Please join me at the Security Analysis Book Club to read Security Analysis by Graham & Dodd, a must-read for anyone who is serious about value investing.
Chapter 4: Distinctions Between Investment and Speculation.
Traditionally, people thought: (1) bonds are investments while stocks are speculative; (2) investments are outright purchases while purchasing on margin is speculation; (3) investments are permanent holdings while speculations are temporary holdings; (4) investments are for income while speculations are for profit/capital gain; and, (5) investments are made in "safe" securities while speculations are made in "risky" issues.
Graham argued against traditional thoughts. He explained why investments can be made in stock, using margin, as temporary holding, for profit and income, in "risky" issues.
A Proposed Definition of Investment
An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative. An investment operation is one that can be justified on both qualitative and quantitative grounds.
Graham redefined investments using the term "investment operation" because there is no such thing as an "investment issue". A company may be "safe", but its bond or stock may be an investment or speculative depending on the price. "Operation" takes into consideration everything relating to investing, including sufficient diversification, the margin of safety in each issue, and the use of margin. Graham also considers arbitrage an investment operation. (Arbitrage in its purest sense is a risk-free operation that does not require any capital. Risk arbitrage [an oxymoron], on the other hand, involves risk and ties up capital.)
By "thorough analysis", Graham means analyzing enough of all available facts using established standards of safety and value. By "promises safety", Graham means the relative safety of principal under normal conditions rather than absolute safety of principal. By "satisfactory return", Graham means the return you (the investor) are willing to accept - this is similar to the discount rate that value investors use (one that is not based on "beta").
An observation: Benjamin Graham operates with a perspective quite different from Nassim Nicholas Taleb (author of "The Black Swan"). Graham operates under the premise of "normal conditions", whereas Taleb operates under the premise of "inevitable black swans". Though Graham did write that "for investments, the future is essentially something to be guarded against rather than to be profited from" - perhaps he was thinking about "black swans". In any case, I think we should follow Graham's method of buying undervalued security with a margin of safety, but Taleb's "Black Swan" idea is useful when we think about risks.
Types of "Investment"
Graham defined various types of "investment" by adding an adjective to it - business investment (money in business), financial investment (or investment generally, referring to securities in general), sheltered investment (low-risk securities), and analyst's investment (investments that fit the definition proposed above).
Types of "Speculation"
Speculation is not all bad - operating a business, no matter how well run, always involve an element of speculation. Intelligent speculation is "the taking of a risks that appears justified after careful weighing of pros and cons". Unintelligent speculation is "risk taking without adequate study of the situation". If we are to speculate, we should speculate intelligently. Unintelligent speculation is the highway to bankruptville.
Investment and speculative components and intrinsic value
When a security's price does not satisfy the Graham's proposed definition of an investment, the value of the security may be split into its investment and speculative components. The investment component is a conservative valuation using past data. The speculative component represents the appraisal of the company's long-term prospects. I'd suggest that the speculative component includes your evaluation of the company's economic moat (competitive advantage) and what additional returns you expect it to bring. The intrinsic value of a security is a combination of its investment value and an intelligently speculated speculative value.
P.S. This post was featured in the 114th Edition of the Festival of Stocks at Fat Pitch Financials.
1 comments:
This is cool, thanks for doing the review, it's finally making me read Security Analysis. It's something I've wanted to do but kept putting off.
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