Are you a speculator who thinks he’s an investor?
Posted on November 12, 2008 by Richard Beddard
Filed Under Companies, Editor's choice, Investing |
Apologies for this chart, a sketch from my notebook, but I’ve never seen it drawn by anyone with the patience to use a ruler, so this will have to do*1.
I imagine many of us thought we were investors in the bull market and, having, seen our profits evaporate, we’re now coming to terms with the notion that there may have been a quantum of speculation in our decision-making.
This chart, which I found described*2 (but not drawn) on page 45 of the Rediscovered Benjamin Graham, explains the difference between speculation and investing as the father of value investing saw it. I think the model still works.
The two lines, the straight one going from top left to the bottom right, and the ‘U’ shaped curve, represent company stocks in the 1920’s and 1958 respectively. In 1958, Graham made a speech titled “The New Speculation in Common Stocks” to the Financial Analysts Society, from which I derived the chart.
In the 1920’s, when he started investing, companies with long earnings histories, backed by solid assets and good credit ratings were the least speculative. The ‘cruddy companies’ as I have oh-so succinctly labelled them, were the most speculative. Investors and speculators tended to pay similar prices for either category of share, relative to the value of their rather splendid, or cruddy, assets, or earnings.
By 1958, investors were thinking much more about the future. Human nature being what it is, they rated the most profitable companies in the past most highly, and paid more for them. This, Graham said, was a new kind of speculation. Investors were paying way more than the company’s assets were worth, or its past earnings implied, because they believed it would grow. It wasn’t the companies that were speculative, at least towards the right of the curve, it was investors’ thoughts, and the prices they paid.
In the very old days (1920’s), investment occurred on the right extreme of the curve and speculation towards the left, but by the not-so old days (1958), he believed speculators operated at both extremes leaving investors the middle ground, the bottom of the ‘U’.
I think the model still applies, although there are probably variations where one side of the ‘U’ is more dominant, a ladle perhaps, or companies that fit in both speculative categories like the kind of detritus people speculated on during the dot.com boom. Famously then, speculators paid vast sums for companies with few assets and no earnings.
So what’s a right-sided speculative stock now? Reckitt Benckiser (RB-) comes to mind, mostly because a friend mentioned it to me while we played poker last night. Having given it a five-second appraisal in the cold light of morning I can see it’s probably a fine manufacturer of toilet cleaner and mustard. Its debt to equity ratio is quite low, and its increasing earnings have rewarded and enthused investors. No matter how bad things get, we’re not going to stop cleaning our toilets, are we?
But the shares cost thirty-one times earnings averaged over the last six years. That’s an earnings yield of little more than 3%. The less conservative, and less useful, historic price earnings ratio is 23, an earnings yield of little more than 4%. That’s your return if the company doesn’t grow. Even if it grows as fast as analysts, who are generally too optimistic, expect, the earnings yield is just over 5%.
The speculation, uncertainty, risk - whatever you want to call it - isn’t in the company; it’s in the price, and the likelihood that flighty speculators will dump it when better prospects come along.
I’m working through a list of 244 ‘bottom of the U’ type stocks, with long term price earnings ratios of less than 16, debt to equity ratios under 100%, and good cash flow, but I’m stuck on AGA (AGA, iBall). It has very little debt, a nine-year PE of only four, and a brand that inspires loyalty and disbelief in equal measure. Unfortunately, it’s chained to a massive pension scheme. Though currently in surplus, it appreciates or depreciates by tens of millions of pounds every time the actuary, or the stockmarket, twitches, dragging the company closer and closer, In my opinion, to the twilight (speculative) zone…
Which brings me back to you, and me. Are we investing, or are we denizens of the twilight zone? I am a bottom of the ‘U’ type investor but, to be honest, I lean to the left, sometimes disastrously. To improve, I must resist my compulsion to buy weak companies that look very, very cheap.
I may have part of the answer.
Footnotes:
- Click on it for a bigger version.
- Here’s the original spiel (sorry about the quality).
- Why all the fuss about Benjamin Graham? Two reasons: Graham would have been looking at the current stockmarket with a growing sense of opportunity, I think, and I’m writing a feature on him for Money Observer magazine.
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10 Responses to “Are you a speculator who thinks he’s an investor?”
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I have following the markets for the last 14-16 years.If one had to compare the major/estabished
stock-markets in 10 years periods for the last fifty years,therefore 5 “cycles”.
One can safely conclude that the markets did not perform(under)as expected in the last 1 and half “cycles”;that is a period of approx.15 years.
I do not know what it be like in the future,but it is likened more of a random walk to…!!! ???
This has been a catalyst for people to finding ways to BEAT THE MARKET differently..This has brought about new ways of “doing-it”..call-it “hedge-funds “,”short-selling” and other exotic trading-strategies.The result:flat returns!
(Do not forget,the people who run them are paid;
performance-linked..the better !!)
To conclude,I have my doubts whether there will be any significant change of things to come,
be it sooner or later.
I’m afraid I agree with Victor.
I really can’t see how anything is going to move until this massive debt burden (at least) starts reducing.
In truth, I’m very fearful for the economy for at least the next five years and possibly as time passes and I get the opportunity to reassess the situation, further still.
