In a recent post, Richard Beddard mentions Ben Graham’s speech “The New Speculation in Common Stocks” and particularly how it ends with a quote from the Roman poet Ovid:
“You will go safest in the middle course.”
At the end of that talk, Graham adds: “I think this principle holds good for investors and their security-analyst advisors.”
What Graham is saying is that investors should avoid both stocks that are speculative because the underlying enterprise is speculative and stocks that are speculative because the price is speculative.
I agree with Graham on this one. And I think it helps clear up some confusion that readers have with my own approach to investing. I get a lot of questions from investors – each coming from one of the two opposing philosophical camps – that go something like this: “When I look at the stocks you own, I wonder are you really 100% a value investor?” That’s the question from the Ben Graham value camp. And then the other question goes something like: “When I look at the stocks you own, I wonder are you really 100% a wide moat investor?”
My answer to these questions tends to go something like this:
If you look back at all the stocks I’ve bought, how many times in my life have I ever really paid more than about a P/E of 15?
And, if you look back at all the stocks I’ve bought, how many times in my life have I ever really bought into a company with a weak competitive position?
Those – to me – are the two speculations the average investor slides right into without much thought.
1. He speculates that this business he likes is not just better than other businesses but better enough to more than offset paying a higher than average price for the stock (that is, a P/E over 15).
2. And he speculates that this business he likes will withstand the ravages of competition that are an ever-present part of capitalism.
Now, there are other kinds of speculations you can make. Readers are quick to point out that I own NACCO (NC) which is basically a speculation that no more than one of the coal power plants the company supplies will be shut down in the truly near-term future. I also own BWX Technologies (BWXT) which is a speculation that the U.S. Navy will continue to use aircraft carriers, ballistic missile submarines, and attack submarines – and that those 3 classes will be nuclear powered. I own Frost (CFR) which is a speculation on higher interest rates in the sense that if the Fed Funds Rate was never to rise from the level it is at today, my returns in Frost would be middling.
But when you stretch the word “speculation” that far, you demolish any distinction between investment and speculation in the way Graham used those words. The future is always uncertain. But, we have to be able to define the words “investment” and “speculation” in such a way that we can all agree lottery tickets are speculations and savings bonds are investments; that stock options are speculations and investment grade corporate bonds are investments.
How would we apply this distinction between investment and speculation to stocks today?
Well, we would say that Tesla (TSLA) and Twitter (TWTR) are speculations, because the enterprises themselves are speculative (they have yet to make money). These stocks would be speculative at any price. It is – as yet – impossible to make an “investment” in them.
And we would also say that Amazon (AMZN) and Netflix (NFLX) are speculations. The enterprises themselves aren’t speculative. They are proven money makers. But, the prices investors now put on these stocks make them speculative. There is no measure – P/E, P/B, EV/EBITDA, etc. – by which either Amazon or Netflix are within spitting distance of an average price. So, a buyer of either Amazon or Netflix stock is not just betting that these businesses are above average. He is betting that they are better enough to offset paying a higher than average price for the stock.
What then is an investment?
I would say Omnicom (OMC) at $67 a share is an investment. The competitive position is not speculative. And the stock’s price – at 13 times earnings – is not speculative. So, it is an investment. I would also say The Cheesecake Factory (CAKE) at $44 a share is an investment. The competitive position is not speculative. And the stock’s price – at 16 times earnings – is not speculative.
What wouldn’t I say?
I wouldn’t say that Omnicom and the Cheesecake Factory at $67 and $44 a share respectively are better stocks than Amazon and Twitter at $1,120 and $19 respectively. Amazon and Twitter may be good speculations. And Omnicom and Cheesecake Factory may be bad investments. Reasonable people can disagree about that. The future is always uncertain. But that does not mean the line between investment and speculation is invisible.
Amazon and Twitter are speculations. Omnicom and Cheesecake Factory are investments.
There is a real danger some of us will forget that. Amazon’s future may be brighter than Omnicom’s. But, when we make a statement like that – we are comparing two entirely different classes of financial assets. Amazon’s future needs to be many, many times brighter than Omnicom’s to preserve even a fraction of the capital you put into it today. Just because society has several hundred billion dollars riding on a certain stock doesn’t make that stock any less of a speculation.
Is it wrong to speculate?
Should you ever speculate?
My own investment process is based on finding investments not speculations. So, my answer would be that you should train yourself to distinguish between good and bad investments and ignore speculations all together.
Having said that, I wrote about Hostess Brands warrants (TWNKW). At today’s price of $2.66 for a pair of warrants (owning a pair of warrants gives you the right to buy one share of TWNK common stock at $11.50 in late 2021), I think they might be a good speculation.
They aren’t an investment.
And I think it’s important to remember that. No matter how good a speculation those warrants are – a Hostess Brands warrant at $1.33 is a speculation and Omnicom stock at $67 is an investment. The Hostess warrants can outperform the Omnicom stock. But that should never fool us into thinking a speculation has become an investment.
Words have meaning.