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Principles of Graham: Investment Vs. Speculation

December 02, 2011 | About:
John Emerson

John Emerson

145 followers
"An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative." — Ben Graham

It occurs to me that the typical individual who buys and sells common stocks makes little or no distinction between the concepts of speculation versus investment. Instead they are much more interested in the daily fluctuations in their stock portfolios which are reflected by their current bid and ask prices. Indeed, it is the daily quotations rather than the underlying value of their stocks which derives their sense of success or failure. It is exactly that misguided sense of priorities which dooms them to long-term underperformance or in the extreme case, financial ruin.

The purpose of today's article is to help readers to distinguish between whether they are speculating or investing. I intend to use the framework provided by Ben Graham and elaborated upon by Warren Buffett to distinguish between the two acts.

It is important to note that the difference between investing and speculating is often times a fine line. Subjective judgments are frequently employed when one attempts to ascertain the intrinsic value of a stock. Errors in calculation are a fact of investing as is the tendency for human beings to possess an innate sense of overconfidence. Of course the answer to those potential pitfalls can be remedied by employing a substantial margin of safety. However, that is a topic for another day, today we will focus on separating speculation from investment.

The Concept of Pricing vs. Predicting Market Fluctuations

"There are two possible ways to take advantage of the recurring wide fluctuations in stock prices, by way of timing or by way of pricing" — Ben Graham

Frequently when a novice reporter interviews Warren Buffett, he is asked his opinion in regard to the direction of the market looking forward. His standard answer is that he makes no attempt to predict market movements. Rather he expends his energy by attempting to price individual securities. What exactly does Mr Buffett mean when he makes that statement?

The concept of pricing lies at the core of value investing; an investor attempts to profit in the long term by purchasing stocks at a substantial discount to their intrinsic value, while a speculator attempts to profit by successfully predicting the short term fluctuations of a stock. In other words, the speculator believes price volatility and the ability to prognosticate the direction of that volatility is of paramount importance.

Price volatility is important to the investor as well but only when it is considered in relation to the calculated value of the stock. The successful investor endeavors to purchase stocks when the market is overly pessimistic. The investor then attempts to purchase a stock at a substantial discount to its calculated intrinsic value. During periods of market optimism, the investor is perfectly happy to sell his stock when the market offers a price which approaches or exceeds his/her calculated intrinsic value of the equity.

At first glance the distinction appears to be semantic maneuvering; all investors/speculators attempt to profit by the upward movement of a stock (unless they are short the equity), otherwise they would not purchase the stock. So what is the underlying difference between a speculator and the investor?

The difference lies in the defensive nature of the investor versus the speculator or more specifically the probability that the transaction will not result in a loss of principal. In other words, the distinction is largely a function of risk. When one purchases an "undervalued" stock, risk is directly correlated to the investor's ability to properly discern the underlying value of the stock. In other words, the risk is consummate to an error in calculation. On the other hand, risk for the speculator is directly correlated to the short-term volatility (price movement) of the stock. In other words, risk is consummate to improper timing.

The premise for the aforementioned concept is reflected in Buffett summation of Ben Graham's philosophy: "In the short run, the market is a voting machine but in the long run it is a weighing machine." — Buffett's 1987 Annual Letter

In the case of the investor, time is his ally; in the case of the speculator, proper timing is the essence of his game. Applying that schema, it is easy to understand why a patient investor consistently outperforms a speculator in the longer term.

Patience and Investing

Two things are paramount to the success of an investor:

1) The ability to calculate a reasonably accurate intrinsic value for a stock

2) The patience to hold the stock until it approaches its intrinsic value

Since time is one of the two key elements which favors the investor over the speculator, patience becomes instrumental in the ultimate success or failure of the investor.

When an investor successfully uncovers an undervalued equity, he or she can not expect to reap the gains of the mispricing overnight. Frequently such stocks have been undervalued for a long period of time and unless the investor has also uncovered a catalyst for the stock, they are likely to remain undervalued for an extended period. It is the waiting game that frequently unnerves the investor, particularly if the overall market is advancing while the "undervalued" equity remains stagnant.

