Business Moats:- The dhandho Investor Chapter 9

Hello friends, in today’s article, we see business moats from chapter 9 of the book the Dhandho Investor by author Mohnish Pabrai. In this chapter, we see investing in businesses with durable moats. By investing in this, you get a competitive advantage as compared to their competitor.

so let’s see how to find, that companies that have durable accounts.

Previous Chapter 8

Invest In Business with Durable Moats:-

Business Moat:- The dhandho Investor Chapter 9

In starting this chapter the author explains what is the moat, with his barbershop arbitrage

the author says, ” As we saw in the barbershop arbitrage example, our barber is initially the only game in town. he is thus able to charge significantly more than the barbers in the neighboring towns and make supernormal profits.

Capitalism is greed-driven, and as barbers in the other town, get word of the spectacular opportunities in town C, they rush to open up barbershops.

Over time, the price to get a trim in town C is no different from town A or Town B. Capitalists strive hard to capitalize on any opportunity to make outsize profits. the irony is that, in that pursuit, they usually destroy all outsized profits.

but every once in a while a business with a secret sauce for enduring outsize profits emerges.

take the example, of one of my favorite restaurants Chipotle. whenever I go there, there is usually a line all the way to the door. In spite of the fact that there is this long line and I live in southern California with a plethora of choices for Mexican food, I remain loyal to Chipotle. (Business Moat:- The dhandho Investor Chapter 9)

Why? Well partly it’s the fresh high-quality ingredients, partly it’s the tasty food, partly and ambiance, and partly the ability to precisely decide which ingredients I want and in what quantity.

All the other Mexican and fast-food restaurant owners in town are fully aware of the chipotle phenomenon. they hate it and want to do something about it, but they can’t – not easily anyway. It would be a significant uphill battle to replicate chipotle, I’m sure many will try, and eventually, a few might succeed but in the meanwhile chipotle is likely to continue to thrive for years on end.

when more players enter the market, they are likely to take customers away from other restaurants rather than chipotle.”

then author explains, the Chipotle business moat,

the author says, ” From a standing start just 13 years ago, Chipotle recently opened its 500th restaurant. it could easily grow 10 times or more.

Its present footprint, not to mention its enormous prospects overseas. Chipotle has a durable moat.

This moat allows chipotle to have the ability to earn supernormal profits. Best I can tell those profits are here to stay at least for the next decade or longer. (Business Moat:- The dhandho Investor Chapter 9)

There are businesses with deep moats all around US-American express. Coca-cola, H & R Block, Citigroup, BMW, Harley-Davidson, WD-40, Nabisco’s Oreo cookies- the list is endless.

There are businesses with shallow or nonexistent moats all around the US its well- Delta Airlines, General Motors, Cooper tires, encyclopedia Britannica, Gateway computers, and so on.”

then the author explains, how to find the moat, and most moats of companies are hidden

the author says, ” Sometimes the moat is hidden. take a look at Tesoro Corporation. It is in the Oil Refining business- which is a community. Tesoro has no control over the price of its principal finished good, gasoline, nonetheless, it has a fine Moat.

Tesoro’s Refineries are primarily on the west coast and in Hawaii. Refining on the west coast is a great business with a good moat.

There hasn’t been a refinery built in the United States for the past 20 years. Over that period. the number of refineries has gone down from 220 to 150, while oil demand has gone up about 2 percent a year. the average U.S. refinery is operating at well over 90 percent of capacity. (Business Moat:- The dhandho Investor Chapter 9)

anytime you have a surge in demand, refining margins Escalate because there is just not enough, Capacity. West Coast refiners also have a good moat because state EPA regulations in California and Hawaii are very stringent and require unique formulations.

Refining on the West Coast and Hawaii carries much higher margins than the rest of the country. A refiner in Texas can not easily serve the California market. the California refiner is the one that usually serves the California market, which means that when Tesoro has a refinery in California it has a very large captive market.”

then the author talks about how we know when a business has a hidden moat and what that moat is

the author says, ” In the overwhelming majority of businesses the various moats are mostly hidden or only in partial view. it takes some digging to get to the moat.

how do we know when a business has a hidden moat and what that moat is? the answer is, usually visible from looking at its financial statements. good businesses with good moats, like our barber, generate high returns on invested capital.

