SPECULATION VERSUS INVESTING

Separate and distinct things not to be confused,
as every thoughtful investor knows, are real worth and market price.

—JOHN BURR WILLIAMS

Decades ago, investing was haphazard. Investors figured that a stock was worth whatever people were willing to pay, and the game was to guess what people will pay tomorrow for a stock you buy today. Then John Burr Williams unleashed a revolution by arguing that investors could use something called present value to estimate the intrinsic value of a company’s stock.

Think of a stock as a machine that generates cash every few months—cash that happens to be called dividends. The key question is how much you would pay to own the machine in order to get the cash. This is the stock’s intrinsic value. People who think this way are called value investors.

In contrast, speculators buy a stock not for the cash it dispenses, but to sell to others for a profit. To a speculator, a stock is worth what somebody else will pay for it, and the challenge is to guess what others will pay tomorrow for the stock you buy today. This guessing game is derisively called the Greater Fool Theory: Buy stocks at inflated prices and hope to sell to even bigger fools at still higher prices.

Legendary investor Warren Buffett has this aphorism: “My favorite holding period is forever.” If we think this way, never planning to sell, we force ourselves to value stocks based on the cash they generate, instead of being distracted by guesses about future prices. A Buffett variation on this theme is, “I never attempt to make money on the stock market. I buy on the assumption that they could close the market the next day and not reopen it for five years.” If we think this way, we stop speculating about zigs and zags in stock prices and focus on the cash generated by the money machine.

The idea is simple and powerful, but often elusive. It is very hard to buy a stock without looking at what its price has been in the past and thinking about what its price might be in the future. It is very hard to think about waiting patiently for cash to accumulate when it is so tempting to think about making a quick killing by flipping stocks.

People are often lured to the stock market by the ill-conceived notion that riches are there for the taking—that they can buy a stock right before the price leaves the launchpad. This dream is aided and abetted by get-rich-quick gurus peddling fantasies. I once received a letter that began “Dear friend.” There’s the first red flag: Real friends don’t address you as “Dear friend.” The letter went on, “IMAGINE turning $1,000 into $34,500 in less than one year!” The letter said that “no special background or education” was needed and that “it’s an investment you can make with spare cash that you might ordinarily spend on lottery tickets or the racetrack.” Second red flag: I don’t buy lottery tickets or bet on horses. Where did they get my name? Why did they think I was a sucker? This was getting embarrassing.

The “secret” was low-priced stocks. To demonstrate the “explosive profit potential,” the letter listed twenty low-priced stocks and said that $100 invested in each ($2,000 in all) would have grown in the blink of an eye to $26,611. Not only that, but another stock, LKA International, had gone from 2 cents to 69 cents a share in a few months, which would have turned $1,000 into $34,500. The letter concluded by offering a special $39 report that would give me access to “the carefully guarded territory of a few shrewd ‘inner circle’ investors.”

That was the third red flag. Why would anyone who had a real get-rich-quick system peddle it instead of using it? Why waste precious time selling newsletters for $39? Some self-proclaimed gurus assert that they have made more than enough money and want to share their secrets with others who are as poor as they once were: “If a loser like me can make money, so can a loser like you!” If they are truly rich, why don’t they send us money instead of asking for more?

It is preposterous to think that the stock market gives away money. There is a story about two finance professors who see a $100 bill on the sidewalk. As one professor reaches for it, the other says, “Don’t bother; if it were real, someone would have picked it up by now.” Finance professors are fond of saying that the stock market doesn’t leave $100 bills on the sidewalk, meaning that if there were an easy way to make money, someone would have figured it out by now.

There is truth in that, but it is not completely true. Stock prices are sometimes wacky. During speculative booms and financial crises, the stock market leaves suitcases full of $100 bills on the sidewalk. Still, when you think you have found an easy way to make money, you should ask yourself if other investors have overlooked a $100 bill on the sidewalk or if you have overlooked a logical explanation.

Investors make voluntary transactions—some buying and others selling—and a stock won’t trade at 2 cents if it is clear that the price will soon be 69 cents. Even if only a shrewd inner circle know that the price will soon be 69 cents, they will buy millions of shares, driving the price today up to 69 cents.

When LKA traded at 2 cents a share, there were an equal number of buyers and sellers, neither side knowing for sure whether the price would be higher or lower the next day or the day after that. The optimists bought and the pessimists sold. The optimists happened to be right this time. But to count on being right every time, buying stocks at their lowest prices and selling at their highest, is foolish.

Probably the most successful stock market investor of all time is Warren Buffett, who made about 20 percent a year over some fifty years. This isn’t close to the fantasies concocted by dream peddlers, but it is absolutely spectacular compared to the performance of the average investor, who has made about 10 percent a year.

Some stocks do spectacularly well, just as some lottery tickets turn out to be winners. But it is a delusion to think that you will become an instant millionaire by buying stocks or lottery tickets. A more realistic goal is to make intelligent investments and avoid financial potholes.

The key is to resist the temptation to buy and sell stocks based on wishful thinking about prices. Instead, think of stocks as money machines and think about what you would be willing to pay for the cash they generate over an indefinite horizon. If you do, you will be a value investor—and glad of it.