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Focused Compounding YouTube
FOCUSED COMPOUNDING DAILY
For Friday, June 26, 2020
Investment vs. Speculation
One of the most important and least well defined questions in picking stocks is the difference between investment and speculation. What makes an investment an investment and a speculation a speculation?
The word “speculation” means a looking out for – as in looking into the future. And this is often the definition given of speculation: it is a future focused gamble. That might be true. But, it’s true also of investments. Even if you found a company and expect to own it for the rest of your life – it is the future cash flows of the business that will determine your returns. However, this idea of founding a company and keeping it forever as being an investment does have some promise in helping us separate investments from speculations. Investments are focused on the economics of the business as an unlisted entity as opposed to a listed entity. IF an investment is truly an investment – it should matter little that there’s a public quote. This might not be true of a speculation.
I called a speculation a “gamble” on the future, a second ago. So, it’s important to separate out the concept of gambling from speculating. It may be that some stock picking speculations are outright “gambles”. But, if so, these are unintelligent speculations. They aren’t dumb because they are speculations. But, they are dumb on top of being speculations. A smart speculation is not like a gamble. In gambling, the expected value of the best is less than the amount bet. This is almost always true in any gambling you can do. There are exceptions. Certainly, it is not difficult – if you put the same professional effort into picking ponies as I suggest you do into picking stocks – to do better than most people picking which horses will win which races at the track. However, the take-out for the track might be 18%. This means you need to be about 22% better than the crowd – your every $2 bet needs to average bringing you back $2.44 before the track takes their cut – for you to compound your bankroll over time at the horse track. This is gambling. And I’ve actually given a very, very favorable example. If you had to pick a game to become a professional gambler at: - horse handicapping (even with the back take from the track) would be one of the best skills to cultivate. There are even better games. Playing poker at home – away from casinos and their takes – would provide some people with the possibility to compound their money over time versus others. That is a do-able thing. And so, too, is compounding your money through speculating – rather than investing – in stocks a “do-able” thing. I want to draw a distinction here between activities I wouldn’t necessarily advise as sound ways to compound your money = speculating in stocks, betting on horse races, playing in home poker games, etc. – versus true gambling approaches in the sense that the edge is better known and definitely against you. For compounding to be “do-able”, you need an edge. This is true whether you are gambling at the track or a card table, gambling at the racetrack, or speculating in stocks.
Weirdly, it often not true when investing in stocks. Stocks can be said to have two components to their returns. There is the long-term return in stocks that works like the opposite of the example of a track taking 18% on each bet you make on a horse. Here, each basket of bets you make on stocks may tend to average out to giving you 6-10% a year. This has been true historically. The distribution of returns is unusual. And compounding can make this distribution even more unusual over time. So, it is not true that the average stock gives you a better return than say the average bond. The best stocks are such good compounders that a basket of stocks tend to benefit from a few good stocks being thrown into the mix. And so things like indexes, basket of stocks, etc. can be said to benefit from this kind of “give” to you as an investor that works the opposite of a racetrack’s “take”. The reason for this is the constant undervaluation of good, compounding businesses versus other places people can put their money. Historically, stocks have tended to be underpriced for the truly long-run. And so, you have tended to get paid to hold them. This does not have to be true in the future if enough people are willing to overpay for stocks.
We can use the horse races as an illustration of this. In terms of picking stocks versus picking horses there are two big differences. One, in the case of horses – the track may be taking 18% of your bet each race. Two, in the case of stocks, the market may be giving you 8% each year. So, betting on one stock for one year versus betting on one horse race a year – you are getting a lot more bang for your buck on Wall Street than at the track. There is also a compounding aspect that’s important. A major issue in why it’s difficult to be successful betting on horses even if you’re very good at it is the way compounding works. Without getting into the complexities of how much you actually have siphoned off by rolling over bets at a race track – let’s just say it’s difficult to snowball your money at the track the same way it’s difficult to snowball your money in stocks if you keep selling out of one and buying another. It is not so difficult if you hold n to one good stock.
For this reason (among others), some people make the length of holding period of a stock a key criterion of whether it is or is not an investment. In other words, a stock you buy and sell within a year is called a “trade” or “speculation” and a stock you hold for 7 years is called an investment. However, you don’t know how long you’ll hold a stock when going into it. And a stock that performs especially well while you own it such that you end up selling it early would be called a speculation under this approach. That sounds weird to me. Imagine you buy a stock at $14 a share and it rises to $30 a share within a year – and you sell it. Was that an investment or speculation? Based on those facts, I’d say there’s no way to tell. But, if that stock had earned at least $1.40 in each of the last 10 years, if it had a book value of $28 a share, if you knew that competitors in the industry would eagerly offer to buy this company’s properties at $30 a share, etc. – then, I think the purchase at $14 a share should be called an investment whether you ended up holding that investment for 20 weeks or 20 years. The line between investment and speculation has to be a subjective one – not an objective one. We have to define it in terms of the intentions of the buyer.
How do we draw this line between investment and speculation then?
