Of Investments and Speculation

A cow for her milk
A hen for her eggs
And a business, by heck, for its dividends.

An orchard for fruit,
Bees for their honey,
And a stock, besides, for its free cash flows.

Most people use the term “investment” when they lay out cash in the hope of receiving more of it in the future. They should often be calling it a “speculation” or a “gamble”. The two terms are considered identical and interchangeable.

Here is Warren Buffett on this important subject:

So there’s 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…a cow. 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.

Consider these quotes :

“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.”

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

In an investment, you make money as the assets generate a regular and a consistent cash-flow. You may also profit if the price of the asset rises and you chose to sell it. In a speculation, you only make money when there is someone ready to buy the asset from you at a price higher than what you paid.

An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.”- Ben Graham

Let’s start by defining “investing.” The definition is simple but often forgotten: Investing is laying out money now to get more money back in the future–more money in real terms, after taking inflation into account. – WEB

Thoughts on 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 derived from its cash flows and their expected growth.
  • Only assets with expected cash flows can have an IV.

On the first question, here is a definition. intrinsic value the value that you would attach to an asset, based upon its fundamentals: cash flows, expected growth 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 then 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 in 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 do people 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, I have a counter question, when I am asked the question of what the value of a business or stock is: Do you want a value for your business or a price for your business? The answers can be very different.

What is the “intrinsic value” of gold? In my view, gold does not have an intrinsic value but it does have a relative value. For centuries, gold (because of its durability and relative scarcity) has been an alternative to financial assets (that are tied to paper currency). Unlike the gold standard days, where the linkage between paper currency and gold was explicit, the value of paper currency rests entirely on trust in

central banks and governments. As a consequence, the price of gold has varied inversely with the degree of trust that we have in these authorities. Though not a perfect indicator, gold prices have surged when a subset of investors have lost that faith, i.e., they fear that the currency is being debased (inflation) or systematic government failures. What makes this monent in economic history disquieting is that we are getting discordant signals from the market: the low interest rates on treasuries (US, German and Japanese) suggests that investors think expected inflation will be low in the future whereas higher prices for precious metals (gold, silver) give support to the argument that investors (or at least a subset of them) believe the opposite. One of these two groups will be wrong and I would not want to be in that group, when there is a final reckoning.

If Investments can be compared to “milching cows” then speculations can be called “prized thoroughbreds.”

One is prized for its milk producing abilities (free cash flows) and the growth rate of this ability. The owner recovers his investment and a profit on it from the milk he receives.

“Metaphorically, these commercial ‘cows’ will 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

Screenshot 2017-12-26 14.18.49.png

In case of the horse we pay for its beauty, its reputation, its ability to race. But there are no cash-flows to consider. The horse does not produce anything (except dung, which is a cost). We can make money oNLY if and when a buyer chooses to buy it from us at a price higher than what we paid. It is reasonable to assume that the buyer would be buying from us thinking that he will be able to sell the horse after a certain time to yet another buyer at higher price. (the greater fool’s phenomenon).

Screenshot 2017-12-26 14.20.06.png

So what is the best way to go about buying a cow?

Its best to buy it when it is “cheap.” When and why would that happen in the market? After all, others also know what we do about cows. One reason could be when most people become uninterested in cows. Especially so when existing owners are keen to get rid of ones they own and do so fast.

Why one may ask would they be acting this way? Maybe, because milk has become really cheap and this cow isn’t worth keeping. Or maybe there has been a recent outbreak of cow-fever and cows have stopped giving milk. Owners fear the disease may prove life-threatening to cows and wish to sell them before they die. Besides if one owner sees others doing it, he is convinced it must be the right thing to do and joins the herd regardless of the facts and the reasoning. Or maybe just because everyone is selling cows and have taken a liking to buying horses. Horses are not boring and their prices have recently been rising fast.

See the quote below. This takes the definition of a “speculation” a step further:
“According to our view, the high prices paid for ‘the best common stocks’ make these purchases essentially speculative, because they require future growth to justify them.” – Benjamin Graham & David Dodd

This is investment vs speculation taken to a higher level. Never mind committing funds to assets which do not produce cash-flows. Gold, Artworks, Paintings, non-productive real estate, etc. Ben Graham is saying that even when investing in milk-producing cows if you speculate on “the volume, the growth in volume and the life-duration of the cow’s milk-producing abilities, then you are “speculating”.

We account for this with Greenwald’s EPV approach. We use “Normalized Earnings” (an art along with serious CoC expertise) for computing EPV1. We then aim to pay between NRV and EPV if a company has a durable and a defensible economic moat.

If there is evidence of a great moat along with serious prospects for growth, we aim to pay at most EPV1. Buffett did this for Coke.

By being confident of coke’s moat and its growth, he was sure of an EPV2 value and by paying below it he effectively had a MOS.

We asked what is the best way to invest? We Invert and ask: what is the worst way to speculate? It must be when the market is extrapolating prices upwards all the way to heaven.


– Husain Kothari
13th January, 2013

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