Friday, July 18, 2014

Aesop's Investment Axiom Revisited

In this prior post, I included the following excerpt from the 2000 Berkshire Hathaway (BRKa) shareholder letter:

"...Aesop and his enduring, though somewhat incomplete, investment insight was 'a bird in the hand is worth two in the bush.' To flesh out this principle, you must answer only three questions. How certain are you that there are indeed birds in the bush? When will they emerge and how many will there be? What is the risk-free interest rate (which we consider to be the yield on long-term U.S. bonds)? "

Aesop's Investment Axiom

Warren Buffett adds that, if the investor can answer these questions, then both the value and the number of "birds" that should be offered can be understood.

"And, of course, don't literally think birds. Think dollars."

Buffett also writes that the difference between investing and speculating may never be "bright and clear" but the differences do matter. Here's one simple attempt, if limited imperfect way, to make a distinction.

The speculator would be generally troubled if the price of an asset dropped substantially -- even if temporarily -- after purchase. We're talking about necessarily rather short time horizons. So the emphasis is not only on price action going in the right direction, but as soon as possible. When dealing with such short time frames, the reason for the drop ends up mattering not much at all.

Whether the drop is caused by emotions, perceptions, technical factors, the market environment as a whole, or real company specific problems just isn't relevant. With speculation, it's the price action that rules.

The investor should be generally troubled, instead, only if the intrinsic value of something went down substantially after purchase. The emphasis is on price versus value; it's on the stream of cash flows that an asset can produce over the long haul; it's on Aesop's investment axiom. With investment, it's the value that rules.

A drop in what something is intrinsically worth (or if value was misjudged in the first place) is when there's a real chance of permanent capital loss. Otherwise, for the investor, a price dropping against well-judged value can be a very good thing.

Buffett explained it the following way back in 2009:

"When I do invest, I don't care if the stock price goes from $10 to $2 but I do care about if the value went from $10 to $2."

If the investor pays a discount to what that future stream of income is worth in present terms, why should a further drop in price be a problem? Of course an investor wants market prices to reflect the actual business economics in the long run. Yet, the participant with a true emphasis on investment should know that a near-term (or even longer) drop in price is a good thing if it represents an increasingly large discount to estimated value.

Some might correctly make the point that the speculator (with a long position) also likes to see value going up. While this is true, the speculator is not concerned with whether there was an actual change in value, or whether emotions, perceptions, or something else has temporarily moved the market price.

The price needs to increase, for whatever reason, just long enough to sell; enduring value is of little concern.

Now, it's not like non-fundamental forces don't potentially help the investor as well. If, for example, the shares happen to temporarily sell at a bigger discount because of psychological factors that can serve the long-term oriented owner very well. Still, favorable investment outcomes mostly come down to what the business itself produces long-term.

It mostly comes down to whether enduring value is created over time.

Prices from time to time in capital markets will go to extremes.*

From an interview with Buffett:

"Basically, it's subjective, but in investment attitude you look at the asset itself to produce the return."

He adds:

"On the other hand if I buy a stock and I hope it goes up next week, to me that's pure speculation."

For the investor it's about the long run core economics of the business.

For the speculator it's the price.

It may not be black and white -- and there's surely plenty of overlap -- but the differences do matter.

Ben Graham long ago expressed concerns that the two distinct activities were becoming blurred.

Also, John Maynard Keynes once wrote:

"If I may be allowed to appropriate the term speculation for the activity of forecasting the psychology of the market, and the term enterprise for the activity of forecasting the prospective yield of assets over their whole life, it is by no means always the case that speculation predominates over enterprise. As the organisation of investment markets improves, the risk of the predominance of speculation does, however, increase."

Keynes understood that investing was mostly about what an enterprise could produce over time.
(Apparently, for Keynes, the word enterprise and investment were equivalent.)

John Bogle certainly seems to think that speculation and investment has unfortunately become nearly equivalent in the minds of too many.

Keep in mind I'm not suggesting there's something inherently wrong with speculation. Both investment and speculation can be useful in the right proportion. I'd argue the whole system has evolved to overemphasize the latter. Capital markets might just end up functioning in a way that better serves us if the distinction was more broadly appreciated. Considering where we are today, some sensible changes that encourage greater engagement in true investment activities by more participants seems in order.

These days, instead, stock "rental" dwarfs ownership.**

Meaningful improvements to the situation appear very unlikely unless it also occurs at a cultural level. How many today associate the stock market with the convenient ownership of businesses for the long run? I think it's fair to say that many think of it, first and foremost, as a place to speculate on stocks. Change how that question is generally answered and maybe, albeit no doubt slowly, behavioral norms might just change. The emphasis may become more about long-term effects and outcomes; it may become more about wise capital formation and allocation.

