Differences between Investing and Speculation

Key takeaways: Understand and concretely define the key differences between Investing and Speculation

Conventionally, investing has always been perceived as safe and stable, while its devil’s advocate speculation, has always been perceived as risky and dangerous. So what are the fundamental differences between investing and speculation? This is a question that I have always been fascinated and intrigued by. If one were to google this question or search for it in any business books, one would find many contradicting answers.

Some may argue that an investment is one that has almost 100% guarantee of preservation of the principle. It must also possesses stellar credit rating. (Moody’s, S&P, Fitch AAA rating etc.) Then one may argue, before the 2008 Lehman brothers crisis, weren’t many of this now defunct investment linked products (Many of them were bundled together with US reverse mortgage securities) described as “safe” and had AAA ratings?

Some may argue that safe and sound investment is by purchasing stable too big to fail blue chip companies. Then one may argue, if an individual were to purchase these “stable blue chips at the peak of a bull market, wont he/she lost money?

Some may argue that the key differences in investing and speculation has to do with the duration of how long the individual has held the given security. Then one may argue, why does the time duration matter? Dint I just read on social media that some trader, in a couple of weeks managed to make a few million shorting a stock while the “safe investment product” that my family purchased has lost more than 25% of its value over the past year?

Being unaware of the differences between investing and speculation is very dangerous and can severely impede one’s investment and financial goals. Therefore, one must clearly understand the key differences between investment and speculation.

Definition of Investing

In order to define the term “investing”, lets us refer to an age old investment classic titled “Security Analysis”.  This book was first published in 1934 by Benjamin Graham and David Dodd when they were lecturing at Columbia University’s Business school. Benjamin Graham was also the former mentor of Warren Buffett and is often referred to as the father of value investing.

In the book security analysis, Graham and Dodd very articulately and concisely defined the term investing as the following:

An Investment operation is one which upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative. [1]

To investors, buying a stock represents a fractional ownership of the company. Therefore, thorough analysis can be defined as having a good understanding of the company’s financial statements, business model, underlying economics and valuation metrics.

In security analysis, Graham and Dodd elaborated about what they meant by “promising safety of principal and satisfactory return”. A “satisfactory return” is a subjective term used to describe a rate or amount that an investor is willing to accept. Preferably, one should aspire for adequate sustainable returns. In regards to “promising safety or principal”, what this means is that when we invest, our first priority is always capital preservation. Hence, the famous quote by Warren Buffett on investing: “Rule number one, never lose money, Rule number two, never forget rule 1.”

Graham and Dodd stressed that any investment must always consider the price as well as the quality of the security. To truly comprehend this definition, one must return to the fundamental tenets of value investing. In value investing, one seeks to determine the value of an underlying security at its intrinsic value and then purchase it at a discount to its value. Putting everything together, what this means is that after Graham and Dood’s criteria for an investment has been satisfied, one must only consider businesses with good fundamentals bought at discount to its intrinsic value. As in the long run, value investors believe that security prices will tend to reflect the fundamentals of the underlying business.

Therefore, based on Graham and Dodd’s criteria, purchasing a blue chip stock blindly just because it is perceived to be “safe” without following the above criteria is considered to be speculation.

 Definition of Speculation

Speculators, unlike investors, buy and sell securities solely based on whether they believe the prices of the securities they purchased will rise or fall. Speculators judge prices solely based on the prediction or movement of others. Judging prices solely based on the prediction of others is a very dangerous game and favours institutional investors with insider information.

A another key difference between speculation and investing is an investment produces cash flow for the benefit of the owners and shareholders, while speculations do not. The return of the speculation solely depends on the supply and demand characteristics of the market. [2]

Therefore, based on the definitions above, gold is considered to be a speculative instrument. This is because gold is bought with the hopes that it can be sold off at a higher price in the future. Gold cannot generate income unless it is sold. Can you after placing your gold bars into your safe deposit, come back to it 2 years later, and see that it has magically grown by 10%? The same logic goes for collectibles like rare coins, rare collectible cards and art. People hold on and/or purchase such items in hope that its price will rise further based on their perceived future demand.

Does this mean that investing and speculation are mutually exclusive and we should avoid the latter like the plague? Not at all. Even Benjamin Graham (Quoted from his other timeless classic “The Intelligent Investor”) came to acknowledge the necessity of speculation.

“In most periods the investor must recognise the existence of a speculative factor in his common stock holdings. It is his task to keep this component within minor limits, and to be prepared financially and psychologically for adverse results that may be of short or long duration.” [3]

“Outright speculation is neither illegal, immoral, nor (for most people) fattening to the pocketbook. More than that, some speculation is necessary and unavoidable, for in many common stock situations there are substantial possibilities of both profit and loss, and the risks therein must be assumed by someone. There is intelligent speculation as there is intelligent investing. But there are many ways in which speculation may be intelligent. [3]

Furthermore, speculation has been proven to be beneficial. If not for speculation, the latest technology companies would not have been able to raise the necessary equity needed for such seismic growth and expansion.

