The Oracle of Irvine

In just eight years, Mohnish Pabrai, a 43-year-old native of Mumbai, India, has made a name for himself as a value investor to watch. Internet chat rooms track his investments, and devotees quote his “Heads, I win; tails, I don’t lose that much” philosophy of buying companies with huge upside and virtually no downside. Pabrai, a guest speaker at two value investing conferences this spring, has written two books on value investing and been interviewed on CNBC and Bloomberg Television. This summer, following four failed attempts, he outbid rivals for the right to have lunch with the world’s most successful value investor, Berkshire Hathaway chairman and CEO Warren Buffett.

Pabrai has racked up impressive gains. Since 1999, when he began with an initial $1 million, which included $100,000 of his own money and $900,000 from fellow members in the Chicago area’s Young Presidents’ Organization, he has averaged a 29 percent average annual return, after fees, through June 2007.

“Investing is painfully easy for me,” Pabrai has said on more than one occasion.

Eight years is too short a time to declare Pabrai the equal of such master value investors as Peter Cundill, Irving Kahn, Bill Miller and Marty Whitman, let alone Buffett and his partner, Charles Munger. But if a current gamble pays off, Pabrai could prove to skeptics that he has the Buffett touch.

Pabrai manages $600 million in three hedge funds -- two offshore and one domestic -- from a suite of modern, marble-and-brass-appointed offices in Irvine, California. Because of his returns, he has attracted the attention of the hedge fund industry. Most consultants, however, are reluctant to recommend Pabrai Investment Funds to institutional investors. They wonder how Pabrai can manage $600 million with only three part-time assistants, and they balk at his refusal to reveal anything about his holdings beyond what is in his firm’s regulatory filings.

“Yeah, institutions look at us and take a pass because of my bizarre rules,” acknowledges Pabrai. In addition to offering zero transparency, he says he never takes phone calls from investors; never meets with CEOs or senior management; seldom discusses his holdings, even at his annual meetings, one of which is held in Southern California and the other in Chicago; requires a two-year commitment from investors; and forbids them from withdrawing money at year’s end.

Nor is Pabrai registered as an investment adviser with the Securities and Exchange Commission. He says the upside doesn’t justify the time and costs. But like his hero Buffett (and, it should be added, Alfred Winslow Jones, the creator of the first hedge fund), Pabrai charges no management fee. Instead, he takes 25 percent of any profits above a 6 percent hurdle rate.

Then there is his unorthodox workday. Each afternoon, he naps in a small, windowless room, adorned with a map of India on the wall and furnished with a twin bed, nightstand and lamp, all supplied by the Westin hotel chain. He says he adopted the custom as a teenager in Dubai.

Not surprisingly, most of the 400 investors in Pabrai’s three funds are friends, relatives and business associates. Ajay Desai, a Bakersfield, Californiabased radiation oncologist, has known Pabrai since the early 1980s, when he shared an apartment with him and Pabrai’s older brother, Ali, while all three attended Clemson University in South Carolina. Desai began investing with him in 2002, and Pabrai routinely calls him and other investors who are experts in their fields as part of his research.

“He’s very bright, but he can be very blunt,” says Desai, who remembers failing to persuade Pabrai to buy drugmaker ImClone Systems shares after negative publicity involving a 2002 investigation into Martha Stewart’s allegedly improper trading of ImClone shares pushed the stock to new lows, even though Desai thought highly of the company’s cancer-fighting drugs. Pabrai rejected the suggestion, missing a 700 percent rise in ImClone shares over the following two years.

“It was outside my circle of competence,” explains Pabrai, who, like Buffett, professes to invest only in companies whose businesses he can easily understand.

Robert Miles, a Tampa, Floridabased investment adviser and the organizer of a value investing conference at which Pabrai spoke last spring, credits him with having an independent streak and with finding stocks “outside the clique of value investors.” But Miles is reluctant to declare as victor any value investor who has been in the business fewer than 20 years. “It’s easy to say, ‘I invest like Warren,’ but show me how you did in the down years,” says Miles, who has written several books on Buffett.

Like many investors, Pabrai suffered as a result of the subprime meltdown this year. “We will be down during the third quarter, but it won’t be a meaningful event for Pabrai Funds,” he says. One of his biggest gambles right now is Delta Financial Corp., a Woodbury, New Yorkbased subprime mortgage lending company. Pabrai loaded up on its stock over the past year, paying roughly $9 a share. By June he had more than 4.6 million shares, allotting about 10 percent of his assets to the position.

