Saturday, September 12, 2009

The Dhandho Investor: Chapter 11

Mohnish Pabrai is an Indian-American businessman and investor. For a number of years, he turned heads with the performance of Pabrai Investment Funds since its inception in 1999. Pabrai has high regards for Warren Buffett and admits that his investment style is copied from Buffett and others. Over the next few weeks, we'll be exploring the topics in his book about value investing.

Pabrai advises investors to "fixate on arbitrage", especially those situations where downside risk is eliminated, even if upside potential is limited. He discusses the following types of arbitrage, with particular emphasis on the last one:
  1. Traditional: Buying gold on one exchange and selling it for a higher price on another
  2. Correlated: Buying shares of a Class B stock while shorting the Class A if there's a price/value discrepancy
  3. Merger: Buying a company about to be bought-out by another. It's important to note that this type of arbitrage is generally not risk-free.
  4. Dhandho Arbitrage
Dhadho arbitrage is the central theme of this chapter. Dhandho arbitrage allows businesses to earn above normal profits for a limited time, before competitors or substitutes enter and destroy these higher returns. An enduring Dhadho arbitrage is what Buffett would call a moat.

Pabrai goes on to describe the Dhandho arbitrage spreads of several businesses. Some have spreads of just a few months, while others have spreads that span decades. While Pabrai argues that the "Dhadho arbitrage spreads" of all businesses will eventually be eroded, two important factors can allow investors to earn excellent returns in the interim: the size of the spread (or moat), and its duration.

To that end, Pabrai describes a couple of businesses owned by Warren Buffett that no longer have moats, Blue Chip Stamps and World Book. Nevertheless, the "aribitrage spread" earned by these companies over the years has made Buffett a lot of money - for example, Buffett's purchase of See's Candy was partially bought by money earned from Blue Chip. Pabrai advises investors looking for superior returns to invest in companies with wide and durable Dhandho arbitrage spreads.

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