Category Archives: Benjamin Graham’s thoughts

Investment versus speculation

Benjamin Graham's teacher and friend. Mr Graham used Mr. Market as the character to personify the behavior of the stock   market. Photo: Wikipedia.
Benjamin Graham – Wikipedia

In Chapter 1 of The Intelligent Investor, author Benjamin Graham (May 8, 1894 – September 21, 1976), the father of value investing, made a clear distinction between the term “investor” and “speculator“.

Benjamin Graham, as far back as 1934, said in Security Analysis (a book he co-authored): “An investment operation is one which, upon thorough analysis promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.” This was an attempt for a precise formulation of the difference between investment and speculation.

Benjamin Graham then had to defend against the charge that the definition gave too wide a scope to the concept of investment when, in the aftermath of the great market decline of 1929-1932, all common stocks were widely regarded as speculative by nature. Then came a time when Benjamin Graham’s concern became one of people using the term “investor” as a common jargon to describe anyone and everybody in the stock market. An example was a journal in 1970 using the term “reckless investors”. Benjamin Graham said this “reckless investors” term could be regarded as a laughable contradiction in terms – something like “spendthrift misers”.

“The newspaper employed the word ‘investor’ in these instances because, in the easy language of Wall Street, everyone who buys or sells a security has become an investor, regardless of what he buys, or for what purpose, or at what price, or whether for cash or on margin,” said Benjamin Graham, the father of value investing whose most famous disciple is legendary investor Warren Buffett, the chairman of Berkshire Hathaway.

Benjamin Graham said that “the distinction between investment and speculation in common stocks has always been a useful one and its disappearance is a cause for concern.”

“Outright speculation is neither illegal, immoral, nor (for most people) fattening to the pocketbook. More than that, some speculation is necessary and unavoidable, for in many common-stock situations there are substantial possibilities of both profit and loss, and the risks therein must be absorbed by someone. There is intelligent speculation as there is intelligent investing,” said Benjamin Graham.

“But,” warned Benjamin Graham, “there are many ways in which speculation may be unintelligent.” Examples that Benjamin Graham mentioned are “speculating when you think you are investing”, “speculating seriously instead of as a pastime, when you lack knowledge and proper skill for it”, and “risking more money in speculation than you can afford”.

In what he called a conservative view, Benjamin Graham said that “every non-professional who operates on margin should recognize that he is ipso facto speculating.” “And everyone who buys a so-called ‘hot’ common-stock issue, or makes a purchase in anyway similar thereto, is either speculating or gambling.”

Benjamin Graham said” “If you want to try your luck at it (speculation), put aside a portion – the smaller the better – of your capital in a separate fund for this purpose.”

His parting shot: “Never mingle your speculative and investment operations in the same account , nor in any part of your thinking.”


Benjamin Graham’s The Intellingent Investor Chapter 20 (Margin of Safety As The Central Concept Of Investment)

Benjamin Graham's teacher and friend. Mr Graham used Mr. Market as the character to personify the behavior of the stock   market. Photo: Wikipedia.
Benjamin Graham: “Investment is most intelligent when it is most businesslike.” Photo: Wikipedia.

In a section of his  letter to Berkshire Hathaway shareholders on February 28, 2014 for FY2013, Warren Buffett shared “Some Thoughts About Investing”  (Post: Investment is most intelligent when it is most businesslike) .

He also shared more about Benjamin Graham, his teacher and friend, and about Benjamin Graham’s book, The Intelligent Investor .

“Ben’s ideas were explained logically in elegant, easy-to-understand prose (without Greek letters or complicated formulas). For me, the key points were laid out in what later editions labeled Chapters 8 and 20. (The original 1949 edition numbered its chapters differently.) These points guide my investing decisions today.”

So what is   Chapter 20  in the later editions of The Intelligent Investor all about?

As Chapter 20’s title, “Margin of Safety” as the Central Concept of Investment, suggests,  “margin of safety” is the motto governing  Benjamin Graham’s investment policy. It is the thread that runs through all the investment policy discussion in preceding chapters.

The chapter started off with the margin-of-safety concept as applied to “fixed value investments”.

“All experienced investors recognize that the margin-of-safety concept is essential to the choice of sound bonds and preferred stocks. For example, a railroad should have earned its total fixed asset charges better than five times (before income tax), taking a period of years, for its bonds to qualify as investment-grade issues. This past ability to earn in excess of interest requirements constitutes the margin of safety that is counted on to protect the investor against loss or discomfiture in the event of some future decline in net income. (The margin above charges may be stated in other ways – for example, in the percentage by which revenues or profits may decline before the balance after interest disappears – but the underlying idea remains the same.)

The margin-of-safety concept as applied to “fixed value investments” can be carried over to the field of common stocks, says Chapter 20, but with some necessary modifications.

