Looking Up to Warren Buffett

About the only thing slick about this 43-year-old investor is his market-trouncing track record — annualized returns of nearly 25% since he set up shop in 1999, enough to earn him a growing cult following. His "secret"? Probably the most documented investment strategy around — a bare-bones, Warren Buffett style of stock picking. While that description may inspire yawns — sometimes it seems like everybody claims to be a Buffett disciple — Pabrai takes it to an extreme. His office houses an impressive Buffett mini-museum: a wall covered with photos and articles he's amassed over the years. He recently dropped a stunning $650,100 at a charity auction for the privilege of just one lunch with the Berkshire Hathaway (BRK.A) guru. Even his minimalist approach to e-mail mirrors the Buffett philosophy of avoiding distractions. And his track record is more than Warren-worthy: A $100,000 investment in his flagship Pabrai Investment Fund 2 in June 2001 would have been worth $465,200 at the end of 2007; the same amount invested in the Dow, only $145,500. (The minimum investment today: $2.5 million.)

The most obvious question, of course, is how well Pabrai will fare in choppy waters. The results so far are mixed. In the second half of 2007, PIF2 lost 17% of its value, mainly due to a single bad bet. But in the last sustained market downturn, after the tech bubble, Pabrai thrived. In the down years of 2001 and 2002, he beat the S&P 500 by 50 and 19 percentage points, respectively. And in 2003, when stocks rebounded, Pabrai's picks went through the roof, returning 105%. The bottom line: In tough markets like today's, when many nervous investors are bailing out of stocks, bargain hunters like Pabrai calmly look through the rubble for good buys that could take off when conditions improve. He recently bought troubled retailer Sears, for example.

Investing, remarkably, is Pabrai's second career: A native of Mumbai, India, he earned a computer engineering degree in the U.S. and caught the Buffett bug while he was running an IT consultancy. He became a Berkshire Hathaway shareholder and made friends (some of whom became his investors) among fellow disciples at the annual meetings. "I thought I could run an experiment," says Pabrai. "'Can someone just apply Buffett's approach and actually beat the professionals?'" Starting with $1 million of his own money, Pabrai proved that the answer was yes; he now manages about $600 million.

Pabrai values companies based on hard assets and cash flow, and he buys the stocks only when they're trading at half that value or less, as what are known as 50-cent dollars. All Buffett acolytes try to do that, but Pabrai has out-Buffetted many. "He keeps it simple," says Whitney Tilson, comanager of the Tilson Focus fund. Instead of short selling or using complex trades, he just buys his best ideas — typically owning only a dozen companies. He also keeps to himself, declining to talk about specific stocks even with buddies. To Pabrai such dialogue is a psychological trap that could distort his analysis. "I don't know anyone who is as independent in his thinking," Tilson says.

No strategy is perfect, obviously. Pabrai started buying mortgage lender Delta Financial in 2006, but it went bust last year, costing his funds $55 million. Pabrai admits that he failed to anticipate the ripple effects of the subprime meltdown; in fact he bought more of the stock when Delta started struggling. Such a misstep might send the average manager into an identity crisis. But Pabrai, who somehow comes across as easygoing and disciplined at the same time, is sticking to his process. We sat down with him on a sunny day this winter to talk about Delta, the virtue of patience and why he (gasp!) sold Berkshire Hathaway shares.

SmartMoney: You're the ultimate do-it-yourself investor, but you're beating the market and your peers. How?

MP: Lots of other investment managers have large teams; they have a lot more brainpower, they've got a lot more resources. The only advantage Pabrai funds have, which is why we have done better than the market, is attitude — my ability to be patient and not be swayed psychologically.

SM: What about the hard-core financial analysis? Isn't the number crunching the missing piece here?

MP: I don't think so. Most people, if they really think about it, have a business or an industry or two that they understand very well. If you work in a bank, you might know about banking. People get into trouble when they work in a bank and they want to invest in Google (GOOG). They are stepping outside their circle of competence. If people are patient — waiting for the right price — and invest only in areas that they understand, there won't be too many numbers to crunch.