Investing and speculating

Warren Buffett gave an interview in 2010 to help explain why the financial system collapsed in 2008. The interviewer asks the Oracle to explain how he sees speculation as opposed to investing. To which Buff has an interesting answer: “It’s a tricky definition, you know, it’s like pornography.”

I watched the film “Money Monster” during weekend with the leading role played by George Clooney and supporting role by Julia Roberts. The film told a story about a person who makes stock trades by following only the recommendations given by the TV reporter. It is really worth watching, I am strongly recommending. The film is available in video rental or in Amazon.

So what happens when we make deals blindfold and do not think with our own head?

In brief, the same happens to the people following horoscopes. Nothing happens, but there is a possibility to feel oneself later stupid and later… poor. In other words, if you invest money without thinking, you risk without any reason to lose all your money.

Now it is good time to talk about investing and speculating and their difference.

We will start from the broader picture.

The aim of the investor is to ensure the preservation of his capital by investing activities.

Investors, on their turn, invest money in companies. They trust it in the hands of the entrepreneur. But entrepreneurs are risk takers by their nature. Their aim is to develop the company and risk with the money of their own and the company in the name of it. As to business this is a project risk – whether the pending projects guarantee success – create positive cash flow or not. Considering the probability of failure, especially in the start-up stage, this is a clear risk.

The difference of the investor and the entrepreneur can be pointed out based on the sample of banking. A bank is a company in its nature, but the function of the bank itself is to be a lender- so-to-say investor. The lender pursues to choose the projects with no risk or as small probability as possible to lose money when lending out money.

Bankers are afraid of risk by their nature. But the manager of the bank could not be a banker when managing the bank, he has to be an entrepreneur, develop the company, and invest in new projects and products. If he launches a new product, this means that he risks. Every new project is like a start-up with very high failing probability. To invest, for example, in marketing, i.e. spend money which directly decreases the balance sheet volume, as this should be covered by sales which are completely unpredictable.

It means that it is very natural that an entrepreneur is driven by totally different things than banker or investor.

If we look at the matter from the viewpoint of an investor, the probability to lose money increases when the investor does not understand what he is doing.

Especially, when the investor does not understand the business of the entrepreneur. If the business is in decline, this is generally followed by the price of share and the investment made is at risk. The same risk to lose capital is also present when the purchase transactions are made upon the recommendation of another person or analysts. There is no big difference.

As seen, money and investment are extremely personal matters. This is, by the way, also one key factor why machines cannot grow money. They can, but it is impossible to create a universal model which would increase the assets of all people in the same way.

Who is an investor

If the aim of the investor is to ensure at least the preservation of one’s money (inflation, the devil, also gnaws it), some acceptable method should exist how to do it.

Seth Klarman, the stock market genius of the new generation, has comprised three possibilities how to earn money by investing in shares in his legendary book Margin of Safety. I am also adding my own explanations to these points, as the beginner might find these hard to understand.

Three possibilities to earn money by investor:

Through the free cash flow created by the company which in the longer perspective is recorded in the higher price of share or dividends to be distributed. It is quite understandable that the well-functioning company pays dividends added to the capital invested by you. This group often includes dividend investors. Such companies are often quite expensive at the market and no good possibilities for purchase can be found.

The value ratio under change, i.e. investors are generally ready to pay more for the company. EBITDA ratios, P/E indicators etc. In principle this means that the company grows on account of the added profit (see also ROE, P/E indicator etc.) and there is readiness to pay more for companies during certain times. In case of growth companies it is quite usual that >20 times profit is asked for a share (annual profit of the company * 20). For example, it is also possible to look at the dividend yield and earnings yield where it is agreed also with lower dividend yield in the conditions of lower interest rates which means the higher share price by the same dividends. One of the most well-known players in this sector is Seppo Saario. I do not like the search for such opportunities, as in my opinion it is impossible to predict how much the company can yield profit in the future, which expenses will be incurred and dividends paid. This is often the place of growth investors and also value investors in certain terms.

And in case there is a decrease in the price between the value of the company and share price. Often in case where the value of the company is lower than its equity price, for example P/BV indicator. Such situation is common either during stock exchange crashes, or if any sector is not favoured in the eyes of investors or if any company has some difficulties. Then the situation arises where the actual value of the company is higher than the price asked for it at the stock market. I prefer to search for such opportunities at the market.  Here the value investors, deep value investors and turnaround investors, i.e. the ones who seek opportunities in the companies in difficulties, are active.

One feature of an investor is surely to act consciously.

Investors should be able to understand the principle that the performance of the company and the price of the share are two different things.

In general these two, the price and value, do not go hand in hand. As on one day the stock market falls for example by 3% and thus the value of the share under observation is 3% without any changes made in the company. We cannot state that the specific company is now surely less valuable.

The value of the company is set by the company, not the stock market. The stock market sets the price with which it can buy a share in the specific company.

There are times when the value of the company is 1 USD, but at the stock market the sellers offer shares to you with 70 cents. This was exactly the case with ArcelorMittali, Alcoa, Ericsson and Aegon when I bought hem. I got a share in these below their actual value.

It will be of course complicated when the value of the company needs to be set. But fortunately there is ample of databases which provide easy access to all kind of information. I recommend for example which includes an excellent historical overview of the company’s finances and the package of Morningstar Premium provides additional access to the comments of analysts.