One of the most practical ways of drawing the line is separating factors having to do with the market and non-market aspects of an asset you are buying. So, if you buy a stock intending to hold it forever and collect the dividends – that’s an investment, because you never intend to get a return through offering to sell in the open market. However, if you intend to buy a stock today at $40 a share and hold it till the election in November and then offer to sell it the day after the election no matter what the market price at the time – that would clearly be a speculation. You are just speculating that something will happen between now and November that will increase the market price for the stock. You are not analyzing the value of the stock in any way.
But, those are the two extreme cases we can agree on. If you intend to buy and never sell – that’s an investment. And, if you intend to buy now and sell later – without basing your buying and your selling on the value of the business versus the price of the stock in any way, that’s a speculation.
Most people’s intentions when buying a stock seem to be more in the middle. There is a price at which they’d sell a stock they’d be willing to hold forever. So, they might realize a speculative return even in something they intended to be purely and investment. And, most people don’t just buy a stock without paying any attention to what it might be worth. Nor are most people willing to sell out at any price just because a certain event has occurred.
In my experience, most “investors” would be grouped much closer on this spectrum to the speculative side. If we have to order the true investors on the left of this spectrum where they simply buy a stock and never sell it no matter what price the market offers them and on the right side we group the “investors” who buy a stock now and then sell it after some news has happened at whatever price the market will bear, it’s the right hand side of the spectrum that would be more crowded.
This has two important implications if you want to be an investor in stocks. One, you’ll need to recognize that a major part of your returns in buying and selling stocks – whether you intended it to be this way or not – will be speculative in nature. This is not because you sought out speculative returns. This is just because the crowd of people from whom you are doing your buying and selling is so skewed to the speculative side of things, that the volatility of their perceptions of a stock will far exceed the volatility of the underlying business. You could find a business to invest in where the standard deviation of the underlying cash flows is 10% a year. You should not, however, expect that the standard deviation of the stock price will be less than 30% a year. It still could be. I think we can say that the 10% wiggling a yar in those cash flows really represents the investment component of your purchase. And, if you were an investor in this company as a private business, your returns over time could probably be market at more like this 10% a year variation. But, as an investor in public markets, your experience is more likely to be of the 30% a year variation. You’ll be marking your investment to market no matter how much of an investment it is. And, sometimes, you’ll get a chance to buy a stock at a very silly price or sell a stock at a very silly price. This means an investment is based on “inside” factors of what the business is doing. A speculation is based on “outside” factors of what the market for that business is doing. The shorter your holding period in a stock, the more important the “outside” factors will be. The longer your holding period in a stock, the more important the “inside” factors will be.
For this reason, you might be able to make a good investment that you sell for a profit in a year or two – but, you can’t actually plan for this ahead of time. If you buy something worth $20 a share and pay $10 a share – you’ve made a good investment. But, the variation in year-to-year perceptions of that business, its industry, its management, etc. – is likely to be so big that your actual first 12 months of returns in the stock will mostly be the result of changes in attitudes about the business rather than changes in the business itself.
Due to the “random walk” nature of outside forces and the compound nature of inside forces – this becomes less and less true over time. Therefore, your returns in a stock over 12-36 months will be skewed heavily toward “outside forces”. But, your returns over 12-36 years will be skewed heavily toward inside forces. In fact, over 12 months – the investment aspect of a stock matters almost not at all to its returns. However, over 36 years, the speculative aspect of a stock matters almost not at all to its returns. Over 12 months, the fact you are flipping something in a public market is really most of what matters. Over 36 years, your returns in a business are going to be about the same regardless of whether that business is or isn’t marketable. A listed stock and an unlisted business with the same economics will give you similar returns if held for 30-40 decades.
For these reasons, I think an investor can know – ahead of time – if he is making an investment or a speculation. This is because he is the subject doing the stock picking. But, I don’t think any stock can be called an investment or a speculation. If you intend to own a blue-chip stock for 10 weeks – that’s a speculation no matter how solid the business is. If you intend to hold a lousy business bought at a deeply discounted price for 10 years – that might actually be an investment. There is some math we can do to determine this. Basically, how much of your return over time will come from “inside” factors as opposed to “outside” factors. If you buy a business for $10 a share that owns land worth $20 a share – the odds are pretty good that a very meaningful portion of your long-term return in the stock will just come from a rise in the stock price to match the underlying value of the land.
Some people call this a speculation on outside factors, because it requires a change in the perception of the market. But, I find that confusing. An easier way to think of it is this: if there was no public market for this stock, what would the business sell for?
If the business would sell for $20 a share in a negotiated transaction, then the stock has an investment value of $20 a share regardless of the market price.
I think this distinction makes more sense than the time distinction. But, they both make some sense. So, a investment is something bought on a private market basis with the willingness to hold it for a long while a speculation is something bought on a public market basis with the willingness to hold it only a short time.
This might not be a definition. It’s not as definitive as Ben Graham’s.
But, it works as clues to let you know whether you’re investing or speculating.
Investing = Long-term, private approach
Speculating = Short-term, market approach
Speculation can be profitable. But, it’s really outside the scope of what I talk about. So, when talking to you about picking – I’m really just assuming you are always making your commitments on a long-term, private market type approach. This is not how most stock pickers make their decisions. But, it’s what I’m assuming whenever I’m making any statements about what make a good or bad stock.
Whenever I judge a stock as a good or bad stock – I really mean good or bad “investment”. I leave the issue of whether a stock is a good or bad speculations unjudged.