So what defines an intelligent speculator? Personally, I would define an intelligent speculator as someone who has a very deep and conceptual understanding of technical analysis. He/she takes only intelligent, calculated risk. Secondly, this person must possess emotional stability and not act solely based on emotional impulses.

Conclusion

Being unaware of the differences between investing and speculation is very dangerous and can severely impede one’s investment and financial goals. Therefore, one must clearly understand the key differences between investment and speculation and not confuse one for the other. When we invest, it is crucial that we acknowledge that some form of speculation is inevitable. We also need to be able to internally reflect and distinguish between intelligent and unintelligent speculation and not do the latter.

Doctors keep their scalpels and other instruments handy, for emergencies. Keep your philosophy ready too – ready to understand heaven and earth. In everything you do, even the smallest thing, remember the chain that links them. Nothing earthly succeeds by ignoring heaven, nothing heavenly by ignoring the earth.

Meditations by Marcus Aurelius 3.13

References

[1] Graham, B. and L.Dodd, D. (2008). Security Analysis. 6th ed USA: Tata McGraw Hill. pp.100-111.

[2] Klarman, S.A (1991). Margin Of Safety.USA: Harper Business pp.8-9.

[3] Graham, B. (1973). The Intelligent Investor. 4th ed. USA: Harper Business Essentials, pp.18-34.

Financial Statement Analysis: Analysing Inventory and Accounts Receivables

Key takeaways

1) Why an abnormally large inventory or accounts receivable is a potential red flag.

2) Why is it crucial to monitor to monitor both inventory and accounts receivable alongside a company’s revenue.

There is a very simple way to spot red flags in companies. This is by analysing their inventory and accounts receivable alongside their revenue numbers. This step is very crucial, especially when dealing with high tech manufacturing or any other consumer sensitive industries where inventory goes obsolete very quickly due to rapid market changes. Rapid rising inventory and/or accounts receivable with respect to revenue indicates a warning sigh. More investigation into its causes will be needed. Before we proceed, let us review some of the basic fundamentals of each balance sheet item.

Accounts Receivable

Accounts receivable is mostly a current asset item on the balance sheet and is defined as cash due from customers as goods/ services have been performed or rendered. For instance, if I were a fish farm owner, I may allow certain trustworthy and/or credit worthy customers to purchase my fish on credit. I would give them x amount of days/months/years to pay me.

The warning sign comes when accounts receivable starts to rise substantially over a period of time. There are many possible interpretations to this. It could mean that the company may be desperately trying to clear its inventory by using hard sell tactics or allowing liberal credit terms. Such practices are very common in industries where inventory goes obsolete very quickly due to rapid market changes. In bad economic times, accounts receivable write downs may occur and revenue will be affected. Therefore, it is crucial to understand how a company manages its inventory and how credit worthy their clients are.

Inventory

Unlike service companies, manufacturing or retail companies need to stockpile their inventory. Therefore, understanding a furniture company’s inventory will be much for useful than understanding the inventory of a biomedical drug company. This is especially crucial in industries such as retail, semiconductor or the consumer electronics industry where inventory goes obsolete very quickly due to rapid market changes. Large inventory write downs may happen if inventory is not properly managed by the management.

Under inventory, it is very important to individually analyse the different segments of inventory under the annual report’s footnotes. If one were to discover that the finished goods segment of inventories is rising more rapidly than raw materials and/or work in progress, it is likely that the company has an abundance of finished goods and may be anticipating a certain type of demand for its goods. In most cases, if finished goods segment is rising more rapidly than raw materials and/or work in progress, the company will have to slow down its production. This is because bulging inventories are costly. There is a term used to describe this situation. It is known as negative inventory component divergence. [1]

However, if one discovers that the company’s raw materials is advancing much more rapidly than the work in process and finished good components, it is likely that the company is receiving many new orders and therefore an inventory build-up is necessary. This term is described as positive inventory component divergence. [1]

Connecting the various pieces

As mentioned above, when dealing with consumer sensitive retail or high tech manufacturing companies, it is crucial to correlate its revenue with its accounts receivable and inventory.

For instance, a company may be anticipating more demand in its products due to constant rising demand and revenues over the past few years. It may start to produce more goods in anticipation. When inventory rises and becomes much greater than revenue, it may result in unsold inventory or liberal credit terms to clear out the remaining products. In a market where products becomes obsolete very quickly, it may result in inventory or accounts receivable write-downs.

This concept coupled with a good understanding of the company’s products and expansion policies can definitely help prevent future investment losses and help in the forecast of a company’s future earnings. When it comes to analysing financial statements, the devil is always in the details.

References

[1] L.O’Glove, T. (1987). Quality of Earnings. 1st ed. The Free Press, pp.106-125.