The balance sheet tells us the amount of capital deployed in the business, and the income and cash flow statements tell us how much they are earning off that capital. (Business Moat:- The dhandho Investor Chapter 9)

So If a chipotle, store costs $700,000 to open and it generates $250,000 a year in free cash flow, it’s a damn good business. Every three years it can take that cash flow and open another chipotle. when it starts franchising, the return on invested capital is exponentially higher.

throughout history, kings have caught to build heavily fortified castles with ever-widening and deeper moats. At the same time, the marauding invaders continued to attack unabated and endlessly improved the tools, techniques, and armies at their disposal to capture these prize castles, it is virtually a law of nature that no matter how well fortified and defended a castle is, no matter how wide or deep its moat, eventually it is going to full to the Marauding invaders.

Throughout history, every great civilization and kingdom have eventually declined.”

then the author talks about the narrow and nonexistent moats

the author says, ” The business mentioned earlier as having borrow, or nonexistent moats, Delta, Gateway, General Motors, all had pretty formidable moats at one time. (Business Moat:- The dhandho Investor Chapter 9)

they have all eroded over time, just like the moat well-defended castle eventually falls into the enemy’s hand. Here is Charlie Mungers on it:-

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 owner are slim at best.   – Charlie Munger

There are no such things as a permanent moat. even such invincible, businesses today like eBay, Google, Microsoft, Toyota, and American Express will all eventually decline and disappear.

Some moats are more durable than others. Wells Fargo and American Express were founded over 150 years ago, and amazingly both their moats are as robust as ever today. amazingly, as an aside, both American Express and Wells Fargo were founded by the same person, Henry Wells.

But here is the dilemma: if you were picking stocks a century ago, it would have been virtually impossible to pick these two out of the larger available universe, the odds are very high that even if the ones you picked were the bluest of the blue chips, they would eventually wither away. (Business Moat:- The dhandho Investor Chapter 9)

In 1977, Arie de Geus Wrote a Fascinating book called the Living company.

Geus studied the life expectancy of companies of all sizes and was very surprised to find that the average fortune 500 company had a life expectancy of just 40 to 50 years.

it takes about 25 to 30 years from Formation for a highly successful company to Earn a spot on the fortune 500.

Geus found that it typically takes many blue chips less than 20 years after they get on the list to cease to exist. the average fortune 500 business is already past its prime by the time it gets on the list.

Even businesses with durable moats, don’t last forever thus when using the John Burr Williams Intrinsic Value formula, We ought to limit the number of years, we expect the business to thrive. we are best off never calculating a discounted cash flow stream for longer than 10 years or expecting a sale in year 10 to be at anything greater than is times cash flows at that time ( plus any excess capital in the business.) (Business Moat:- The dhandho Investor Chapter 9)

so this is all about chapter 8 of the book the Dhandho Investor on Invest in business with durable advantages.

Intrinsic Value of Simple Businesses

Hello friends, in today’s article we see the intrinsic value of simple businesses, and how it is calculated from the book ” the Dhanndho Investor ” Chapter 7. In this chapter the author Mohnish Pabrai gives the intrinsic value of any business, to help in investing in simple businesses.

so let’s start, with how to invest in simple businesses.

Previous Chapter 6

the Dhandho Investor:- Chapter 7 (Intrinsic value)

Intrinsic value

in this author explain, how we can invest in any business by knowing its intrinsic value. so let’s understand this concept

the author says, ” the advantage of buying a fraction of an existing business is pretty clear, but before we buy, we must know its intrinsic value. how else would know it’s a good deal at a given price? What is the intrinsic value of a business is there a general formula? How do we figure it out?

Every business has an intrinsic value, and it is determined by the same simple formula. John Burr Williams was the first to define it in his theory of investment value. published in 1938.

For William, the intrinsic value of any business is determined by the cash inflows and outflows discounted at an appropriate rate – that can be expected to occur during the remaining life of the business.

the definition is painfully simple.”

then the author gives one example of a gas station, and how the intrinsic value of that gas station.

the author says, ” To illustrate let’s imagine that towards the end of 2006, a neighborhood gas station is put up for sale, and the owner offers it for $500,000. Further, let’s assume that the gas station can be sold for $400,000 after 10 years.

