Last year I read Mohnish Pabrai’s book, The Dhando Investor, and it quickly became one of my favourite value investing books (thanks to everyone here on StokBlogs whom so strongly recommended Mohnish).  I really appreciated his simplistic approach to what he calls "anomaly-based" investing.  My favourite sections of the book were where he explains the Dhando investing framework using real examples, the chapter about "fixating on arbritrage", and the chapter about investing in "low-risk, high-uncertainty" businesses.  Mohnish does a great job aggregating and explaining key value investing concepts that, in my opinion, are ambiguously spread out through dozens of other books and Warren Buffett writings.

Last week in the May 2008 SmartMoney magazine I read an interview with Mohnish titled "Looking Up to Warren Buffett".  I was so inspired that I re-read The Dhando Investor this weekend too!  Here are some highlights from the interview:
 

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.

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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: 580.07, -0.93, -0.16%). 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.

SM: What are some other mistakes investors make?

MP: Using the market to tell you what a business is worth. If a stock goes from $10 to $3, most people freak out and sell out. You have to have your own internal yardstick. Sell to the market when the price is higher than what you think the business is worth, and buy when the price is lower. Another problem is that our brains are very poorly evolved to deal with the stock market.

SM: How so?

MP: Our brains are in sync with the speed at which the market is moving and totally out of sync with the speed at which a business is moving. It seems obvious: The market is repricing a company's stock very quickly. I can process very quickly; therefore, I make decisions based on that. You have to learn to dramatically slow your brain, which is very hard for most people. The reality is that you should make decisions based on how that business is changing, and that's a very slow process.

SM: There is a lot of gloom and doom in the market. Are you bullish?

MP: In the Pabrai funds portfolio, there is a huge discount between what the businesses are worth and where they are trading. That's my estimate, which can be way off. But in the past when we have seen wide gaps, as in the fall of 2002, it's been a good omen. If we have a deep recession, high unemployment, things could change. But stocks start doing well even before a recession ends, so when I look at the Dow, I see a lot of value.

SM: What stocks do you like now?

MP: Pinnacle Airlines. Depending on how things work out, it's anywhere from a double to five or six times return in the next two or three years.

SM: An airline?

MP: It's a regional jet company. The large airlines, like Northwest (NWA: 8.47, -0.70, -7.63%) and Delta (DAL: 7.50, -0.35, -4.45%), outsource the small planes to Pinnacle. Many of the reasons why airlines are so terrible — load factors, price wars — don't matter. The revenue is the same whether there is one passenger or the plane is full and whether Northwest charges $200 or $2,000 round-trip. The contracts are long-term, usually 10 years, and will hold up in the event of a merger. So you can estimate what their cash flows will be many years into the future.

SM: What's the investment case?

MP: Pinnacle has more than $10 a share in cash on the balance sheet. In the next few years, free cash flow will be $3 to $6 a share, depending on how much more business they get. With a simple 10 or 15 multiple on those numbers, you end up with $30.

SM: Why are the shares so cheap?

MP: One overhang is that they have a past-due contract with pilots. But not a lot of Wall Street analysts follow Pinnacle, and the business itself is changing. The evolution away from hub-and-spoke and toward more nonstop flights is driving demand for their services. When you connect one small city to another directly, you aren't going to run a jumbo or a 737.

SM: Pabrai is a hedge fund, but you don't short. How come?

MP: Because it's a stupid bet. The maximum you can make is double, if the stock goes to zero. The maximum you can lose is infinite. Let's say a stock is at $10, and you short it and it goes to $100. You are down about 1,000%. The extent to which the stock can go up is unlimited.

SM: As a value investor, how do you rationalize paying $650,100 for lunch with Warren Buffett?

MP: It's not an investment. It's a debt I owe Mr. Buffett. The best way to thank him for all I have learned was to support a cause he cares about. The lunch is a bonus.