Delta Financial’s stock traded at an all-time high of $13.60 a share in May but began slipping early this summer as the number of foreclosures shot up. The situation worsened dramatically for the company in early August, when it filed its quarterly earnings report a week late because, it explained, the company was negotiating for an emergency cash infusion to meet “substantial margin calls” from banks that had loaned it money, which it in turn had loaned to homeowners.

Pabrai Investment Management was one of two firms that agreed to bail out Delta Financial. Angelo, Gordon & Co., a New Yorkbased hedge fund, provided $60 million in exchange for warrants that allow it to buy 10 million common shares at $5 a share. Pabrai supplied $10 million in exchange for notes that can be converted into 2 million shares at $5 a share for up to one year. Pabrai receives 6 percent interest on the notes for the first 90 days, and 12 percent for the remaining period.

“Delta is one of the best companies and management teams in this space,” Pabrai said in a mid-August press release. “I look for them to emerge from the current market disruption and be well-positioned to take advantage of a less populated competitive landscape.”

The day after missing its filing deadline, Delta Financial saw its stock tumble 30 percent, to below $4 a share. Since then, the company has shed 20 percent of its workforce, or some 300 employees, and suspended its third-quarter dividend. Its shares were recently trading at about $5 apiece.

Lending money to Delta Financial would seem to violate Pabrai’s rule against activist-style investing. Pabrai says the mortgage lender reached out to his firm. “We have a passive position,” he explains. “We would never, ever, suggest to Delta Financial how it should run its affairs.”

But with Delta Financial’s shares now worth half what he paid for them, Pabrai is faced with the inexorable math of investing: When a stock loses 50 percent of its value, it has to bounce back by 100 percent just for investors to break even. Pabrai says he often invests in a company “after a bad event has led the stock market to extrapolate to infinity,” and that his stocks often trade at less than 50 percent of his purchase price for months after he has bought them. To ward off buyer’s remorse, Pabrai says he tries to hold on to positions for at least two years.

Ideally, he likes to allocate 10 percent of his assets to ten positions, but he will own no more than 15 stocks. Quarterly filings with the SEC show that all five of the stocks Pabrai still owns from his June 2005 portfolio have posted gains. They are Berkshire Hathaway (up 43 percent through September 2007), Fairfax Financial Holdings (up 51 percent), Harvest Natural Resources (up 12 percent), Star Gas Partners (up 63 percent) and Universal Stainless & Alloy Products (231 percent). A sixth stock, the steel company Ipsco, was acquired by Swedish steel company SSAB during the third quarter. (For a complete list of Pabrai’s holdings, see the table on this page.)

Pabrai’s peripatetic childhood took him from Mumbai to New Delhi to Dubai, while his entrepreneurial father tried -- and often failed at -- endeavors that included selling high-end stereo speakers, magic kits by mail and real estate. “My father had a tremendous sense of adventure, but he and my mother were terrible financial planners, living like kings until the money ran out,” he recalls. After graduating from Clemson in 1986, Pabrai joined Tellabs, a Naperville, Illinoisbased telecommunications equipment maker, where he worked in research and development.

Two years after he went to work for Tellabs, his father, Om Pabrai, paid him a visit. Frustrated at watching his son rise at 9:30 a.m. and go to work dressed in jeans, he urged him to move to Tellabs’ fledgling international marketing department. In 1990 the 25-year-old Pabrai quit Tellabs and founded TransTech, a systems integration firm, using $30,000 from his 401(k) and $70,000 in credit card loans. By 1999, TransTech was generating $20 million in annual revenue and had 160 employees. Pabrai sold it to consulting firm Kurt Salmon Associates for an undisclosed sum in November 2000.

In 1999, Pabrai started a second company, Digital Disrupters, a software company for electronic billing designed to take advantage of the Internet. Outside investors contributed $2.7 million to the start-up, and Pabrai added $1.8 million. The business failed 11 months later as dot-com euphoria vaporized.

“Digital Disrupters was a very expensive way for me to get a basic investing education,” Pabrai said this July in an interview with GuruFocus, the online service that tracks the stock picks of leading investment managers.

Pabrai’s education as a value investor began in 1994. While waiting in London’s Heathrow Airport for a flight to the U.S., he bought Peter Lynch’s book One Up on Wall Street and read for the first time about Warren Buffett.

“I kept wondering, Who is this person Lynch writes so reverentially about?” recalls Pabrai. He read more books on the famed value investor and, on the advice of the members of his Young Presidents’ Organization, wrote Buffett to ask for a job. Buffett replied that he worked alone.