How a government can come to a conclusion, the way to solve the problem is feed the debt, is beyond me. It’s probably more about political survival, than what’s good for the country.
There may well be opportunities for traders, but that is not investing.
Hi Richard. Nice article and supports an opinion I have on the distinction between a speculator and an investor. It shows that the line between a speculator and an investor is rather fuzzy. It looks like Graham is saying that only people who invest in a company that is undervalued, based on its long term stable earnings, is an ‘investor’. Anyone who invests for growth is a speculator.
Right now I have a conviction that we are still in a bear market (although near the bottom) and we will then have a period of sideways movement while company earnings and job cutting try to form equilibrium. Sadly, good ‘value’ companies may be lost along the way so value investing might be ‘risky’.
As my conviction is quite strong and I have done a lot of research into this idea, is it speculation if I take a trading position on this conviction? For example, go short when the markets swing up and go long when the markets swing down.
This morning I sold various positions because I realised we were in a state where the markets may swing up or down as we are fairly near the October low and people are ‘confused’ to say the least. You have dreadful economic indicators on one hand, and China and Russia pumping in real cash on the other hand. Therefore I sold my positions. If I held them I would have been speculating against my current (albeit temporary) investment strategy.
Hi Robin, thanks for your comment.
This is Graham’s distinction between investment and speculation:
“An investment operation is one which, on thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.”
http://www.wiley.com/legacy/products/subject/finance/bgraham/benlec10.html
So your system could meet the definition of investment so long as you’ve researched it thoroughly, and it works
Regarding value investing. As I’m discovering, there’s more to frustrate a value investor than companies going bust. Managers and private equity are taking advantage of low prices to take companies private.
You can avoid companies likely to go bust by focussing on their financial strength. But you can’t avoid companies likely to be taken private (except I suppose by avoiding those that already have majority shareholders) because they’re exactly the kind that are likely to be attractive to private shareholders (i.e. strong balance sheets, still making profits…)
interesting post Richard. Re Robin Soole
Ignore anyone who says we are near the bottom of the bear market.
often I hear said that stock market recovery presages the real economic recovry.
Phuey - go look at the charts. if it precedes it is by a couple of months at best.
Who thinks we are going to see anything other than 4 quarters of negative growth in the UK next year realistically.
There is very little way to invest into this market beyond buying short etf’s? is that investment?
The FTSE could well sink below 3000 and that would be the ONLY time to buy more shares for the long term in the next 12 months.
Hi Cityunslicker. Thanks for your comment. I Thought I’d jump in!
From the bottom up I think the stockmarket is quite cheap. I think I mentioned a few weeks back the long term pe had fallen to historic lows. That’s not to say it won’t get cheaper, but I think it’s a good time to be looking at stocks and perhaps buying ones with financial strength. Mind you, I think the bottom will only become apparent once the market has staged a good recovery so my approach is rooted in a deep seated scepticism of market timing!
I’ve just edited an article by Ken Fisher, to be published later today in which he says that in every market he’s studied the market recovers before the economy. He gives an average figure of five months. Of course Ken’s been bullish throughout this bear market and his opinion that now is a good time to buy should be viewed as sceptically as anyone else’s! However he is a student of the markets and I imagine the five months figure is a credible one(for US markets).
Hi Richard. I totally agree with the definition of an investor vs. speculator from Graham. Thanks for pointing it out. It also agrees with the idea that you can become more speculative as you increase the uncertainty in your investment.
Hey City-slicker. There is a bottom to this market and I suspect we may be 30% away from it. However I still believe we will then be in a range bound with high volatility (in the range of 20% to 30%) for quite a long time (up to a year or more). There are two reasons for my view. Firstly the excellent graph which Richard published at the start of the year, from Society General, which averaged out the share prices of previous big crashes. The current market behaviour is a close match which suggests a kind of inevitable, unavoidable correction.
Secondly, the S & P 500 currently has a valuation point that is slightly lower than its very long term average. There is this strange kind of belief that the markets will simply stop falling because we have reached this point. This seems utter nonsense to me. It is not the fact that markets will overshoot their fair valuation. It is simply that there is genuine damage to the fundamental economic system which needs time to heal. Companies will be genuinely unprofitable for quite a long time.
I actually hope that at some point, the UK Government will finally recognise that inward investments (e.g. tax breaks and internal infrastructure) are not a means of recovery (at least they are only the smaller part). The sooner they start developing and supporting our outward facing economy (exports) the better. The fact that the UK banking system is an integral part of the exports we offer, then in some ways it makes sense to bail out the banks, but we need much more. Sponsoring University project, for example, to create sustainable industries across Europe and the globe (putting aside old hostilities) would be a fantastic and hope inspiring move (survival of the human race etc).
I wait with baited breath…
Hi Richard,
Looking at the S & P 500 data on spglobal.com, I can see that the price today (848) is the same as the lowest ‘quarter’ price in 2001. After this point, the markets started to rise and never stopped until July 2007.
However, the difference this time is that everyone (from people, to companies to governments) are lumbered with years of debt (which I am sure our children will enjoy paying off).
It is hard to imagine that we can chart a rising course from this point.
It is a sad fact that, after 7 years of unparalleled global growth, the human race has managed to make negative progress in its economic development and is in an even less environmentally sustainable situation than before
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