Tuesday, January 13, 2015

Investment versus Speculation: Don’t Be a Money Loser.

As a “value-investor,” I follow the teaching primarily of Benjamin Graham. Graham wrote the definitive book on value investing, “The Intelligent Investor,” and in the following series of articles I will discuss and synthesize Graham’s core lessons, as well as relate and apply them to our contemporary investment climate.

A primary theme often returned to by Graham in his writings is that of Investment versus Speculation. An investment is noted as something that “upon thorough analysis, promises the investor safety of principal and an adequate return.” Of course, that sounds perfectly clear and reasonable to most, but the sentence does require some unpacking.

Many people that call themselves investors are actually speculating, which means they are basing their decisions on market graphs, emotions, investment fads, and inadequate analysis of the securities or assets that they buy. Sometimes “speculation,” or buying and selling assets without doing your research, can be fun, but it should never be confused with true investing. And never, and I mean NEVER, should it occupy more than 5% to 10% of your total portfolio.  

So what is considered “investing”? Firstly, a true “investment” is made upon thorough analysis and research. What does thorough analysis involve? At its basic level, it would involve evaluating the financial statements of a company for at least a 5 year period, and preferably more. This would include their balance sheet, cash flow statement, and income statement. What exactly one is looking for in each of these statements will be covered in a later article, but at the present, keep in mind that, at a minimum, this needs to be done by yourself, or by whoever you pay to look after your investments, on a regular basis.

A thorough analysis must also include an examination of the current competitive position and atmosphere for the company. For instance, does the company dominate its industry? Or does it have a veritable barrage of competition in the marketplace? Does the company need to keep inventing products to stay profitable in the foreseeable future? Or does the company possess a “durable competitive advantage” in the marketplace? Does the company appear to be on the right side of the blowing social and political winds? Or is it about to face massive lawsuits that might cost billions? These, and many others, are questions that need to be asked by an “investor.”

Secondly, an investment must have a certain “safety of principal.” This in no way means that GIC’s or Canada Savings Bonds are a great investment, what it means is that an investor must be assured that the business they are investing in has a certain degree of insulation from competition, and a safety net or bottom for the share price. Let’s say that XYZ Corporation has shares selling for a market capitalization (the value of all outstanding company shares) of $500 million. If the company has buildings and land valued at $400 million, those assets (something a company owns) provide the investor with a safety net, or some safety of principal if the market value of the shares fall below $400 million. Why? Because it is possible for the company to sell its assets and return to the shareholders the proceeds from the sale.

The reverse side of the above discussion is a warning against investing in companies that do not contain a “safety of principal,” or assets that help limit your “downside risk.” Even worse, there are many companies that actually owe more than they own. Large manufacturing companies that sink a lot of borrowed cash into inventory and equipment can easily run into this trap (think General Motors circa 2008). Financial companies that hold large values of loans on their books, for which they might not actually get re-paid, are also a cautionary tale. In the case of financial companies, however, “the assets” are often the loans and the “liabilities” are the customer deposits. The many risks associated with investing in financial companies will make for an interesting future discussion.

Thirdly, an “investment” must provide an adequate return. The obvious nature of this rule leads people to not delve into it in as much detail as they should. What is an adequate return? Of course, it depends on the individual investor, but at a bare minimum, it should be more than inflation so that you are not actually losing money in real dollars (after removing inflation). Inflation will be discussed at length in a later reading, but for now, suffice it to say that whatever the current rate of inflation is, we need to beat it.

In order to stay ahead of inflation and consistently earn an adequate return, it is important for investors to demand a future stream of cash payments from the assets that they own. We can all try to earn our returns through capital gains, (selling our assets for more in the future than we paid for them), but they can swing wildly from one year to the next and be hard to predict with any degree of certainty. For simplicity, we should buy assets that provide a stream of payments in the form of dividends or interest. Dividend and interest producing assets provide us with evidence, in cash, that our investments provide a real adequate return.

Does the above discussion regarding what constitutes an adequate return imply that we can never rely on capital appreciation or capital gains for our returns? Absolutely not! What it does mean though is that we want to rely on dividend and interest payments first as the base for our investment recipe, and then capital gains as the icing on the cake.

In order to be intelligent investors, we must look at each investment and calculate what kind of adequate return we should be able to expect. In this case, we will use the example of Bell (TSE: BCE) ß (Exchange: Ticker/Symbol). Around the beginning of 2015, Bell paid its shareholders a dividend of 4.50% on an annualized basis. If inflation at the beginning of 2015 was 2.0% per annum according to the Bank of Canada (http://www.bankofcanada.ca/), then we can assume that our investment in BCE will provide us with the minimum adequate return we need, as long as they continue paying this cash to shareholders. Beyond this, BCE could experience earnings growth, and increase our dividend, which could result in higher share prices and capital gains if we sell our shares.

Could earnings in the above example decline? Or could something else change that eliminates our dividend? Of course, but that is where the first two principles of thorough analysis and safety of principal come into action. The intelligent investor only invests in companies after assuring themselves of all three: 1) that they have completed a thorough analysis of the company, 2) that the company provides them with a certain degree of safety of their principal, and 3) that the company provides them with an adequate return. Should the situation with their investment change, the investor must then undergo a re-examination to see if their capital is more useful elsewhere. “Buy and hold” doesn't work if your original investment thesis no longer holds true. 

Happy Investing! 


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