Infrequent Bets by mohnish pabrai Archives

Hello friends, in today’s article, we see a summary of the hand Investor chapter 10, this chapter is on Few bets, Big bets, and infrequent bets. if you understand this chapter then you learn how to bet on a company.

so let’s start

Previous Chapter 9

Dhandho 301:- Few Bets, Big Bets, Infrequent Bets

In this chapter, you learn the kelly formula to bet on companies, that win. so let’s understand, how Mohnish Pabrai, learn and use these few bets, big bets, and infrequent bets, in the author’s words

the author says, ” Let’s assume you were offered the following odds on a $1 bet:

80% chance of winning $21.00
10% chance of winning $7.50
10% chance of losing it all

Let’s further assume that you had $10,000 to your name and you were allowed to bet as much of that bankroll as you wanted. How much of that $10,000 would you be willing to that $10,000 would you be willing to put at stake to play this game once? The answer is clearly not $10,000 as there is a solid 10% chance of being in a poor house.

Betting $1 seems too conservative it isn’t going to move the needle. the good news is that exactly 50 years ago a researcher at Bell Labs in new jersey, in john larry kelly, jr. Pondered this question and published these findings.

Kelly comes up with what is now known as the kelly formula.

The optimal fraction of your bankroll to bet on a favorable bet is:

Edge/odds = Fraction of your bankroll you should bet each time

There is a wonderful book written by William Poundstone entitled fortune’s formula that is well worth reading pounded stone describes the kelly formula beautifully Michael Mauboussin of leggMason recently wrote a paper on the kelly formula where he used the following illustration.” (The dhandho Investor chapter 10)

then the author gives the example to understand the kelly formula

author says, ” Assume you’re offered a coin toss where head means you get $2 and tails cost you $1. how much of your bankroll should you bet if you’re offered these odds?

A/c to the kelly formula. the edge is $0.50 { ( 0.5 * $2 ) + ( 0.5 * -$1)}

the odds are what you win if you win, or $2. so the kelly formula suggests you get 25% ( $0.50 / $2.00) each time.

The first example involves more than 2 outcomes for a detailed treatise on how to calculate the kelly bet size for such bets, go to www.cisiova.com/betsize.asp.

this website not only gives the general case kelly formula, but the author has generously programmed the formula for use by anyone at no charge.

The interested reader may also wish to read Edward thorp’s paper, ” the kelly criteria in blackjack, sports betting, and the stock market

for the first example, the answer is 89.4% of your $10,000 bankroll or $8,940

Papa Patel had likely never heard of the Kelly formula, in chapter 1, we noted that when papa Patel invested $5,000

in his first motel.

He pretty much bet it all on his investment the goods in the aforementioned example are roughly the goods papa Patel was offered an 80 percent chance of having a 21 bagger. (The dhandho Investor chapter 10)

A 10% chance of a 7.5 bagger, and a 10% chance of going broke. In reality, papa Patel was more conservative in his bet than the kelly formula suggested.

He bet 50% of his bankroll. he did have $5,000 to his name and ” bet it all ” but, he had that ace in the hole. the ability to go back, take a job, save $5,000, and try again in a few years. he likely would not to this endlessly because each time he gets older and gets dissuaded from the endless bitter experiences.

Because Dhandho is so deeply rooted in his psyche,

He’s got at least two bets in him. He puts 50 % of his bankroll at risk of the first bet. if it works he does not place a second bet. if it fails, he places a second bet.

Winning the first bet changes the world around him his family no longer lives in the motel. they have hired HDP and can buy a bigger motel. when the now buys another motel ( and hence places his second bet ) it’s with a smaller percentage of his bankroll because the odds are no longer as good.

Even if the odds were simply a 50% probability of a 200% return and a 50% probability of a total loss, the kelly formula suggests that he ought to bet 25% of his bankroll.

historically, the motel business odds have been vastly superior to the aforementioned. the probability of a 100 % loss is well under 5 percent.

the Patel has not been shy about putting up large portions of their bankroll on these mouthwatering odds when they placed their second, third, and nth bet.

they hadn’t heard of kelly or his formula, but it makes perfect Dhandho sense to them, the result is that Papa patels as a group. today own over $40 billion in motel assets, pay over $725 million a year in taxes and employ nearly a million people.

In a speech at the university of southern California’s marshall school of business, Charlie Munger said:

the wise ones bet, heavily when the world offers them that opportunity. they bet big when they have the odds. and the rest of the time they don’t. it’s just that simple.”

then the author explains, how papa Patel, manilla Mittal and you also make a few bets that are given pretty well.

the author says, ” papa Patel, Manilal, Mittal, and Yours truly have always fixated on making very few bets and each bet is pretty large. (The dhandho Investor chapter 10)

All have tried to place bets when the odds were heavily in our favor. this betting lingo is deliberate. to be a good capital allocator, you have to think probabilistically.

the most obvious business model entirely based on over probabilities is a casino. Connoisseurs of blackjack know that the odds change with every card that is dealt. they are always fixating on trying to figure out when the odds are with them and raising their bets accordingly.

