After the financial crisis, the Financial Crisis Inquiry Commission (FCIC) was created to determine the root cause of the crisis; as part of that effort, the commission was required to make the ensuing interviews of hedge fund managers, bankers, and economists available to the public. One of the people interviewed was Warren Buffett, and as expected, he didn’t disappoint. During the interview, he was asked to discuss the difference between investment and speculation; here was his response (bold added for emphasis):
“It’s a tricky definition, you know; it’s like pornography, the famous quote and all that, but I look at it in terms of the intent of the person engaging in the transaction. And an investment operation, and that’s not the way Graham defines it in his book, but an investment operation in my view is one where you look to the asset itself to determine your decision to lay out some money now to get some more money back later on. So you look to the apartment house, you look to the stock, you look to the farm in terms of what that will produce. And you don’t really care whether there’s a quote under it all. You are basically committing some funds now to get more funds later on through the operation of the asset. Speculation, I would define, as much more focused on the price action of the stock, particularly that you buy or the indexed future or something of the sort. Because you are not really, you are counting on, for whatever factors, could be quarterly earnings, could be up or it’s going to split or whatever it may be or increase the dividend, but you are not looking to the asset itself. And I say the real test of how you, what you’re doing is whether you care whether the markets are open. When buy a stock, I don’t care whether they close the stock market tomorrow for a couple of years because I’m looking to the business, Coca-Cola or whatever it may be to produce returns for me in the future from the business. Now if I care whether the stock market is open tomorrow then I say to some extent I’m speculating because I’m thinking about whether the price is going to up tomorrow or not.”
Warren’s differentiation between investment and speculation is dependent upon price action; the trader, for example, lets the market price guide their actions, and believes that the value of their equity stake in a company is tied to the next uptick or downtick in the price.
The key tenants of value investing, on the other hand, are rooted in the fact that the markets are not efficient, and cannot be looked upon as a soothsayer with the “right” answer; as Warren notes, the investor doesn’t really care whether there’s a quote at all, beyond the extent that it represent a price at which Mr. Market will buy or sell to you (in other words, this information is independent of the intrinsic value of the business).
While many people would agree with that statement and still proudly call themselves a value investor, I don’t think that title is always fitting. An investment, by Warren’s definition, is the act of looking at an asset and determining to lay out some money now to get some more money back later on. Logically, this requires a couple of things on our end: we must know the current amount to be laid out (easy enough to find), but we must also be able to estimate the amount of money to be recovered in the future (a bit more difficult). This requires in-depth analysis that focuses on sustainable competitive advantages and conservatively estimates the future cash flow generation of the business, while avoiding outsized attention on short term fluctuations that are beyond the company’s control and unrelated to the fundamentals in question (for example, commodity cost volatility); collectively, this information can provide the basis upon which one can confidently invest in securities backed by a sizeable margin of safety.
By this definition, many analysts are not looking at securities as investments; for example, Staples (SPLS) was recently downgraded by Bernstein, which cited citing stalling employment trends in the United States and a broadening recession in Europe as a justification for cutting the price target on the stock by more than 1/5th. It doesn’t take much to see the disparity between the rationale and the size of the adjustment – if Bernstein was looking at the long term prospects of the business (rather than last month’s employment statistics) and based their price target on the discounted cash flows to be generated by the business over the coming decades, this change in price target would be unjustifiable; instead, they likely acted because the stock has declined as of late, and they look to the market for guidance upon which they peg their price target.
Compare this to your own actions; with this as our guidance, can you call you what you’re doing investing? Are you approaching each investment with a long term view, and conservatively estimating the cash flow that can be generated by the business over the coming years, regardless of fluctuations in the business cycle? Are you happily buying more of securities as the disconnect between price and value increases, or are you scared out of holdings when Mr. Market gets particularly pessimistic? By definition, anybody that implements a stop-loss strategy is not investing; they are simply speculating, and are irrationally committing to dispose of a stake in a company as it becomes cheaper while they happily hold a position in that same company at a richer valuation.
As I’ve noted in the past, I think an investment journal is a fantastic way to assure that you are in fact investing, rather than speculating; anytime you enter a new position, force yourself to pen out the thesis, in addition to a price target and some risks/catalysts that would cause you to rethink your original analysis.
If you sit down to do this and struggle, good: at least you have rooted out the fact that what you’ve been calling investing is really just speculation; with that, you can set yourself on the right path to bridge the gap between intelligent capital allocation and gambling.
About the author:
I think Charlie Munger has the right idea: "Patience followed by pretty aggressive conduct."
I run a fairly concentrated portfolio, with 2-5 positions accounting for the majority of my equity portfolio. From the perspective of a businessman, I believe this is sufficient diversification.