It is mandatory that investors take a multi-year prospective when investing in undervalued stocks. Warren Buffet offered the following advice in that regard:

"Only buy something that you’d be perfectly happy to hold if the market shut down for 10 years".

"I never attempt to make money on the stock market. I buy on the assumption that they could close the market the next day and not reopen it for five years."

Clearly, the element of patience and the ability to "sit chilly" while the rest of the investment world is reacting to daily fluctuations in stock prices is a fundamental requirement for all successful value investors.

Warning Signals of Market Speculation

I would like to conclude today's article with a set of warning signs which might signal that an investor is entering the realm of speculation:

1) Undue emphasis on quarterly results

If your investment strategy relies upon buying or selling a stock based upon its most recent quarterly report, you are probably speculating rather than investing. While it is important to sell a stock if one uncovers a fundamental miscalculation in the value of an equity, hasty decisions based upon a quarterly disappointments are rarely beneficial to the investor in the long run. Nor are hasty buying decisions which are based upon a quarterly earnings surprise.

2) The tendency to trade stocks based upon current market sentiment



If you are more likely to purchase stocks during periods when the market is rising or tend to sell out of positions during periods of market pessimism, you are probably speculating excessively. The emotional urge to trade based upon the direction of the market has nothing to do with investing or attempting to ascertain the underlying value of a common stock.

3) Purchasing stocks without attempting to price them first

If you buy a stock simply because you believe it will rise or simply because it has dropped precipitously, you are speculating rather than investing. Buying stocks following a huge drop is part of every value investors arsenal; however if you have not attempted to ascertain the intrinsic value of the stock then you are speculating instead of investing.

4) Relying upon macro conditions to time the market

Ralph Wanger once pointed out: "The Stock market is a reliable indicator of where the economy is headed, but you’ll get no help looking at it the other way around"

The market invariably anticipates economic improvements well in advance. If you attempt to base your investment decisions upon your current perception of the economy rather than attempting to price individual stocks, you are definitely speculating rather than investing.

5) Investing in a stock without fully understanding the business

It is an excellent idea to pay attention to the stock purchases of respected investors; however, blind coat-tailing is merely an advanced form of speculation. If one does not understand a business or attempt to ascertain the intrinsic value of the stock, it is impossible to make an intelligent decision as to when the stock should be purchased or sold.

Conclusion

The line between investing and speculating is frequently blurred. It could be argued that many successful investors are also astute speculators. For instance, many value investors now require a perceived catalyst before they will invest in an undervalued equity. Frequently that catalyst is little more than a speculation. Maybe the investor believes the sector is improving, the business is about to turn profitable or that recent M&A activity is likely to drive the stock towards fair value.

Successful speculation is largely a function of knowledge which is created by extensive reading. Additionally it is no coincidence that savvy investors are frequently better market timers than ordinary investors. The reason is that successful investors understand the relationship between pricing and market volatility as well as holding a superior understanding of the business its overall sector. Good investors tend to purchase equities when opportunities exist, while the average person tends to purchase equities during periods of positive momentum.

The best time to purchase common stocks is when they are on sale. Unfortunately for investors that is also the time when their emotions tell them to back away. I would submit that most outstanding investors, Seth Klarman for instance, engage in market timing. Klarman is notorious for pulling out of markets when they are expensive and loading up when he deems them to be cheap. The lesson is clear; market timing should be a function of price rather than momentum.

Clearly, market timing is a form of speculation and value-based market timers are frequently early. What separates them from traditional speculators is two-fold: 1) they have patience and do not panic 2) they rarely employ leverage which would introduce a time element into their market timing.

As Warren Buffett has pointed out on numerous occasions, leverage is the only element which can take an investor out of the game. On that note I conclude today's discussion.

About the author:

John Emerson
I have been of student of value investing since the mid 1990s. I have continued to read and study value theory on an ongoing basis. My investment philosophy most closely resembles Walter Schloss although I employ considerably less diversification. I also pattern my style after Buffett's early investment career when he was able to purchase shares of tiny companies.