Or if to think about these three options offered by Seth Klarman, there are practically no more options to grow money in case of investing in shares ( I actually prefer to say investing in companies) than these three provided above. When I read Klarman’s book about 10 years ago, I felt cold shivers running down my back, as all complicated information acquired within years was ingeniously summed up in one book. If this is understood, everything else will follow by itself.

But every coin has two sides. This is the case here too.

To understand investing, one should also understand what is not investing

The opposite of investing is speculating. In other words, if you are not investor, you are just a speculator. One or another. I mentioned at the beginning of the article that if an investor does not understand the activities of the company, it risks losing money without reason. Such situation is though speculation.

The aim of the speculator is to earn money from the deviation of share prices.

These people are sometimes also called traders, but this is not quite exact. We keep to speculating.

Do you notice difference?

If an investor can separate the price of the share from the actual value of the company, the speculator buys and sells shares depending on how the prices of shares change. He observes the charts, emotions, is emotional and does not know when to buy or sell the shares. If an investor knows it all proceeding from what he sees as to the company, the price of share is not setting the value of the company as we know.

Thus, the activities of the speculator are always risky and related to ignorance. In addition the speculator is always related to all other risks such as industry risk, market risk etc. – i.e. if he has not made his decisions based on the company’s activities, then he is automatically open to all potential risks.

Do not speculate, invest!

But if investment decisions are made only based on the company’s activities, the risks are considerably more defined.

In principle, we do need the stock market for making investments. We need the market only to know the price of the company currently on sale. If the company has done well and we believe that all goes well also further on, then in principle it is not important how the remaining sector and stock market as a whole is doing. As we invested in the specific company and we think as entrepreneurs.

In case of value investors one more thing is important related to the belief that I mentioned before. In other words, whether we believe that the company is doing well or bad in the future. I would like to say that predicting the future is very complicated and in general this will not be exact. This means that in any case we are still related to risk and speculations. True!

There is still one possibility to avoid it all.

I would cite again one great man. This time Walter Schloss who has worded this in his article from the previous century, by summing it very exactly up into three sentences.

 “We looked for stocks that were selling below their book value. What we tried to do was to buy assets at a discount instead of buying earnings. Earnings can change quickly, but assets don’t, and so the new strategy worked well for a while.“

Walter Schloss was a very successful investor during his lifetime and could increase assets more than 15% a year and this for a very long time. His videos can be also found in YouTube. A very simple man made investing very simple for himself. He originates, by the way, also from Graham school like all other legendary value investors.

His idea is so simple that it is weird to explain it.

  • Walter just did not want to deal with predicting.
  • He just bought the companies the book value of which per share (owners’ equity – which is easy to find from all annual reports) was higher than the value of the share at the stock market.
  • The whole story and so 50 years in succession.

Walter Schloss set the value of the company based only on the balance sheet, by using practically one ratio Price / Book value. As the income statement is just like a horoscope which can change very fast, it can be distorted. The profits of the company can change really fast, but the assets, i.e. the book value changes much slower.

How to find successful candidates?

It takes time when you will recognize the right company you would like to invest money into. The search for such company from the market is surely very complicated, but not impossible.

The share of steel producer Nokia (as of 01/2017), for example, is less valuable than the net assets of the company. The company’s Price/Book value is 1.4. In this viewpoint the share of Apple is considerably more expensive and 5 times of its piece of book value is asked.

Why are the investors not ready to pay so much for Apple and less for the long term rival Nokia? Why some companies trade below their equity value?

The right answers can be found only in the company! Sometimes some sectors are so-called underestimated, i.e. not so much will be paid for them at the market. The price of these shares is in this relation lower than the ones of the company acting in some other sector. But this regards already more detailed analysis of the sector and the company and I will not dwell upon this.

To sum up, still more about speculating and investing.

If to try to predict future and invest based on this, then whether the making of investment decisions based on future predictions is also speculating. Partly yes, but the value investors are smart. If we see investment risk, be it then even predicting the future cash flow, this will be immediately discounted to the price of share. This means that I would like to become the shareholder of this company only provided I can get the share so cheap that it covers the unawareness and potential risk to lose thereby capital.

Example. When I bought the share of the insurance company Credit Suisse at the end of the last year, I was unable to predict the future cash flows of the Swiss bank. Moreover, this company is currently making a loss. Okay, he has a plan how to restart to yield profit, but come on. Anything can happen within the next five years.

An even if I tried to predict the profit of these next years, I would not be exact in this. I am probably unable to assess the book value of this company. The assessment of banks is just extremely complicated.

Thus, I will make a decision on some other basis.

I am still trying to find an interval which could be the fair value of the share. I will take the book value as a basis, adjust it slightly conservatively and deduct potential loss and discounts. If the price of the share is higher than the interval found by me, I will start buying this share bit by bit.

I keep the relevance of this share as low as possible and make further purchase decisions already based on the information received – in other words I am looking for confirmation based on news whether my arguments found are correct or not.

But as I have acquired the company cheaper than its actual value in my opinion, the probability for further fall is lower. The risk is of course that the company is doing even worse. Yes, but my task is to choose such companies here which do not collapse just so and will not be in financial difficulties. Thus, I pursue to learn more about the company, I will examine its strategic plans, listen to what the managers do and say and look at its debt burden and the composition of capital in case of a bank. In case of companies in difficulties in my list to follow, I will see whether their products are necessary for the people and whether they have as low debt burden as possible.

In my opinion this is quite a nice base where to act as an investor.

By making an investment I have taken little failure reserve into account and as the headline of Seth Klarman’s book says the “Margin of Safety” is of vital importance for investors.

So much about speculating and investing.

by A.R.