“There are instances where a common stock may be considered sound because it enjoys a margin of safety as large as that of a good bond. This will occur, for example, when a company has outstanding only common stock that under depressed conditions is selling for less than the amount of bonds that could safely be issued against its property and earning power. That was the position of a host of strongly financed industrial companies at the low price levels of 1932-33. In such instances, the investor can obtain the margin of safety associated with a bond, plus all the chances of larger income and principal appreciation inherent in a common stock. (The only thing he lacks is the legal power to insist on dividend payments “or else – but this is a small drawback as compared with his advantages.”

Elsewhere in Chapter 20, it says “the risk of paying too high a price for good-quality stocks – while a real one – is not the chief hazard confronting the average buyer of securities”. “Observation over many years has taught us that the chief losses to investors come from the purchase of low-quality securities at times of favorable business conditions. The purchasers view the current good earnings as equivalent to “earning power” and assume that prosperity is synonymous with safety.”

As for growth stocks, the danger lies in the market’s “tendency to set prices that will not be adequately protected by a conservative projection of future earnings”.

The margin of safety is much more evident in the field of undervalued  or bargain securities.  By definition, it means there is a favorable difference between price on the one hand and indicated or appraised value on the other. “That difference is the margin of safety”.

The gem of Chapter 20 comes in this famous Benjamin Graham quote: “Investment is most intelligent when it is most businesslike.”

“It is amazing to see how many capable businessmen try to operate in Wall Street with complete disregard of all the sound principles through which they gained success in their own undertakings.”

Related posts: (1) The Intelligent Investor Chapter 8

(2) Warren Buffett on intelligent investing

Recommended reading:

The Intelligent Investor: The Definitive Book on Value Investing. A Book of Practical Counsel (Revised Edition) (Collins Business Essentials)

 

Benjamin Graham’s The Intelligent Investor Chapter 8 (The Investor and Market Fluctuations)

Benjamin Graham's teacher and friend. Mr Graham used Mr. Market as the character to personify the behavior of the stock   market. Photo: Wikipedia.
Benjamin Graham, author of The Intelligent Investor Photo: Wikipedia

In a section of his  letter to Berkshire Hathaway shareholders on February 28, 2014 for FY2013, Warren Buffett shared “Some Thoughts About Investing”  (Post: Investment is most intelligent when it is most businesslike) .

He also shared more about Benjamin Graham, his teacher and friend, and about Benjamin Graham’s book, The Intelligent Investor .

“Ben’s ideas were explained logically in elegant, easy-to-understand prose (without Greek letters or complicated formulas). For me, the key points were laid out in what later editions labeled Chapters 8 and 20. (The original 1949 edition numbered its chapters differently.) These points guide my investing decisions today.”

So what is   Chapter 8  in the later editions of The Intelligent Investor all about?

The takeaway  lesson from Chapter 8 of The Intelligent Investor is Benjamin Graham’s parable about Mr Market, a character that Benjamin Graham used to demonstrate the behavior of the stock market.

Here is the Benjamin Graham parable: “Imagine that in some private business you own a small share that cost you $1,000. One of your partners, named Mr Market, is very obliging indeed. Everyday he tells you what your interest is worth and further offers to buy you out or sell you an additional interest on that basis. Sometimes his idea of value appears plausible and justified by business developments and prospects as you know them. Often, on the other hand, Mr Market lets his enthusiasm or his fears run away with him, and the value he proposes to you seems to you a little short of silly.

“If you are a prudent investor or a sensible businessman will you let Mr Market’s daily communications determine your view of the value of $1,000 interest in the enterprise? Only in case you agree with him, or in case you want to trade with him. You may be happy to sell out  to him when he quotes you a ridiculously high price, and equally happy to sell to him when his price is low. But the rest of the time you will be wiser to form your own idea of the value of your holdings, based on full reports from the company about its operations and financial position.

“The true investor is in that very position when he owns a listed common stock. He can take advantage of the daily market price or leave it alone, as dictated by his own judgment and inclination. He must take cognizance of important price movements, for otherwise his judgment will have nothing to work on. Conceivably they may give him a warning signal which he will do well to heed – this in plain English means he is to sell his shares because the price has gone down, foreboding worse things to come. In our view such signals are misleading at least as often as they are helpful. Basically, price fluctuations have only one significant meaning for the true investor. They provide him with an opportunity to buy wisely when prices fall sharply and to sell wisely when they advance a great deal. At other times he would be better off if he forgets about the stock market and pays attention to his dividend returns and to the operating results of his companies.”

Related posts: (1) The Intelligent Investor Chapter 20

(2) Mr Market’s Incurable Emotional Problems.

Recommended reading:

The Intelligent Investor: The Definitive Book on Value Investing. A Book of Practical Counsel (Revised Edition) (Collins Business Essentials)