Earlier, we explored a lesser-known passage of Graham & Dodd’s seminal work, “Security Analysis,” in which the authors outlined several strategies for the retail investor. They offered that an individual can invest for income, for profit and for speculation. Today, we look at their thoughts on speculation, expressed with their characteristic wit, and whether it is possible for individuals to make money doing so.
What is speculation?
Simply put, speculation is the purchase (or short sale) of an asset in an attempt to profit from short-term fluctuations in price. It is distinct from investment in that the decision to enter the market is based primarily on factors like price action -- what in Graham and Dodd’s time would have been called "reading the tape" -- as opposed to the underlying economic fundamentals of the asset.
Crucially, the speculator buys a security in the belief that it will become more valuable due to demand from other speculators who also wish to flip it for a quick buck, not because they think it is undervalued relative to its intrinsic value.
Of course, the line between speculation and investment is not always clearly delineated -- Jesse Livermore, probably the most famous speculator in Wall Street history, once cynically remarked, “There are no investments. There is only speculation.” Nevertheless, Graham and Dodd certainly believed that there was a difference, even if the line could become blurred. Here is what they thought about it.
A losers game?
“The investor of small means is privileged, of course, to step out of his role and become a speculator. (He is also privileged to regret his action afterwards).”
Graham and Dodd believed that there were three distinct types of speculation a person could engage in, the first being:
“Buying stock in new or virtually new ventures. This we can condemn unhesitatingly and with emphasis. The odds are so strongly against the man who buys into these new flotations that he might as well throw three-quarters of the money out of the window and keep the rest in the bank.”
If this sounds like venture capital investment, that’s because it is. Unlike the practice of buying bargain stocks at discount prices (value investing), venture capitalists have no margin of safety -- startups either survive or they don’t, and more often than not, they don’t. Startups definitionally do not have any earnings history, dividend payout history or any other historical data that can be used to value a company. VCs buy into good ideas and stories, not into solid cash flows and good price-book ratios. This is not necessarily a bad thing, but it certainly is not value investing, and Graham and Dodd understood this (of course, they were also referring to companies with new public offerings, but the same point stands).
“Trading in the market. It is fortunate for Wall Street as an institution that a small minority of people can trade successfully and that many others think they can. The accepted view holds that stock trading is like anything else; i.e., with intelligence and application, or with good professional guidance, profits can be realized. Our own opinion is sceptical, perhaps jaundiced. We think that, regardless of preparation and method, success in trading is either accidental and impermanent or else due to a highly uncommon talent. Hence the vast majority of stock traders are inevitably doomed to failure. We do not expect this conclusion to have much effect on the public.”
This is what most people think of as speculation: the pit trader buying cotton futures at 86 cents in lots of 500, and then turning around and roaring "sell!" when the price hits 89. Or perhaps we think of a day trader with his charts and trend lines, buying and selling a range-bound stock as they ping off support and resistance levels.
Regardless, Graham and Dodd’s disdain for this activity is clear: They believed it was a loser’s game for 99% of participants and that success was either due to luck or exceptional, unreplicable talent. What they forgot to mention was that success could also be achieved through the possession of insider information, or by just being faster than other market participants. One wonders what they would have made of algorithmic trading, front-running and other modern methods of market manipulation.
“Purchase of 'growth stocks' at generous prices. In calling this “speculation,” we contravene most authoritative views. For reasons previously expressed, we consider this popular approach to be inherently dangerous and increasingly so as it becomes more popular. But the chances of individual success are much brighter here than in the other forms of speculation, and there is a better field for the exercise of foresight, judgement and moderation.”
In part one, we highlighted Graham and Dodd’s approach to growth investing where “the basis of purchase is a confidence in future growth not held by the public” and said that this is really more like value investing. By contrast, what they are talking about here is a phenomenon that should be recognizable to anyone who has been following tech stocks over the last few years.
The public expects breakneck growth to continue even as these upstart companies move into a more mature part of their lives and real growth slows down, causing more people to buy, which bids up the price and blows valuations completely out of proportion. Graham and Dodd rightly identified this kind of decoupling of price and value as driven by speculative activity.
Summary
When we hear the word "speculation," we usually think of the second type -- day trading and trying to catch tiny swings in price, often with significant use of leverage. The general belief among the investing public is that this is a risky and ultimately loss-making activity, and there is a general skepticism about it. But on the other two types -- buying issues of new ventures and buying hyped growth stocks -- public opinion is typically at least agnostic. Certainly, the financial media goes out of its way to glamorize venture capitalists and high-flying growth stocks. Even the most disciplined of value investors must guard against the danger of being sucked into these compelling narratives. So the next time you see a growth stock being promoted at 200x forward earnings, ask yourself: Is this investment, or is this speculation?
Disclaimer: The author owns no stocks mentioned.
Read more here:Â
Graham & Dodd’s Hidden Gems: The Investor of Small Means, Part 1
Ray Dalio’s Right-Hand Man Sees a More Negative Outlook for Growth