Now eight years into his third career, as an investment manager, Pabrai wants to educate others in the ways of picking what he calls low-risk, high-uncertainty stocks. These are often companies that have been tarnished by the falling fortunes of their competitors. Pabrai says an insightful investor who digs deep enough will be able to discern which companies are likely to bounce back, and his second book, The Dhandho Investor, is a highly readable account of some of his successes doing just that.

In June, Delta Financial looked like one of those low-risk, high-uncertainty stocks to Pabrai. Wall Street had thrown the proverbial baby out with the bathwater, he told a TV interviewer. If Delta Financial survives the subprime meltdown, Pabrai will receive kudos for his investment acumen. If not, he can always tell his grandchildren that he had lunch with Warren Buffett.

It’s a Date: How Pabrai Won Lunch with Buffett

Investment manager Mohnish Pabrai had failed four times since 2003 to outbid rivals for the chance to eat lunch with his hero, Warren Buffett. So in June, Pabrai and his co-bidder and friend, Guy Spier, who runs hedge fund firm Aquamarine Capital Management in New York, made a pact to go as high as $2 million for the annual charity lunch, which was being auctioned on eBay. As it turned out, they didn’t need to. Their winning bid was $650,100.

Pabrai is footing two thirds of the bill, with Spier picking up the rest. The contribution is tax-deductible; the proceeds benefit the Glide Foundation, a San Francisco charity supported by Buffett. Manhattan steak house Smith & Wollensky will contribute $10,000 to the charity and pick up the tab for the June 2008 lunch.

Given that both Pabrai and Spier are value investors -- bargain hunters who try to buy an asset worth $1 for 50 cents -- the lunch doesn’t appear to meet their investment guidelines. Moreover, it’s unlikely to include any investment insights, as the Sage of Omaha is famously unwilling to discuss his holdings.

Spier’s reasons for wanting to attend the lunch are personal. He believes that preparing to spend time with Buffett will improve him as an investor. “It’s like playing up when your tennis opponent is better than you,” he explains.

Pabrai wants to thank Buffett and, indirectly, Buffett’s partner, Charles Munger, for illuminating the principles of value investing, first handed down by Benjamin Graham, through annual meetings and letters to shareholders of their holding company, Berkshire Hathaway.

“The lunch itself is icing on the cake,” Pabrai says. “The main driver for me is to repay the tuition bill. I’ve learned so much from Mr. Buffett.”

The five-day online auction began on Sunday, June 24, at 7:00 p.m., Pacific time. All bidders, including Pabrai, had to be prequalified by Kompolt, the San Luis Obispo, Californiabased agency that runs eBay’s charity auctions. The minimum opening bid was $25,000. Pabrai’s first bid was $77,000. The amount, he says, was chosen to honor Buffett, who turned 77 this year. Of course, other participants had no way of knowing his maximum bid, because the way eBay works, the amount that is shown online is the lowest bid needed to beat everyone else.

“If someone puts in a $30,000 bid, then the only price it shows is $30,100 from me, automatically,” Pabrai explains. “So, until the bidding crossed $77,000 from another bidder, I was in the lead.”

By Monday morning the price had soared past Pabrai’s offer. At 9:45, he put in his next one -- $184,000, because, he says, “Mr. Munger turns 84 in January.” On Tuesday, Pabrai bid $194,801.

“The reason for that number is, 1948 is the year Israel got created -- I was being secular and a citizen of the world and all that,” Pabrai says of his logic. “And I added $1 because whenever Hindus give a monetary gift, they always want to end it with the number one.”

Another bidder quickly passed him, so Pabrai followed with an offer of $401,948, combining 1948 and 400,000. The latter, he says, represents the $4 billion that Berkshire paid last year for Israeli company Iscar Cutting Tools.

On Friday evening, with just 20 minutes left in the auction, a rival trumped Pabrai with a bid of $426,000. Five minutes later Pabrai upped his maximum to $1,000,001. But he was worried that someone using automated software would come in at the last second to top him, so he decided to go for broke with a $2 million bid. According to Pabrai, the eBay system would not accept it, even though he’d been preapproved.

“With the auction ending in three minutes, I was frantically e-mailing my contacts at Glide and Kompolt,” recounts Pabrai. “When I finally got someone on the phone, there were 20 seconds left. The other guy had put in a bid of $650,000, and mine showed up as $650,100. As I was trying to explain the problem, the auction ended. So here was no need to use most of the dry powder.” -- J.S.