Rating: 4.0/5 (25 votes)

Comments

m.siddiquee
M.siddiquee - 2 years ago
thanks John. i enjoyed your piece. expecting more.
ry.zamora
Ry.zamora - 2 years ago
The line between investing and speculating is frequently blurred. It could be argued that many successful investors are also astute speculators. For instance, many value investors now require a perceived catalyst before they will invest in an undervalued equity. Frequently that catalyst is little more than a speculation. Maybe the investor believes the sector is improving, the business is about to turn profitable or that recent M&A activity is likely to drive the stock towards fair value.

Successful speculation is largely a function of knowledge which is created by extensive reading. Additionally it is no coincidence that savvy investors are frequently better market timers than ordinary investors. The reason is that successful investors understand the relationship between pricing and market volatility as well as holding a superior understanding of the business its overall sector. Good investors tend to purchase equities when opportunities exist, while the average person tends to purchase equities during periods of positive momentum.


Hey John, it's me again. :D

What happened to your article on Greenwald's Valuation style?

Anyway, anyway, if you don't mind, I'd like to give my two cents.

You cannot really take away the "speculation element" from investing. You're putting your money into a business, and unless you own at least 20% of the underlying enterprise, the only returns you're going to get are twofold: capital appreciation and dividends.

Capital appreciation flows directly from both the growth of the business and the price you paid for it. Dividends, on the other hand, can stem from either the business's continuing existence, or its further growth. (This assumes it's not debt-financed and the company is in a state of dangerous decline.)

Since you do not control the business, since you have absolutely no say in its shareholder management policies (dividends, buybacks, etc.), you leave the fate of the corporation -- and the probability of generating real returns -- in the hands of the majority owners and the managers they hire.

It is thus in your best interest to look into the future of the company. First, the future of the entity itself (competitive advantages), and second the future of its battlefield (industry & technology analysis, planned actions of the company). The former represents the probability of the company maintaining value-adding returns over the medium-term, and the latter being the catalysts mentioned in your article, which are more often than not speculative or "intelligent guesses" in nature.

Even the valuation models have an element of speculation in it. The NAV approach (liquidation value, reproduction costs) try to assess the liquidation/fair value of the business's assets. DCF models employ assumptions that can be either broad or specific. Relative valuation hides these assumptions from sight and employs a convenient multiple in their stead, whether it be EV/EBITDA or normalized P/E.

When you have a target in mind, what are your options? You can buy early, and hope for the market to rise in the next few years, but doing so exposes you to the risk of the price crashing because of some unforeseen error in your judgment (which is unlikely if you were thorough with your analysis), OR because of macroeconomic disasters, which is more common than ever in this decade.

Whether doom or paradise is "priced in" or not does not matter -- when judgment day comes and its coming is spread worldwide through the Internet, price moves in an instant. What happened in August is a VERY good example of this. Another good one would be the multiple setbacks faced by Europe and the false hopes it generated from September to this very day.

Sure, if you stood by your guns, raised your middle finger at the market, and closed the book with the intent of returning the next year, then, assuming nothing but good happens on the macro side, you're bound to make money. Hell, if you stick it through the economic panic, you're going to earn in the end, but that's assuming you don't lose hope and faith in your own analytical ability.

But what happens then? Portfolio performance drops. Returns aren't maximized. You start thinking, if you had been more patient with your purchases or if you had been a bit more adventurous during the market volatility, when you know whatever happens on the macro scale isn't likely to affect the company's fundamental position in the medium-term, perhaps you could've earned more by the time everything reverts to normality...

John Emerson
John Emerson - 2 years ago


First off, thank you for your long response, it is flattening to think that people actually pay attention to the content of my articles. Secondly, I will get back to Greenwald philosophy before too long with the second addition of valuing assets by replacement value.

