"October. This is one of the peculiarly dangerous months to speculate in stocks. The others are July, January, September, April, November, May, March, June, December, August and February." -- Mark Twain
The difference between speculation and investment is widely misunderstood. It could be argued that many people who believe they are investing, in reality, are engaging in speculation. Of course when the market is steadily rising they could care less about such distinctions. Instead they rush to their TVs to watch the daily rants of Jim Cramer who promotes speculation, although he cloaks it as "investment advice." Just like the choir to which he preaches, I do not think he truly understands the difference.
The first task at hand is to define the difference between investing and speculating. Here we turn to Benjamin Graham for help: "An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative."
In Graham's early days, the common consensus was that purchasing bonds represented an "investment," while buying stocks represented a "speculation." Individuals who bought and sold stocks during that period were frequently described as Stock Operators. The pejorative nature of the expression speaks for itself. The expression of the day "Gentleman prefer bonds" is attributed to Andrew Mellon. The prevailing sentiment was that price was of little significance when purchasing a bond. Rather, yield was what really mattered. Of course reality set in during 1929 and the notion that bonds automatically represented safety of principle without regard to price was abruptly dispelled.
Benjamin Graham is generally credited with introducing the idea that stocks can represent a sound and safe investment if they meet certain criteria. He is also credited with the introduction of arithmetic into security analysis, which introduced scientific methodology into the analysis of common stocks.
Enough history. Allow me to take a common sense approach to the dichotomy between investing and speculating. Simply stated, speculation is an attempt to predict the short term movement of a market or an individual equity. A few individuals excel at this process, but the vast majority of us are woefully inept at predicting market or stock fluctuations. Typically, speculators follow momentum when predicting the direction of the market. Jessie Livermore liked to describe this process as "the path of least resistance."
When momentum rather than underlying value become the key element, any margin of safety is eliminated and the process quickly degenerates into a game of selling to a "greater fool." Adding leverage into the mix, in an attempt to super charge gains and loss of principal becomes nearly inevitable. In essence, the speculator has turned into a casino player and all the human frailties which I have discussed in prior articles come directly into play. Time becomes his nemesis rather than his ally, a ticking time bomb has been set directly under the speculator's monetary stake. Sometimes the fuse is extinguished in time, but many times it is not.
Investment, on the other hand, which emphasizes pricing and safety of principle, minimizes the risk of time so long as the investor disdains the use of leverage. Time is instrumental in the concept of safety principle. It allows an investor to hold an undervalued set of assets indefinitely until the market realizes the mispricing, or a buyer enters and makes a bid on the company. This risk becomes one of miscalculation or in some cases, a failure of the market to recognize the value of an equity. Sir John Templeton was willing to hold a stock up to five years before giving up on the market's ability to recognize the mispricing.
Speculation tends to increase dramatically during bull markets. Warren Buffett assessed the phenomenon eloquently:
"The line separating investment and speculation, which is never bright and clear, becomes blurred still further when most market participants have recently enjoyed triumphs. Nothing sedates rationality like large doses of effortless money. After a heady experience of that kind, normally sensible people drift into behavior akin to that of Cinderella at the ball. They know that overstaying the festivities — that is, continuing to speculate in companies that have gigantic valuations relative to the cash they are likely to generate in the future — will eventually bring on pumpkins and mice. But they nevertheless hate to miss a single minute of what is one helluva party. Therefore, the giddy participants all plan to leave just seconds before midnight. There’s a problem, though: They are dancing in a room in which the clocks have no hands."
In general, glamor and growth stocks are more susceptible to speculative fervor than mundane ones. Buyers of such equities frequently experience long-term underperformance when selecting "hot stocks" with high anticipated growth rates. In his book The Future for Investors, Jeremy Siegel analyzes the long-term returns to investors of low-growth, dividend-paying stocks vs. the high-growth, glamor stocks. Not surprisingly, the boring stocks dramatically outperform the glamorous ones. I believe it is a direct result of investors not paying attention to how much they pay for a stock, speculating rather than investing and over estimating growth potential instead of emphasizing safety of principles and fundamental valuation principles.
Conclusion
Where can investors turn to uncover companies that promise safety of principal and adequate returns over time? I submit that focusing on particular sets of conditions which lend themselves to unfairly driving down the price of good stocks is the place to begin. The following are some examples which I have used in the past:
1) Delve into under-followed stocks with small market capitalizations.
2) Take advantage of periods of extreme market pessimism such as 2008/2009.
3) Take a Walter Schloss approach and comb through the 52-week lows, in search of unloved bargains.
4) Examine companies which have experienced negative news recently which is unlikely to damage their future cash flows.
