Our recently published Annual Letter has received some good feedback from friends, some of whom noted that anything over fifteen pages should be classified as a paper rather than a letter. We’ll take that into consideration, along with the suggestion to “chop it up into smaller portions” at more regular intervals. Lucky for us, the folks at Beyond Proxy have given us a good start by doing just that. So any readers who might be scared off by a seventeen page “investment paper” can read it in chunks at their leisure, here. The first few segments of our letter were posted earlier this week. I imagine the remaining segments – which review a few of our new positions – will be posted over the next few days.
I have nothing against “chunks” but I do have a hard time circling back to previous posts before moving onto something else that has caught my attention. I think that’s what makes this work so interesting. It’s also why we tend to flush out an idea completely before publishing rather than doing it piecemeal, although my wife would tell you that it’s just ADD. She may have a point. I started a piece a few months back titled Speculation and fully intended to follow it with a post titled Investment. That was back in October. I know the suspense has been killing you judging by the overwhelming responses we have received since then, but rather than attempt to finish the thought which occurred to me over three months ago, here’s Seth Klarman on Investing Versus Speculation compliments of our friends at ValueWalk who reminded me of this in the first place!
Mark Twain said that there are two times in a man’s life when he should not speculate: when he can’t afford it and when he can. Because this is so, understanding the difference between investment and speculation is the first step in achieving investment success.
To investors stocks represent fractional ownership of underlying businesses and bonds are loans to those businesses. Investors make buy and sell decisions on the basis of the current prices of securities compared with the perceived values of those securities. They transact when they think they know something that others don’t know, don’t care about, or prefer to ignore. They buy securities that appear to offer attractive return for the risk incurred and sell when the return no longer justifies the risk.
Investors believe that over the long run security prices tend to reflect fundamental developments involving the underlying businesses. Investors in a stock thus expect to profit in at least one of three possible ways: from free cash flow generated by the underlying business, which eventually will be reflected in a higher share price or distributed as dividends; from an increase in the multiple that investors are willing to pay for the underlying business as reflected in a higher share price; or by a narrowing of the gap between share price and underlying business value.
Speculators, by contrast, buy and sell securities based on whether they believe those securities will next rise or fall in price. Their judgment regarding future price movements is based, not on fundamentals, but on a prediction of the behavior of others. They regard securities as pieces of paper to be swapped back and forth and are generally ignorant of or indifferent to investment fundamentals. They buy securities because they “act” well and sell when they don’t. Indeed, even if it were certain that the world would end tomorrow, it is likely that some speculators would continue to trade securities based on what they thought the market would do today.
Speculators are obsessed with predicting-guessing-the direction of stock prices. Every morning on cable television, every afternoon on the stock market report, every weekend in Barron’s, every week in dozens of market newsletters, and whenever business people get together, there is rampant conjecture on where the market is heading. Many speculators attempt to predict the market direction by using technical analysis-past stock price fluctuations-as a guide. Technical analysis is based on the presumption that past share price meanderings, rather than underlying business value, hold the key to future stock prices. In reality, no one knows what the market will do; trying to predict it is a waste of time, and investing based upon that prediction is a speculative undertaking.
Market participants do not wear badges that identify them as investors or speculators. It is sometimes difficult to tell the two apart without studying their behavior at length. Examining what they own is not a giveaway, for any security can be owned by investors, speculators, or both. Indeed, many “investment professionals” actually perform as speculators much of the time because of the way they define their mission, pursuing short-term trading profits from predictions of market fluctuations rather than long-term investment profits based on business fundamentals. As we shall see, investors have a reasonable chance of achieving long-term investment success; speculators, by contrast, are likely to lose money over time.
Badges? We don’t need no stinking badges!