As blackjack is played today in casinos, the overall odds are sound with the house, and playing blackjack at a casino is a losing proportion. I have to admit that this hasn’t stopped me.

But it wasn’t always a losing proposition, in 1960, an MIT math professor, ED thorp, used MIT’s computers to run a variety of calculations and come up with optimized blackjack play.

Thorp named the optimal play of cards a basic strategy. he wrote the best-selling book Beat the Dealer. it is, even today regardless of classic work, blackjack players, the world over rely on basic strategy to optimize their card play.

In the 1960s casinos offered single-deck blackjack and dealt with the entire deck. thorp calculated that players who counted cards and scaled their bets based on the residual cards/ left in the deck had an edge over the casinos.

he used the Kelly formula to figure out how much of your bankroll you ought to bet each time based on how favorable the odds were.

for example, if the deck had an overrepresentation of tens and aces, that was good for the player

If the odds were 52:48 in the favor of the player the kelly formula suggested that the player bet 4 percent of his bankroll. that’s what thorp would endeavor to do with every hand.

For thorp, this wasn’t an academic exercise he started frequenting the Nevada casinos and cleaning up. the casinos didn’t understand why he was consistently winning, but, with the mob running the casinos they didn’t wait to understand.

they simply showed him the door and made it very clear that if he ever returned, the reception wouldn’t be so civil.

when Thorp published beat the dealer, players the world over started cleaning up. Casino owners also read thorp’s book and began to make changes to the game over the past four decades, the game has gone through numerous changes.

Each time casinos made a change, some smart gambler would figure it out and make another change. today, most casinos deal from a shoe of six to eight decks. They don’t play the last couple of decks and pit bosses watch the action like hawks. In some casinos, auto shufflers recycle the used cards back in real-time – ensuring that the card pool never has an over or underrepresentation of specific cards. (The dhandho Investor chapter 10)

Thorp related to this changing reality( along with the demanding threats ) and decided that he’d be better off if he applied his talents to a casino where

There were no table limits
the offered odds were vastly better
the house was civil about taking large losses
the mob wasn’t running the casino

He found that such a casino existed and it was the new york stock exchange ( NYSE) and the fledgling options market. rumor has it that Thorp figured out something along the lines of the Black-Scholes formula years before black and Scholes did.

He decided not to publish his finding that the Black-Scholes formula is effective, basic strategy for the options market. it dictates what a specific option ought to be priced at.

Because he was one of the only players armed with this knowledge, thorp could buy underpriced options and sell overpriced ones- making a killing in the process.”

then the author talks about the Thorp

the author says, ” thorp set up a hedge fund, Princeton-Newport partners over a 20-year span, the professor delivered 20% annualized returns to his investors with ultra-low volatility. One of his potential investors was actor Paul Newman.

Newman once asked Thorp how much he could make playing blackjack full-time. thorp could still beat the casinos with his skilled card counting and replied that it would be about $300,000 a year.

Newman then asked him why he wasn’t pursuing it. thorp looked at him and said that the NYSE and options market casinos made him over $6 million a year with minuscule risk. Why pursue $300,000 and take on added risk to life and limb?

In investing, there is no such thing as a sure bet. Even the most blue-chip business on the planet has a probability of not being in business tomorrow. (The dhandho Investor chapter 10)

Investing is all about the odds- just like blackjack thorp is the most vivid example of a human who has mastered these concepts fully. He has repeatedly played the odds on the strip of wall street over the decades and won handsomely on both fronts – creating a huge fortune for himself and his investors. when an investor approaches the equity markets, it has to be with the same mindset that.

Thorp had when he played blackjack; if the odds are overwhelmingly in your favor, bet heavily.

Let’s assume that you have adopted the Dhandho framework and have found an existing publicly-traded company with a simple business model.

further, it happens to be a business under temporary distress, and this has led to a collapse in its stock price. the best part- is it’s a good business with a durable moat. the business is squarely within your circle of competence, and you’ve figured out its intrinsic value today and two to three years out. you’ve found that

the current stock price is less than half of the expected intrinsic value in two to three years. what would cause your stock to reach its intrinsic value in a few years at most? senator William Fulbright fixated on this question and asked benjamin graham about it during one of the more interesting exchanges in a U.S. Senate banking and Commerce Committee hearing on March 11 in 1955.”

then the author gives their conversation about finding undervalue in the company

Fulbright:- One other question and I will desist. when you find a special situation and you decide, just for illustration, that you can buy for $10 and it’s worth $30, and you take a position and then you cannot realize it until a lot of other people decide it is with $30 how is that process brought about by advertising, or what happens? what causes a cheap stock to find its value?