Nothing about the current situation is inevitable. That doesn't mean improvements will come easily. Even some modest enhancements in this regard would be a healthy development.

Also, for those who see stocks for what they are -- convenient partial business ownership -- and can resist the temptation to trade frenetically, the fact is it has never been more straightforward and low cost to invest for the long haul.

It's not a good thing that these two distinct activities are now so often viewed as being nearly one and the same. That's not to say there isn't a place for speculation. Trading with an emphasis on the short-term is a necessary and useful element in the capital markets. At least, it is up a point. Just because a certain amount of something is useful doesn't logically mean more of it is even more wonderful. With systems, even relatively simple ones, the right proportion matters.

I mean,take something like a petrol engine. It works just fine with the right amount of air and fuel. Well, at least it does if the ratio remains within a narrow range. Yet, step outside that range and it just doesn't work. So the right amount of fuel is a good thing but, eventually, too much of it begins hurting engine performance.

This is just one less than perfect, but possibly useful, way to think about the implications of excessive speculation.

More from the 2000 Berkshire letter:

"...there are many times when the most brilliant of investors can't muster a conviction about the birds to emerge, not even when a very broad range of estimates is employed. This kind of uncertainty frequently occurs when new businesses and rapidly changing industries are under examination. In cases of this sort, any capital commitment must be labeled speculative.

Now, speculation -- in which the focus is not on what an asset will produce but rather on what the next fellow will pay for it -- is neither illegal, immoral nor un-American. But it is not a game in which Charlie and I wish to play. We bring nothing to the party, so why should we expect to take anything home?

The line separating investment and speculation, which is never bright and clear, becomes blurred still further when most market participants have recently enjoyed triumphs. Nothing sedates rationality like large doses of effortless money."

There is nothing inherently wrong with speculation but each participant should know where their own true emphasis lies.

Keep in mind that both speculation and investment may utilize fundamental factors to guide their decisions.

So the difference does not necessarily come down to whether the fundamentals influence decision-making. Occasionally, I'll hear or read that someone is a "fundamental investor". Yet their typical holding period will be very short.

Well, that's still mostly speculation in my book. The fact that fundamentals are taken into account does not turn the activity into investment.

There's nothing inherently wrong with speculation but it shouldn't be confused with investment; they're, in fact, two rather distinct activities.

The real problem with speculation is that, for too many, it creates high levels of activity and frictional costs instead of high returns. Lots of effort; modest rewards or losses.

There's nothing wrong with speculation until the vast proportion of market participants are engaged in it.

There's nothing wrong with speculation unless the scale becomes so large that it absorbs lots of capable people who could, instead, be engaged in something more productive and useful.

Come to think of it, there's plenty wrong with amount of speculation these days.

Adam

Long position in BRKb established at much lower than recent market prices

Related posts:

Munger: "Cognitive Failure" In Economics
Ignore The Noise: John Bogle on Market Fluctuations
Aesop's Investment Axiom
Margin of Safety & Mr. Market's Mood
On Speculation and Investment
John Bogle: The Clash of the Cultures
Buffett on Gambling and Speculation
Buffett on Speculation and Investment - Part II
Buffett on Speculation and Investment - Part I
Buffett: "Two Types of Assets"
Munger: "Separate Derivatives from the Basic Bridges of Civilization"
Bogle: History and the Classics
"Stock Renters"
Buffett on Aesop's Formula for Value
Michael Porter on Business and Investing

* This inherent moodiness should either be ignored or turned into an advantage. A temporary drop in price even further below well-judged value provides a chance to buy more shares at a discount. The other extreme might offer the opportunity to sell. The tough part is avoid being tempted toward excessive amounts of activity. Otherwise, investment will quickly morph into speculation even with the best intentions. Excessive activity can lead to lots of unnecessary mistakes and frictional costs. Also, equities will always become mispriced, but that doesn't make attempts to reduce the damage these huge distortions can do not worthwhile. The current system seems, at times, a capital misallocation machine. The compounded effect of such things is almost certainly harmful.
** How many drive a rental car with the idea they want to make sure it remains a useful asset for as long as possible? Well, when speculation and short-term oriented traders -- the "renters" -- dominate, maybe some valuable business assets end up being treated much like that rental car. When the intent is to own something for minutes, days, weeks, months, or even a few years, the long-term implications of decisions being made today can take a back seat. Well, even the best businesses face unique challenges and opportunities. More true "owners" would be welcome. The average public company may then just end up with improved governance and executive leadership. 
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