2. Speculations

The second major category involves assets that will never produce anything, but that are purchased in the buyer’s hope that someone else — who also knows that the assets will be forever unproductive — will pay more for them in the future. Tulips, of all things, briefly became a favourite of such buyers in the 17th century. This type of investment requires an expanding pool of buyers, who, in turn, are enticed because they believe the buying pool will expand still further. Owners are not inspired by what the asset itself can produce — it will remain lifeless forever — but rather by the belief that others will desire it even more avidly in the future.

The major asset in this category is gold, a huge favorite of investors who fear almost all other assets, especially paper money (of whose value, as noted, they are right to be fearful). Gold, however, has two significant shortcomings, being neither of much use nor procreative. True, gold has some industrial and decorative utility, but the demand for these purposes is both limited and incapable of soaking up new production. Meanwhile, if you own one ounce of gold for an eternity, you will still own one ounce at its end. What motivates most gold purchasers is their belief that the ranks of the fearful will grow. During the past decade that belief has proved correct. Beyond that, the rising price has on its own generated additional buying enthusiasm, attracting purchasers who see the rise as validating an investment thesis. As “bandwagon” investors join any party, they create their own truth and a bubble– for a while.

In these bubbles, an army of originally skeptical investors succumbed to the “proof ” delivered by the market, and the pool of buyers — for a time — expanded sufficiently to keep the bandwagon rolling. But bubbles blown large enough inevitably pop. And then the old proverb is confirmed once again: “What the wise man does in the beginning, the fool does in the end.”

Today the world’s gold stock is about 170,000 metric tons. If all of this gold were melded together, it would form a cube of about 68 feet per side. (Picture it fitting comfortably within a baseball infield.) At $1,650 per ounce today its value would be about $9 trillion. Call this cube pile A.
Let’s now create a pile B costing an equal amount. For that, we could buy all U.S. cropland (400 million acres with output of about $200 billion annually), plus 16 Exxon Mobils (the world’s most profitable company, one earning more than $40 billion annually). After these purchases, we would have about $0.5 trillion left over for walking-around money (no sense feeling strapped after this buying binge). Can you imagine an investor with $9 trillion selecting pile A over pile B?

A 100 years from now, people, anywhere on earth, regardless of any currency they follow, will be willing to exchange a couple of minutes of their daily labor for a Coca-Cola. World population will move more goods, consume more food, and require more living space than it does now. People will forever exchange what they produce for what others produce. And businesses will continue to efficiently deliver goods and services desired by the world’s citizens.

“Metaphorically, these commercial cowswill live for centuries and give ever greater quantities of ‘milk’ to boot. Their value will be determined not by the medium of exchange but rather by their capacity to deliver milk. Proceeds from the sale of the milk will compound for the owners of the cows, just as they did during the 20th century when the Dow increased from 66 to 11,497 (and paid loads of dividends as well).” – Warren Buffett

Dow Jones industrial average 2002-2012

Investments vs Speculations: a contrast

The two terms are widely and erroneously used and considered as equivalent. They couldn’t be more different.

Here is Warren Buffett on this important subject:

So there two types of assets to buy. One is where the asset itself delivers a return to you, such as, you know, rental properties, stocks, a farm… And then there’s assets that you buy where you hope somebody else pays you more later on, but the asset itself doesn’t produce anything. And those are two different games. I regard the second game as speculation. Now there’s nothing immoral or illegal or fattening about speculation, but it is an entirely different game to buy a lump of something and hope that somebody else pays you more for that lump two years from now than it is to buy something you expect to produce income for you over time. I bought a farm 30 years ago, not far from here. I’ve never had a quote on it since. What I do is I look at what it produces every year, and it produces a very satisfactory amount relative to what I paid for it.

If they closed the stock market for 10 years and we owned Coca-Cola and Wells Fargo and some other businesses, it wouldn’t bother me because I’m looking at what the business produces. If I buy a McDonald’s stand, I don’t get a quote on it every day. I look at how my business is every day. So those are the kind of assets I like to own, something that actually is going to deliver, and hopefully deliver to meet my expectations over time. A piece of art, you know, may go from $1,000 to $50 million, but it’s dependent on what the next guy wants to pay me. The art itself— the painting itself is not going to dispense cash. So I have to find somebody that’s going to like it more. And with most— with an asset like gold, for example, you know, basically gold is a way of going along on fear, and it’s been a pretty good way of going along on fear from time to time. But you really have to hope people become more afraid in the year or two years than they are now. And if they become more afraid you make money, if they become less afraid you lose money. But the gold itself doesn’t produce anything.

Further:

“Investing is an activity of forecasting the yield on the assets over its life; Speculation is the activity of forecasting the psychology of the market.” – Warren Buffett

“Investing is determining what the asset will do, Speculation is about guessing what the price will do” – Warren Buffett

Of Intrinsic Value

What is intrinsic value? Does every asset have an intrinsic value?

Short answers:

• There are two kinds of values. Intrinsic Value(IV) and Relative Value.
• An asset’s IV is that which is derived from its cash flows and their expected growth.
• Only assets with cash flows can have an IV.
• Currency-based and Investments have an IV. Speculations do not.

On the first question, here is a definition. Intrinsic value is “the value that you would attach to an asset, based upon its fundamentals: cash flows, expected growth of earnings and risk”. The essence of intrinsic value is that you can estimate it in a vacuum without any information on how the market is pricing it or similar assets (though it does certainly help to have that information). A discounted cash flow model is an intrinsic valuation model, because you are valuing an asset based upon its expected cash flows, adjusted for risk. Even a book value approach is an intrinsic valuation approach, where you are assuming that the accountant’s estimate of what fixed and current assets are worth is the true value of a business.

This definition answers the second question. Only assets that are expected to generate cash flows can have intrinsic values. Thus, a bond (coupons), a stock (dividends), a business (operating cash flows) or commercial real estate (net rental income) all have intrinsic values, though computing those values can be easier for some assets than others. At the other extreme, fine art and baseball cards do not have intrinsic value, since they generate no cash flows (though they may generate a more amorphous utility for their owners) and value, in a sense, is entirely in the eye of the beholder. Residential real estate is closer to the latter than the former and estimating the intrinsic value of your house is an exercise in futility.

So, how does the market value assets where intrinsic value cannot be estimated? They look at what other people are paying for similar or comparable assets: i.e., they use relative valuation. Thus, an auction house sets a value for your Picasso, based on what other Picasso’s have sold for in the recent past, adjusted for differences (which is where the experts come in). The realtor sets the price for residential real estate, based on what other residences in the neighborhood have sold for, adjusted for differences again. In fact, let’s face it: this is the way even assets that have intrinsic value are evaluated for the most part. Thus, the investment banker who takes Groupon public may go through the process of providing a discounted cash flow model to back up the valuation, but the pricing of the IPO will be determined largely by the euphoric reception that Linkedin got a few weeks ago.

This calls for clarification of terms. Most people who claim to be valuation specialists, experts or appraisers are really pricing specialists, experts and appraisers. In other words, what separates them in terms of skills is in how good they are in finding comparable assets and adjusting for differences across assets. In fact, when asked the question, “ of what the value of a business or stock is”, one should counter with: “Do you want a value for your business or a price for your business?”. The answers can be very different.

Note: this article has extracted text in several places from an article by Warren Buffet titled “Of Stocks, Bonds and Gold”.

Husain Kothari
March 17th, 2013