Graham:- that is one of the mysteries of our business and it is a mystery to me as well as to everybody else. but we know from experience that eventually the market catches up with value. (The dhandho Investor chapter 10)

Whenever there is a dislocating event like 9/11 or pearl harbor, stock prices can be severely impacted in the short term, but they tend to bounce back over time. table 10.1

Table 10.1:- DJIA Decline and subsequent Performance after crisis Events

		DJIA Loss	DIJA	Percentage	Gain
			Days	After Reaction	Dates
Event	Reaction Dates	Gain/loss (%)	22	63	126
Fall of France	05/09/1940 – 06/22/1940	-17.1	-0.5	8.4	7.0
Korean War	06/23/1950 – 07/13/1950	-12.0	9.1	15.3	19.2
U.S. Bombs Cambodia	04/29/1970 – 05/26/1970	-14.4	9.9	20.3	20.7
Arab oil Embargo	10/18/1973 – 12/05/1973	-17.9	9.3	10.2	7.2
Nixon resigns	08/09/1974 – 08/29/1974	-15.5	-7.9	-5.7	12.5
Hunt Silver Crisis	02/13/1980 – 03/27/1980	-15.9	6.7	16.2	25.8
Financial Panic 1987	10/02/1987 – 10/19/1987	-34.2	11.5	11.4	15.0
Asian stock market Crisis	10/07/1997 – 10/27/1997	-12.4	8.8	10.5	25.0
Russian LTCM Crisis	08/18/1998 – 10/08/1998	-11.3	15.1	24.7	33.7
Mean		-16.7	6.9	12.4	18.5
Medium		-15.5	9.1	11.4	19.2

The nine events outlined in Table 10.1 all led to double-digit declines in the Dow in a Few days a week. However, a few months later, the dow had recovered most, if not all of the fall.

Business-specific micro-events for business, like the Tylenol scare, the Exxon Valdez oil spill, or the American Express ” Salad oil Crisis” in the 1960s have similar traits. they all led to big instantaneous drops as panic and fever set in.

over time, as rationality prevailed prices did recover to more rational levels. similarly, if you invert, in any under or overpriced business, it will eventually trade around its intrinsic value- leading to an appropriate profit or loss.

We can pretty much treat this as a low of investing and hang our hat on it. thus, if we can determine the intrinsic value of a given business for two to three years but can acquire a stake in that business at a deep discount to its value profits are all but assured.

In determining the amount to bet, the kelly formula is a useful guide.”

then the author gives the example of the American Express Salad Oil Crisis

The American Express Salad Oil Crisis:-The dhandho Investor chapter 10

In this, the author says, ” Betting heavily when the odds are overwhelmingly in your favor is something to which warren buffet and Charlie Munger have always subscribed.

In November 1963, Mr. Buffett invested 40% of the Buffett partnership’s assets into a single business, American Express (AmEx)

Where he had no control or say. Because virtually his entire liquid net worth was in the Buffett partnership, he had effectively put 40% of his personal liquid net worth into Amex. (The dhandho Investor chapter 10)

All the time, the buffet partnership had about $17.5 million under management. thus about $7 million was invested in buying the stock of American Express – which had seen its stock price cut in half just before Buffett’s large purchase.

American Express had been hit hard by the Salad Oil Crisis. the company had lent $60 million Against collateral that consisted of a warehouse full of vats of Salad Oil.

It later found that the vats contained mostly seawater and its shady borrower was bankrupt. American Express announced the $60 million loss, and its stock price was instantly cut in half.

At the time, with a total market capitalization of about $150 million, the $60 million was a huge hit to Amex’s fledging, Balance sheet.

Mr. Buffett analyzed the situation carefully and concluded that as long as the trust associated with American Express travels’ checks and charge cards was unaffected, the company’s intrinsic value was significantly higher than the current price at which it was being offered. Seeing virtually no downside and a massive upside, he placed the largest bet he’s ever placed.

he effectively bet 40% of his net worth on a scandal-ridden business making negative headlines daily. What were the odds that this bet offered? if we knew the odds we could pay the kelly formula and see if the bet made sense.

I don’t believe that question has ever been answered directly by Mr. Buffett, but there are some clues in his letter. to partners from 1964 to 1967:

We might invest up to 40% of our net worth in a single security under conditions coupling an extremely high probability that our facts and reasoning are correct with a very low probability that anything could change the underlying value of the investment.

We are obviously only going to go to 40% in very rare situations- this rarity, of course, is what makes it necessary that we concentrate so heavily. (The dhandho Investor chapter 10)

When we see such an opportunity. we probably have had only five or six situations in the nine-year history of the partnerships where we have exceeded 25% any such situations are going to have to promise very significant superior performance.

. … They are also going to have to possess such superior qualitative and/or quantitative factors that the chance of serious permanent loss is minimal….. In Selecting the limit to which, I will go in any one investment, I attempt to reduce to a tiny figure the probability that the single investment can produce a result for our portfolio that would be more than 10% points poorer than the dow.

— Warren Buffett

Note that the language that Mr. Buffett uses is not talking about Surebets- every investment has a probability of a loss. he is not talking about sure bets – every investment has a probability of a loss. He fixated on the odds and did not hesitate in placing large bets when the odds were overwhelming in his favor.

Mr. Buffett generated a three or four-bagger return on his American express investment over three years.

Based on the available facts, let’s assume the conservative odds of this bet are as follows:-