Thursday, June 30, 2011

Buffett on Speculation and Investment

From this CNBC interview with Warren Buffett:

"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. 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." - Warren Buffett

In yesterdays post, I basically said a well-designed system to support capital development, among other things, efficiently helps money meet a good idea with minimal frictional costs.

It will also more often than not produce market prices that, at least to a reasonable extent, approximate the discounted value of the cash a business can produce over its remaining life.

In reality, financial markets will always have a tendency to be alternatively manic then depressive in nature. The mood swings in markets are not going to stop producing prices in marketable securities that vary quite a bit, on both the high and low side, around the approximate underlying value of the assets.

Yet, I think modern financial markets have developed in a way that unnecessarily amplifies this nature. It's not like we're going to create a perfect system anytime soon but we'd be better off reversing the direction we've been heading for some time.

Some of this gets back to the question of what is speculation versus what is investing. The answer is clearly not black and white but that doesn't mean the differences are unimportant or small.

Investing is the ownership of an asset, partially or entirely, with the emphasis on benefiting from what that asset can produce in value itself over an extended period of time.

Speculating is altogether different. Speculation is betting on the near or even medium term price action of marketable securities. What the asset itself can produce in value over time is of little or, in the case of increasingly popular things like high frequency trading and technical analysis, of no interest. More from the CNBC interview:

"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." - Warren Buffett

If an investor buys something hoping the price will go up in the near-term, it's speculation. Investing is not about price action, it's about what the asset can produce in the long run relative to what was paid for the asset. What the price does next week, month, or even much longer matters little.

In a separate interview, Buffett had this to say:

"Basically, it's subjective, but in investment attitude you look at the asset itself to produce the return. So if I buy a farm and I expect it to produce $80 an acre for me in terms of its revenue from corn, soybeans etc. and it cost me $600. I'm looking at the return from the farm itself. I'm not looking at the price of the farm every day or every week or every year. On the other hand if I buy a stock and I hope it goes up next week, to me that's pure speculation." - Warren Buffett

So speculating is like investing the same way a Chihuahua is like a Doberman, a horse is like a zebra, and a house cat is like a lion. These things may seem, in some ways, very much the same but that's only if your definition of being the same is rather imprecise.

The differences matter.

There is certainly nothing wrong with speculation but the proportion of market participants that are speculators isn't exactly irrelevant. If most participants are focused more on price action, less on underlying value, it seems clear that the system will work below its potential. More frequent mispricings, sometimes substantial, seem an inevitable outcome.

To me, a market dominated by those focused on price action, less by those anchored by intrinsic value (the financial markets equivalent to gravity), naturally ends up with assets mispriced (on the high and low side) more frequently and by larger amounts. The more time and distance that prices remain disconnected from underlying value means ultimately more capital gets misallocated. This misallocation has got to be costly for all over the long haul*.

In the long run, the weighing machine wins (the financial equivalent to gravity assures this so a true long-term investor in a good business will do just fine) but in the short-to-intermediate run the system is less effective at performing its primary functions.

If I bought some farmland, owned it passively and rented it out to someone over the past 40 years, I think it's fair to say that I'm not a speculator in farmland. I primary look at the rent checks I collect over time to judge how wise the investment was. 

I become a passive part owner in a restaurant with the intention to own it "forever". While I may sell someday, what it could be sold for on any given day to someone else is not my focus.  I mainly judge my investment based on my share of the income and value it produces over many years relative to the price paid for the partial ownership. It's what the business produces relative to my capital at risk. I think in that scenario it's also fair to say I'm not a speculator in restaurants. 

The same is true for a long-term investor in something like Coca-Cola (KO) or Johnson & Johnson (JNJ). An investor who bought shares of either of stock in the early-to-mid 1980s now owns an asset that earns each year roughly what was paid for the stock (they are both remarkably consistent long-term value creators). Those earnings, of course, continue to grow. The dividend checks alone now easily produce a 40% return per year on the original capital invested (dividends that naturally also continue to grow). The dividend income stream alone represents a nice return even if those shares of Coca-Cola or Johnson & Johnson end up never being sold. Besides, selling means giving up the ownership of a proven productive asset and creates a new problem.

Finding another one.

If the market did not produce another quote on either Coca-Cola or Johnson & Johnson for a decade, the owner of shares would do just fine. The portion of the earnings that are not paid out as dividends, if management does its job, is invested in a manner that should create even more wealth for owners down the road.

I'm guessing, even if not quite as spectacular, someone who invests in these businesses now will not regret it in 25 years.

I'm not saying 25 or 30 years is somehow required to be considered an investment but a longer time frame helps make the point. There is room for speculators in any market. Yet, with the average holding period of stocks now standing at less than 3 months**, I think the proportion of participants in the market who think and behave like owners has clearly got to be too low (with prices more likely to swing wildly above and below the approximate intrinsic value of underlying assets).

When returns are primarily driven by well-timed trades around price action, it's speculating.

When returns are primarily driven by what the underlying asset produces in value over a long period of time, it's investing.

In reality, there's often a bit of each in any transaction but an emphasis more on the latter in the markets these days would be welcome.


Long stocks mentioned

Related posts:
Buffett on Gambling and Speculation (follow-up)
Buffett on Speculation and Investment - Part II (follow-up)

* Costly in terms of some opportunities getting undercapitalized while others end up swimming in capital who have questionable prospects or maybe don't even need the funds. Many good businesses were created in the late 1990s. At the same time many not even remotely viable businesses chewed up capital that could have been put to use elsewhere. The widespread mispricing (on the high side) of internet related businesses made it seem like easy money. Meanwhile, at the time, it's almost certain something non-internet related but more viable couldn't even get a return call from the distracted investment bankers and venture capitalists. That's why widespread mispricing in the capital markets makes bubbles so expensive and painful economically. Money gets burned up on bad investments while others are starved for capital. It may seem like a big party at the time but it is, in fact, very costly.
** Historically, the norm has been much longer.
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