Greenwald’s Value Investing Seminar, where you used an analogy about
smoke-filled theaters and spectacular waterfalls. Can you discuss this concept?
Monish Pabrai : I was recently discussing this concept with a bunch of value investors
and they all said they never heard Buffett use this analogy,
but I could swear that I heard it from Buffett.
So for now, I will continue to say that I got it from Warren Buffett.
Here is the basic concept.
Let’s say you go to see a movie and you pay $10 to buy a ticket.
Every seat in the theater is occupied – the house is full.
Suddenly, the smoke alarm goes off in the middle of the movie
and as smoke begins to fill the theater, people run for the exit.
Now, this movie theater has special rules, and the rule is that
you can only leave the theater as long as you find someone from
outside the theater who will take your ticket and seat.
You must enter into some type of transaction
where that person pays you for your ticket.
So the question that comes up is at what price
will that $10 ticket sell for now that there is this alarm
and smoke in the theater, and the answer is that it
probably doesn’t sell for very much, or you might have to
give it away for free, or you may even have to pay the guy
to take it off of your hands.
That theater is the New York Stock Exchange,
because on the stock exchange every share of any business
is owned by someone at all times.
If there is an event which is a distressing event for a company
which leads people to say I no longer want to own the stock,
that is like the smoke in the theater and people wanting to exit the theater.
The person who you want to sell the stock to,
which is the person who wants to enter the theater,
has access to the exact same information that you do.
He also knows there is smoke in the theater.
Therefore, for him to still be willing to buy it,
the price at which the transaction takes place, is likely to be
a significant discount at what the stock was trading at before the smoke.
If you enter selected smoke-filled theaters, and you later find that
the smoke is really nothing to worry about, or it has been put out,
then there is a chance you have gotten a great investment
and you can do quite well with it.
The second part of this is when you have smoke in theaters,
you are going to have these huge collapses in stock prices.
If you look at the stock’s chart, these will look like a waterfall.
So what this means is that smoke-filled theaters are likely
to lead to spectacular waterfalls.
As a value investor, you don’t want to enter every smoke-filled theater.
What you want to do is carefully analyze these smoke-filled theaters
to try to find one where the smoke is not real,
or the fire alarm is not real, it went off for no reason,
and then buy those tickets at hugely discounted prices,
then sit back and watch the rest of the movie.
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Read more at : http://www8.gsb.columbia.edu/sites/valueinvesting/files/files/Graham%20And%20Doddsville%20-%20Issue%204%20Summer%202008.pdf
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