Free Cashflow- Money that can be pulled out of the business – is expected to be $100,000 a year for 10 years. let’s say that we have an alternative low-risk investment that would give us a 10% annualized return on the money.

Are we better off buying the gas station or taking our virtually assured 10% return? I used a Texas Instruments BA-35 calculator to do these discounted Cash Flow ( DCF) Calculations.

Alternatively, you could use excel. astable 7.1 demonstrate, the gas station has an intrinsic value of about %775,000

Table 7.1 Discounted Cash Flow (DCF) Analysis of the gas station

Year Free Cash Flow ($) Present Value ($) of Future Cash Flow ( 10%)
2007 100,000 90,909
2008 100,000 82,645
2009 100,000 75,131
2010 100,000 68,301
2011 100,000 62,092
2012 100,000 56,447
2013 100,000 51,315
2014 100,000 46,650
2015 100,000 42,410
2016 100,000 38,554
2017 Sale Price  400,000 154,217
Total 768,671

We would be buying it for $500,000 so we’d be buying it for roughly two-thirds of its intrinsic value. If we did the DCF Analysis it looks like Table 7.2

Table 7.2 Discounted Cash Flow ( DCF) Analysis of the 10 percent yielding low-risk alternative.

Year Free Cash Flow ($) Present Value ($) of Future Cash Flow ( 10%)
2007    50,000 45,454
2008     50,000 41,332
2009    50,000 37,566
2010    50,000 34,151
2011    50,000 31,046
2012    50,000 28,224
2013    50,000 25,658
2014     50,000 23,325
2015    50,000 21,205
2016      50,000 17,277
2017     Capital returned  500,000 192,772
Total 500,000

Not surprisingly the $500,000 invested in our low-risk alternative has a present value of exactly that – $500,000

Investing in the gas station is a better deal than putting the cash in a 10% yielding bond- assuming that the expected cash flows and sale price are all but assured.”

so above calculation, you see that buying the $500,000 is below the intrinsic value of a Gas Station. then the author gives the same example, in the stock market also.

the author says, ” The stock market gives us the price at which thousands of businesses can be purchased. We also have the formula to figure out what these businesses are worth, it is simple

When we see a huge gap between the price and intrinsic value of a given business – and that gap is in our favor – we can act and buy that business- and let’s take the of a well-known retail business, Bet, Bath, Beyond (BBBY).

I have to admit that I have never analyzed BBBY before. I have been to its stores a few times over the years, and it has been a pleasant experience.

As I write this, BBBY has a quoted stock price of $36 per share and a market cap of $10.7 billion.”

then the author calculates the intrinsic value of BBB Y’s company

the author says, ” What is BBBy’s intrinsic Value? let’s take a look at a few BBBY statistics a Yahoo finance, BBBY had $505 million in net income for the year ended February 28, 2005

Capital Expenditures for the year were $191 million and depreciation was $99 million. the ” Back of the Envelope.” net Free cash was about $413 million.

It looks like BBBY is growing revenues by 15% to 20% and net income by 25% to 30% a year. it also takes like it stepped up Capital expenditure (Opex) spending in 2005, let’s assume that free cash flow grows by 30% a year for the next three years and then grows 15 % a year for the following three years

then 10% a year after where. further, let’s assume that the business is sold at the end of that year for 10 to 15 times free Cash flow plus any excess capital in the business.

BBBY has about $850 million in cash in the business presently ( see table 7.3)

Table 7.3 Aggressive Discounted Cash Flow ( DCF) Analysis of Bed Bath and Beyond

Year Free Cash Flow ($MM) Present Value ($MM) of Future Cash Flow ( 10%)
Excess CASH    850
2006     523 475
2007    679 561
2008    883 663
2009    1016 693
2010    1168 725
2011    1340 758
2012     1478 758
2013    1625 758
2014      1787 758
2015     1967 758
2016 Sale Price 29,500 11,373
Total 19,130

so, the intrinsic value of BBBY is about $19 billion, and it can be bought at $10.7 billion. I’d say that’s a pretty good deal, but look at my assumptions – they appear to be pretty aggressive.

I’m Assuming no hiccups in its execution no changes in consumer behavior, and the ability to grow revenues and cash flows pretty dramatically over the years, what if we made some conservative assumptions?

