“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.
“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
Purchasing stocks without attempting to price them first
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.
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.
Common stocks have one important characteristics and one important speculative characteristic. Their investment value and average market price tend to increase irregularly but persistently over the decades, as their net worth builds up through the reinvestment of undistributed earnings– incidentally, with no clear-cut plus or minus response to inflation.
However, most of the time common stocks are subject to irrational and excessive price fluctuations in both directions, as the consequence of the ingrained tendency of most people to speculate or gamble–i.e., to give way to hope, fear and greed.
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, or whether for cash or on margin. Compare this with the attitude of the public toward common stocks in 1948, when over 90 percent of those queried expressed themselves as opposed to the purchase of common stocks. About half gave as their reason “not safe, a gamble,” and about half, the reason “not
It is indeed ironical (though not surprising) that common-stock purchases of all kinds were quite generally regarded as highly speculative or risky at a time when they were selling on a most attractive basis, and due soon to begin their greatest advance in history; conversely the very fact they had advanced to what were undoubtedly dangerous levels as judged by past experience later transformed them into “investments” and the entire stock-buying public into “investors.”
Two plausible and seemingly innocent ideas, the first that good stocks are good investments; the second, that values depend on earning power–were distorted and exploited into a frenzied financial gospel which ended by converting all our investors into speculators, by making our corporations rich and their stockholders poor, by producing topsy-turvy accounting policies and wholly irrational standards of value–and in no small measure was responsible for the paradoxical depression in which we find ourselves submerged.
Value has come to be associated exclusively with earning power, the stockholder no longer pays any attention to what his company owns–not even its money in the bank.
It is undoubtedly true that the old-time investor laid too much stress upon book values and too little upon what the property could earn. It was a salutary step to ignore the figures at which the plants were carried on the books, unless they showed a commensurate earning power.
The reported earnings–which might only be temporary or even deceptive- -and in a complete eclipse of what had always been regarded as a vital factor in security values, namely the company’s working capital position.
Stocks now sell below their liquid asset value is the fear of future operating losses. Many readers will assert that this is the overshadowing cause of the present low market level. These quotations reflect not only the absence of earning power, but the existence of “losing power” which threatened to dissipate the working capital behind the shares today.
Being against speculation is almost like being against sin. But speculation really is a sin to the untrained member of the public. The ordinary man is more apt to get poorer by speculating on the market. A man can earn some money by taking a sensible attitude toward investment, but I don’t see how a man can earn money by being an untrained speculator. He just doesn’t put enough into it to justify the hopes of getting something out of it.
The new analytical concepts of growth-stock valuation, of “cash flow,”
of the desirability of tax-free dividends from companies which are triumphantly able to report earnings deficits – all have enough plausibility and lack of inner discipline to lead both investors and speculators far astray.
This multiplier could not have been justified by any conservative valuation formulae such as those we have been discussing.
These institutional policies raise two implications of importance to financial analysts. First, what should a conservative analyst have done in the heady area and era of high-growth, high multiplier companies? I must say mournfully that he would have to do the near impossible – namely, turn his back on them and let them alone. The institutions themselves had gradually transformed these investment-type companies into speculative stocks. I repeat that the ordinary
analyst cannot expect long-term satisfactory results in the field of speculative issues, whether they are speculative by the company’s circumstances or by the high price levels at which they habitually sell.
Principles of Graham: Investment Vs. Speculation