Graham writes: “An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return.”
According to this definition, there are three components in investing:
· thorough analysis;
· safety of principal; and
· Adequate return.
Graham sustains that if an operation does not meet these three aspects, then it is considered speculative. According to certain analysts there are two other components that should be added: 1) any term shorter than the normal business cycle is considered speculation and the time period should typically be 3 to 5 years and 2) purchases made based on market movements or forecasts also involve speculative acts.
It is widely necessary to make the difference between investing and speculation. The reason was one stated by Graham, who in 1949 said: “. . . in the easy language of Wall Street, everyone who buys or sells a security has become an investor, regardless of what he buys, or for what purpose, or at what price. . . .”
Sometimes the financial media refers to investors when it is really talking about speculators. The media states that “investors” are those who take profits, bargain and drive prices upwards or downwards on a particular day. However, investors and speculators have different views and thus different actions.
Investors usually want to know what a business is worth and think themselves as business owners. By contrast to speculators, they have a long term approach. As it has been stated, as they act as if they own the business, they pay attention to corporate management, the company´s structure, and other issues that may affect the company in the future and its ability to create wealth. Furthermore, they profit from the voting rights their holdings grant to provide advice in respect to managing the business. Speculators are not interested in what a business is worth. They focus on what a third party will pay to own their shares. They are short-term players who follow the changes in the stock price and do not pay much attention to the underlying value of the company.
Speculation has a flaw. It is very difficult to predict how much a third party will pay for the shares an investor owns, either today, tomorrow or on a given day. Stock markets are extremely fluctuating and oscillate between the extremes. They are always affected by fear and greed. For instance, in the 90s the market suffered severe swings. In 1998, the S&P 500 index advanced or fell over 3 percent for 9 days. Volatility moved up and down from 3 to 17 in 2002. Actually this daily fluctuation enabled investors to concentrate on business value.
Long-term investors are not focused on day-to-day prices unless prices have fallen thus giving them an important margin of safety. Furthermore, they have little interest in factors that do not affect business value: market or interest-rate forecasts, or day-to-day stock price fluctuations.
There are businesses that are not worth what they sell for in the stock market and there are other businesses that are almost given away. These are the companies that provide a margin of safety. The way to find these companies is to analyze them internally.
Value investors do not pay attention to factors that do not affect business value. These factors are daily fluctuations and market or interest-rate forecasts. They pay attention to the relationship between business value and stock price at a specific level. They ignore general market characteristics with short-term developments.