We can run the numbers with any assumptions. the company has not yet released numbers for the year ended February 28, 2006, but we do have nine months of Data ( through November 2005)

We can compare November 2005 data to November 2004 data. Nine-month revenues increased from $3.7 billion to $4.1 billion from November 2004 to November 2005 and earnings increased from $324 million to $375 million. It looks like the top line is growing by 1% a year- going from 15% to 5% and its the final sale price is 10 times 2015 free cash flow the BBBY’s intrinsic Value looks like Table 7.4

Table 7.4 Conservative Discounted Cash Flow ( DCF) Analysis of Bed Bath and Beyond

Year Free Cash Flow ($MM) Present Value ($MM) of Future Cash Flow ( 10%)
Excess CASH    850
2006     469 426
2007    535 442
2008    604 454
2009    680 464
2010    751 466
2011    827 467
2012     901 462
2013    973 454
2014      1041 442
2015     1103 425
2016 Sale Price 11,030 4252
Total 9,604

Now, we end up with an intrinsic value of $9.6 billion.

BBBY’s Current Markt Cap is $10.7  billion. if we made the investment, we would end up with an annualized return of a little under 10%.

if we have good, low-risk, alternatives where we can earn 10%, then BBBY does not look like a good investment at all. so what is BBBY’s real intrinsic value?

My best guess is that it lies somewhere between $8 to $18 billion. And in these calculations, I’ve assumed no dilution of stock via option grants, which might reduce intrinsic value further.

With a present price tag of around $11 billion and an intrinsic value range of $8 to $18 billion. I’d not be especially enthused about this investment. there isn’t that much upside and a fairly decent chance of delivery under 10% a year. for me, it’s an easy pass.”

then the author comes the lesson of these examples,

the author says, ” We’re getting off track, the objective of this exercise is not to figure out whether to invest in BBBY stock. it is simply to demonstrate that while John Burr William’s definition of Intrinsic value is painfully simple, calculating it for a given business may not be so simple.

I think of BBBY as a fairly straightforward, low-tech, and simple business to understand. Even with its simplicity, we end up with a pretty wide range of its intrinsic value.

If we were to look at a business like Google. it starts getting very complicated. Google has undergone spectacular growth in revenues and cash flow over the past few years If we extrapolate that into the future, the business appears to be tracking at a big discount to its underlying and intrinsic value.

if we assume that not only is its growth rate likely to topper off, but that its core search business monopoly may be successfully challenged – by Microsoft, Yahoo, or some upstart – the picture is quite different. In that scenario, the current valuation of google might well be. many times it’s under intrinsic value.

The Dhandho way to deal with this dilemma is painfully simple: only invest in businesses that are simple- ones where conservative assumptions about future cash flows are easy to figure out.

What businesses are simple? well, simplicity lies in the eye of the beholder. Papa Patel bought a business that’s very easy to understand. the motel had a long history of revenues, cash flows, and profitability available for analysis.

From that data, it is not too hard to get a ballpark range of estimated cash flow that the motel is likely to generate in the future. Papa Patel also has a good handle on potential repairs and capital expenses that were likely to be required in the future based on the historical data and the condition of the property.”

then author explains the power of simplicity

the author says, ” simplicity is a very powerful construct. Henry Thoreau recognized this when he said, ” Our life Is frittered away by detail… simplify, simplify,” Einstein also recognized the power of simplicity, and it was the key to his breakthroughs in physics. he noted that the five ascending levels of intellect were, ” Smart, Intelligent, Brilliant, Genius, simple,”

for Einstein, simplicity was simply the highest level of intellect. Everything about, Warren Buffett’s investment style is simple. it is the thinkers like Einstein and Buffett, who fixate on simplicity who triumph. the genius behind E=mc2 is its simple elegance.

Everything about the Dhandho is simple, and therein lies its power. As we see in Chapter 15, the psychological warfare with our brains really gets heated after we buy stock.

The most potent weapon in your arsenal to fight these powerfully simple. there’s for why you’re to make a great, deal of money and unlikely to lose much. I always write the there down. if it takes more than a short paragraph, there is a fundamental problem. If it requires me to fire up excel, it is a big red flag that strongly suggests that I ought to take a pass.”

If you want to learn more about value investing, and finding great business, then buy this book from the following link

so this is all about the Intrinsic Value, from the book ” The Dhandho Investor” Chapter 7 written by author Mohnish Pabrai.