As far as your comments about the speculative nature of investment I generally agree; however it has been my experience that in most cases if one purchases a stock at a sufficient discount, it will eventually move to fair value. It is the timing of the movement which is highly unpredictable. Further many times if the market does not accurately value the company a suitor will step in and make a bid on the company. Even if the bid is turned back, it generally acts as a catalyst.

As you are aware I generally try to view discounts in terms of assets, of course not all assets are created equal and as you mentioned; evaluation is subject to some speculation. Finished inventory for instance is particularly hard to evaluate and in the case of net/net stocks frequently the most worthless one's possess much of their discount in the way of inventory.

You are right on when you mentioned that management ultimately controls the fate of an insignificant shareholder; that is the best argument I could give for reading the proxy statement before the annual. If the management's compensation is the major reason for the existence of the company and they control the voting shares through the common or the some type of preferred, then you are probably better served to look elsewhere unless they pay a hefty regular dividend.

Seth Klarman made that point in the interview which recently appeared on Gurufocus and I discussed it prior to that point when I told my story about Fairchild in a recent article. I learned that lesson the hard way. Valuation metrics are worthless unless the management returns capital to shareholders on a regular basis or profits more by increasing the equity of the company rather than by fat paychecks, ala Berkshire.

One minor point on which I would disagree is that capital appreciation is solely a function of growth. While that is often the case, particularly in the short term, I consider that view to be a Wall St. fallacy which is pepetuated by the likes of Jim Cramer on a daily basis. Undervalued low/no growth companies frequently move to fair value however the timing of that move is highly unpredictable in nature. Still it is the crux of my investment philosophy, ie buy undervalued tangible assets and evenutually something good will happen so long as the assets are not burned in the interium.



Thanks for the comments
ry.zamora
Ry.zamora - 2 years ago
Thank you for your long response, it is flattening to think that people actually pay attention to the content of my articles

Anytime I give a long response, expect it to a criticism, a set of long questions, or a supplement to what you wrote. :P

It is the timing of the movement which is highly unpredictable. Further many times if the market does not accurately value the company a suitor will step in and make a bid on the company. Even if the bid is turned back, it generally acts as a catalyst.

Still, it points to unpredictability as you don't know when the catalyst card kicks in. Perfectly timing it on a consistent basis is near-impossible.

One minor point on which I would disagree is that capital appreciation is solely a function of growth. While that is often the case, particularly in the short term, I consider that view to be a Wall St. fallacy which is pepetuated by the likes of Jim Cramer on a daily basis. Undervalued low/no growth companies frequently move to fair value however the timing of that move is highly unpredictable in nature

I never said capital appreciation is "solely a function of growth". I stated that it comes from both the growth of the business and the price you pay for it, a statement of James Montier that I both agreed on and internalized.

Think about it. The impact of growth is a given, but what of "the price you pay"? A company once fairly valued, then dragged down by a massive yet recoverable tragedy in its business, its industry or its home economy, lends to the undervaluation you would be talking about, even if the companies have low growth prospects to begin with.

I relish seeing something like "lower sales in the quarter", "decreased net profits", and the like on the news updates on my brokerage account, whether it be on something I'm currently holding, or a security I'm stalking like a predator, so long as the victim's a strong company in a decent, presently sustainable business.

John Emerson
John Emerson - 2 years ago
I stated that it comes from both the growth of the business and the price you pay for it,Sorry, somehow I misread your statement and missed the latter half. I would concur that the price one pays for a stock is imperative to any capital appreciation; although I view growth as the "cherry on the top" for the average investor.

Buffett and Munger repeatedly emphasize that one must not overpay as a caveat to buying a business with a durable competitive advantage. That said, I believe the average investor generally over estimates and over pays for growth, incidently that statement is directly from the Montier school of thought. That is why I believe that most individuals are better served by approaching stock-picking from a traditional Graham prospective rather than a Fisher prospective.

I also agree that finding extraordinary value in larger and well known businesses is rarely available barring some kind of perceived disaster. Thus proper timing as well as availablity of cash become paramount in acheiving significant capital gains, unless one wishes to put a strain on their margin of safety by utilizing leverage.

Good points!

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