Sunday, September 6, 2009

The Dhandho Investor: Chapter 9

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.

While no moat can last forever, Pabrai suggests readers invest in businesses with competitive advantages that can last for several years. There is an endless list of businesses with durable moats, and Pabrai goes on to name some including: Chipotle, American Express, Coca-Cola, H&R Block, Citigroup, BMW, Harley-Davidson, and WD-40.

Pabrai also lists a few companies with no moat at all: Delta Airlines, General Motors, Cooper Tires, Encyclopedia Britannica, and Gateway Computers.

Sometimes the moat is not so clear. The example of Tesoro Corporation, an oil refiner, is highlighted. While Tesoro has no control over the price of its supplies (crude oil) or the price of its principal product (gasoline), it does have an advantage: refineries on the west coast. While the number of refineries has declined over the years, Tesoro holds a growing advantage due to environmental regulations for gasoline products that are specific to the West Coast.

While a business' moat is often hidden, whether a company has one is usually clear from its financial statements: good businesses generate high returns on invested capital. For example, if opening a Chipotle store costs $700,000 and it generates $250,000 per year in free cash flow, in Pabrai's words "it's a damn good business."

While some moats are more durable than others (e.g. American Express was founded 150 years ago, and still has a strong moat.), it's important to note that all moats erode over time. As noted by Charlie Munger, "Of the fifty most important stocks on the NYSE in 1911, today only one, General Electric, remains in business...". Even seemingly invincible businesses today such as eBay, Google, Microsoft, Toyota and American Express will all eventually decline and then disappear. Pabrai notes the results of Arie de Geus' study that showed the average life of a Fortune 500 company is just 40 to 50 years (and it takes about 25 to 30 years from inception for the typical company to get to the Fortune 500, meaning the typical company ceases to exist after spending less than 20 years on the list). The implication of this is that discounted cash flow estimates into the future should be kept to relatively short timeframes.

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