Invest. Don’t Speculate
The manic/panic history of capital markets has produced many more losing investment strategies than winning ones. By diligently avoiding losing strategies investors can gain an advantage over much of the field. While simply avoiding losing strategies sounds simple, it is a surprisingly uncommon tactic.
So what is a losing strategy? Many losing strategies begin with the assumption that they can guess the next direction of asset prices with little or no attention paid to the asset’s fundamental value. These types of strategies are purely speculative. They are also seductive to those looking to invest because they are easy: prices are readily available, measurable and chartable. They fail because they consider only one half of the relationship between price and value.
EASY MONEY OR FALSE HOPES
Speculative strategies can appear to work for a time. Witness the high-yield bond boom in the 1980s, the dot-com boom at the turn of the century and the housing boom that ended in 2007. People made money during all of these eras if they got out quickly enough, but those who stayed too long lost big. All these cycles began based on sound investment principles evaluating prices relative to values. However, they gradually abandoned the value side of the equation as people saw only rising prices and increasingly believed they couldn’t lose money. What started out as rational investing became speculative when investors failed to recognize that ever increasing prices became the only important variable in the equation.
Besides those catastrophic examples, there are many more subtle and pervasive speculative strategies masquerading as investment programs that investors must avoid. These may never reach “bubble” status, but can be equally destructive to an investor’s long-term portfolio. It isn’t hard to find such strategies espoused by experts in both the popular and financial press and even among investment managers.
For example, CNBC's talking heads have recommended that viewers purchase Netflix, Inc. common stock on several recent occasions. What do investors get for their purchase of NFLX at $193/sh? They acquire the rights to $1.56 of free cash flow per year or a free cash flow yield of 0.81% and a P/E of 73x. This paltry cash flow yield is comparable to 3-year US Treasuries, which contain no principal risk. In contrast, NFLX represents substantial principal risk at this price level. Moreover, the future circumstances that would justify this valuation are heroic and improbable. The only rationale for such a purchase is that some other unwitting speculator will acquire these shares at an even more unreasonable price.
RECOGNIZING THE ENEMY
The common misconception describing speculation as investment comes from commentators’ and pundits’ inability to distinguish the characteristics of investing versus speculating. The crucial step for the sound investor to avoid speculation is recognizing the difference.
Speculation can weasel itself into any proper investment strategy in many subtle ways. The most common of these are gambles by a speculator-investor on market direction, emotional decision making, short-term return orientation, and blindly following consensus conclusions about asset valuation and the market. One of the principal challenges in investing is being honest about whether any of these influences have crept into an otherwise robust investment program.
An investor can recognize speculative strategies and influences by their approach: their first question is “how much can I make?” The first question of a sound investment strategy should be “how much do I stand to lose?” Only once the risk of loss has been vetted should an investor decide whether it is worthwhile to put money at risk and seek gains. Where risk is central to proper investing it is ignored by speculators.
When a friend, Eric, buys a new car, he's going to take it for a test drive, check the engine, kick the tires and even get a warranty from the seller that the thing will work for a certain amount of time. Speculative strategies essentially say "I'll buy the car without doing any of this and hope I can sell it to someone else for more money." Chances are, the speculator is going to end up with a pile of junk and no one willing to buy it from him.
Best not to take a flier and wait for a greater fool to pay a greater price. Prices in the markets result from the daily votes of investors and speculators on which assets are worth owning. In the short-term, investors and speculators may act irrationally and cause prices to reflect these influences. But eventually, prices will converge with the underlying value of an asset. Value derives from cash generated by these assets, which may be tangible, intangible, living, contractual or other. An investment is worthwhile only if its price is less than its value. A strategy built on these principals will produce superior results to one built on speculation.