The final edition of Tenets of Value Investing will focus on the dangers of leverage.
The difference between speculation and investment is widely misunderstood. It could be argued that many people who believe they are investing, in reality, are engaging in speculation. Of course when the market is steadily rising they could care less about such distinctions. Instead they rush to their TVs to watch the daily rants of Jim Cramer who promotes speculation, although he cloaks it as "investment advice." Just like the choir to which he preaches, I do not think he truly understands the difference.
The first task at hand is to define the difference between investing and speculating. Here we turn to Benjamin Graham for help: "An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative."
In Graham's early days, the common consensus was that purchasing bonds represented an "investment," while buying stocks represented a "speculation." Individuals who bought and sold stocks during that period were frequently described as Stock Operators. The pejorative nature of the expression speaks for itself. The expression of the day "Gentleman prefer bonds" is attributed to Andrew Mellon. The prevailing sentiment was that price was of little significance when purchasing a bond. Rather, yield was what really mattered. Of course reality set in during 1929 and the notion that bonds automatically represented safety of principle without regard to price was abruptly dispelled.
Benjamin Graham is generally credited with introducing the idea that stocks can represent a sound and safe investment if they meet certain criteria. He is also credited with the introduction of arithmetic into security analysis, which introduced scientific methodology into the analysis of common stocks.
Enough history. Allow me to take a common sense approach to the dichotomy between investing and speculating. Simply stated, speculation is an attempt to predict the short term movement of a market or an individual equity. A few individuals excel at this process, but the vast majority of us are woefully inept at predicting market or stock fluctuations. Typically, speculators follow momentum when predicting the direction of the market. Jessie Livermore liked to describe this process as "the path of least resistance."
When momentum rather than underlying value become the key element, any margin of safety is eliminated and the process quickly degenerates into a game of selling to a "greater fool." Adding leverage into the mix, in an attempt to super charge gains and loss of principal becomes nearly inevitable. In essence, the speculator has turned into a casino player and all the human frailties which I have discussed in prior articles come directly into play. Time becomes his nemesis rather than his ally, a ticking time bomb has been set directly under the speculator's monetary stake. Sometimes the fuse is extinguished in time, but many times it is not.
Investment, on the other hand, which emphasizes pricing and safety of principle, minimizes the risk of time so long as the investor disdains the use of leverage. Time is instrumental in the concept of safety principle. It allows an investor to hold an undervalued set of assets indefinitely until the market realizes the mispricing, or a buyer enters and makes a bid on the company. This risk becomes one of miscalculation or in some cases, a failure of the market to recognize the value of an equity. Sir John Templeton was willing to hold a stock up to five years before giving up on the market's ability to recognize the mispricing.
Speculation tends to increase dramatically during bull markets. Warren Buffett assessed the phenomenon eloquently:
"The line separating investment and speculation, which is never bright and clear, becomes blurred still further when most market participants have recently enjoyed triumphs. Nothing sedates rationality like large doses of effortless money. After a heady experience of that kind, normally sensible people drift into behavior akin to that of Cinderella at the ball. They know that overstaying the festivities — that is, continuing to speculate in companies that have gigantic valuations relative to the cash they are likely to generate in the future — will eventually bring on pumpkins and mice. But they nevertheless hate to miss a single minute of what is one helluva party. Therefore, the giddy participants all plan to leave just seconds before midnight. There’s a problem, though: They are dancing in a room in which the clocks have no hands."
In general, glamor and growth stocks are more susceptible to speculative fervor than mundane ones. Buyers of such equities frequently experience long-term underperformance when selecting "hot stocks" with high anticipated growth rates. In his book The Future for Investors, Jeremy Siegel analyzes the long-term returns to investors of low-growth, dividend-paying stocks vs. the high-growth, glamor stocks. Not surprisingly, the boring stocks dramatically outperform the glamorous ones. I believe it is a direct result of investors not paying attention to how much they pay for a stock, speculating rather than investing and over estimating growth potential instead of emphasizing safety of principles and fundamental valuation principles.
Conclusion
Where can investors turn to uncover companies that promise safety of principal and adequate returns over time? I submit that focusing on particular sets of conditions which lend themselves to unfairly driving down the price of good stocks is the place to begin. The following are some examples which I have used in the past:
1) Delve into under-followed stocks with small market capitalizations.
2) Take advantage of periods of extreme market pessimism such as 2008/2009.
3) Take a Walter Schloss approach and comb through the 52-week lows, in search of unloved bargains.
4) Examine companies which have experienced negative news recently which is unlikely to damage their future cash flows.
The final edition of Tenets of Value Investing will focus on the dangers of leverage.
