sears is likely their most similar competitor—in inventory, assets, and sales—and it has 324,000 employees, producing 46.77 billion in sales, at a gross margin of 27.05% and an operating margin of 1.31%. Wal-Mart, with its gargantuan 405 billion in sales, brings a lower gross margin of 24.52% and an operating margin of 5.6%. (So that’s what we should mean when we say we will make it up on volume.)

With these numbers, Target’s excellent margins leap from the page—an observation which seemingly runs contrary to our opening thesis: that offering the lowest price produces the best competitive advantages in retailing. So the question is: how can Target sell the same stuff for higher prices than its competitors?

My hypothesis is that Target offers a unique shopping experience, one which many women in their 20s, 30s and 40s particularly love. I say women largely based on my own idiosyncratic anecdotal evidence. For one, my wife and her sisters craft their weekends and shopping needs around a weekly excursion to Target, and it is indeed an excursion, because most of the trip involves just walking around, picking over shoes, accessories, clothes, baby gear, towels, sheets, and household décor. For all of these items, I have never seen any of them make a purchase from Wal-Mart or Sears. And of course, once you’re in the door, the convenience brings household goods and groceries into your cart.

Perhaps more interesting and illustrative is a simple Google search for “I love Target” or “Why I love Target.” Compared to competitors, the fan base is quite remarkable. “Target Brand Boxed Riesling is packaged in such an irresistibly cute green box that I could not resist it.” “Tonight I popped in Target after teaching a Kindermusik class… I ran across these shoes [picture].” “This is why I love Target… I want to kiss the person who designed them and make out with the person that decided to only charge me $30! LOVE IT! [link]” Sure, such banter is fun, spontaneous, and whimsical, and not too much should be drawn from it. But it does strike me that Target has established a shopping experience, shared by many, that compels sales of superfluous goods at profitable prices.

Fans talk about wide, uncrowded aisles, the shoe designers, the lighting, the employees. The reasons are multiple, but the passion is earnest. When thinking about the prospects of Target’s moat, it is hard to interpret the competitive advantage expressed by this passion. But certainly something is there that other retailers are missing.

Disclosure: I, or persons whose accounts I manage, own debt of Sears Holdings at the time of this writing.

* Schroeder, Alice.  The Snowball: Warren Buffett and the Business of Life (Random House, 2008): 332.

Concentration or Diversification

Over the last couple of days, we’ve argued that it is a mistake for Mohnish Pabrai, or other successful investors, to expand the number of positions in their portfolio in order to lessen volatility. Yet, you’ve heard enough from me; what do the professionals have to say?

In You Can Be a Stock Market Genius (Simon & Schuster, 1997), Joel Greenblatt, whose annualized returns at Gotham Capital from 1985-1995 were 50%, states that a concentrated portfolio of five securities will only carry 3% more downside potential (within one standard deviation of the mean) than a portfolio of fifty securities. Said differently, a portfolio of fifty securities stands a two out of three chance of returning between -8% and 28%; a portfolio of five securities stands a two out of three chance of returning between -11% and 31%. The returns on ten securities should fall between -10% and 30%. In short, there isn’t a significant difference in variability if one owns five, ten, twenty, or five hundred securities.

Warren Buffett’s compounded annual partnership returns from 1957-1969 were 31.6%. Though it is not easy to determine the relative size of the partnership’s positions, it is well known that Buffett put 40% of the partnership’s assets into American Express during the Salad Oil Scandal of 1964. Martin and Puthenpurackal found that “Berkshire Hathaway’s portfolio is concentrated in relatively few stocks with the top five holdings averaging 73% of the portfolio value.” As Buffett himself has said, “if you really know businesses, you probably shouldn’t own more than six of them. If you can identify six wonderful businesses that is all the diversification you need… going into a seventh one, rather than putting money into your first one, has got to be a terrible mistake.” Buffett has even gone so far as to say that he would have been willing to allocate up to 75% of his portfolio in the distressed assets of Long Term Capital Management in 1998.

Charlie Munger, Buffett’s partner at Berkshire, has quipped that you could be adequately diversified if you owned the best office building in town, the best apartments in town, the dominant car dealership, and the highest grossing McDonald’s.

Now, to be clear, these three are speaking primarily to dedicated investors willing to devote time and intensity to studying businesses. Broad diversification achieved through index funds is likely the best strategy for the majority of market participants. But for those who make it their profession to beat the market’s returns, concentration is an important component of success.

All told, this series gives voice to my growing conviction that the majority of one’s investing returns will come from a few great ideas. Looking at Buffett’s returns, substantial gains came from relatively few holdings—National Indemnity, American Express (the first time), Geico, See’s Candies, Capital Cities, the Washington Post, and Coca Cola. Though countless reasons can be offered for diversifying, it is hard to argue against the success that has followed his concentration.

Pabrai, Position Sizes, and Volatility

Equity investors endured some quick sledding in 2008, with the S&P 500 down over 39%. Though the hill was even more icy in 1931 (with the S&P down over 43%), this historic drop has left its mark on both the portfolios and investing habits of even the best investors.

