The Graham and Doddsville newsletter, compiled by the students of Columbia Business School, is a fantastic resource for value investors. First published in 2008, the publication has interviewed some of the top value investors over the years .
The lead interview of the second newsletter was a conversation with Mohnish Pabrai (Trades, Portfolio), which covered many topics, but chief among these was value investing.
Many of the topics discussed in the interview have been covered before, so I'm not going to go over these again. One interesting quote, however, deserves more attention: smoke-filled theaters and spectacular waterfalls.
Smoke-filled theaters and spectacular waterfalls
I've not heard this quote before, so I felt it would be beneficial to pull it out from the newsletter. It's an analogy involving a cinema filling with smoke. Pabrai says he got this initially from a speech Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial) CEOĂ‚ Warren Buffett (Trades, Portfolio) once gave, but hadn't been able to find any proof of this.
Here is the basic concept as described in the newsletter interview:
"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."
This theater, he goes on to say, is the New York Stock Exchange. On the stock exchange, every share of any business is always owned by someone at all times. To buy or sell the stock, you have to find someone willing to sell or vice versa.
Pabrai continues the analogy, saying that "if there is an event which is a distressing event for a company" then this is the smoke in the theater. Both the buyer and seller have exactly the same information available to them, they both know there is smoke in the theater and, therefore, for the buyer to be willing to buy it still "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."
This is where the idea of a waterfall comes in. When you have smoke in theaters, you will have a massive collapse in stock prices, which looks similar to a waterfall on a chart.
The job of a value investor is to look at these waterfalls and smoke-filled theaters and decide if the smoke is a false alarm or not:
"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."
In situations like these, logic goes out the window. When there is a stampede out of the theater, all reason and logic disappear. This is an excellent way of looking at a value opportunity -- whether it comes from Buffett or not.
When everyone else is running away, it pays to take a step back and look at the situation from a distance.
Disclosure: The author owns shares of Berkshire Hathaway.
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