Mohnish Pabrai, managing partner of Pabrai Investment Funds and author of The Dhandho Investor, is one such marked man. In his January letter to investors, Pabrai relayed that he was changing the size of his portfolio positions due to recent market foibles. In the past, Pabrai had sought to put 10% of a Fund’s assets into 10 investments. In practice, this was difficult to achieve, as market prices would move higher before the position was filled, some investments were too illiquid or thinly traded, or the market capitalizations of the target company were too small. Most often the Funds held 80% of their assets in 10 positions, with the remaining 20% invested in a handful of smaller positions. This strategy of concentration has served Pabrai well, and it coheres with the advice of his mentors Buffett and Munger, who counsel professionals to concentrate their investment portfolios.

However, Pabrai has now decided to size his normal positions at 5% of a Fund’s total assets. Strongly correlated positions will only warrant 2% of the portfolio, to prevent sector weakness from inordinately depressing annual results. In the rare case, perhaps every couple of years, Pabrai will size a position at 10%, but only “if seven moons line up.”

This is a significant change for a successful investor to make, and it contradicts the specific advice of two of his esteemed mentors, Buffett and Munger. And the primary reason for the change is “to temper volatility.”

At the risk of sounding disrespectful, I say turkey feathers (or choose your own animal excrement). As Pabrai himself acknowledges, this change will lower future returns for the Funds, though he assures that “we’ve given up a modest amount of the upside to gain a meaningful drop in volatility going forward.” Despite reassurances, the change runs directly contrary to his long-term investors’ interests. As Pabrai knows, volatility is a statistical device, and not a reliable proxy for risk. Volatility is the effect of Mr. Market’s manic-depressive behavior. Volatility is the intelligent investor’s best friend, for without volatility (particularly the depressive side of it), bargains would be less cheap.

The truth of the matter is that Pabrai has opted to allocate some funds from his best ten ideas to his second best ten ideas, in order to moderate the effect of any “mistakes” on his overall returns. This “solution” strikes me as far worse than volatility or mistakes. Even worse it suggests that Pabrai no longer fully appreciates the difference between his best idea and his twentieth best idea.

‘The Dhandho Investor’ Review

Mohnish Pabrai begins his The Dhandho Investor: The Low-Risk Value Method to High Returns (Wiley, 2007) with a stunning observation: “one in five hundred Americans is a Patel… [but] over half of all the motels in the entire country are owned and operated by Patels” (1). For those less worldly, Patels are from a tiny area in Southern Gujarat, which resides in the Indian state of Gujarat, the birthplace of Mahatma Gandhi. Having only started arriving in the United States as refugees in the early 1970s, Patels today own over $40 billion in motel assets. How was this quick concentration of wealth possible? Dhandho.

“Dhandho” is a Gujarati word that, most literally, means “endeavors that create wealth.” But more specifically, Pabrai observes that Dhandho is the pursuit of wealth in low risk, high return business opportunities. Pabrai’s father was an early practitioner of the Dhandho way, when, in 1973, he staked all his savings and some borrowed money on a 20 room motel. According to Pabrai’s calculations, if his father failed, he would only be out his original stake of $5000; if he succeeded, he would have an investment whose net present value was worth $93,400. And the odds of success Pabrai puts at 90%. This is pure Dhandho–the no-brainer bet that all investors seek, “Heads, I win; tails, I don’t lose much” (12).

Pabrai uses this Dhandho way in managing his Pabrai Investment Funds. That means, more specifically, that he seeks simple businesses, with durable competitive advantages, in industries with an ultra-slow rate of change, often in situations of temporary distress. When Pabrai finds such businesses, he bets heavily, so long as the odds are favorable, and the price falls significantly below the business’ intrinsic value. Such investments offer low risks and high returns—investing the Dhandho way.

Given our interests at Wide Moat Investing, I found Pabrai’s discussion of durable economic moats fairly brief. Noting that few moats are permanently durable, Pabrai highlights Charlie Munger’s observation that “of the fifty most important stocks on the NYSE in 1911, today only one, General Electric, remains in business… That’s how powerful the forces of competitive destruction are. Over the very long term, history shows that the chances of any business surviving in a manner agreeable to a company’s owners are slim at best” (68). Building from this observation, Pabrai concludes that “even such invincible businesses like eBay, Google, Microsoft, Toyota, and American Express will all eventually decline and disappear” (68). Capitalism’s competitive destruction compels Pabrai to never calculate a discounted cash flow stream for longer than 10 years, nor expect the sale of a business ten years hence at more than fifteen times cash flows (69). Though businesses like Chipotle, Coca-Cola, H&R Block, BMW, Harley Davidson, WD-40, and Tesoro have wide economic moats and durable competitive advantages today, the Dhandho investor is unwilling to make investments based on the projection that they will be even wider or more durable in the future.

All told, The Dhandho Investor was a quick, enjoyable read that succinctly describes Pabrai’s nine investing principles, as well as a few successful Dhandho investments (Servicemaster, Level 3 convertible bonds, and Frontline). While Pabrai spends less time analyzing successful businesses than we might like, he does well to habituate his reader into seeing potential investments probabilistically.