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Chapter 4: Investment and Speculation

·         Graham asserts that safety cannot be judged by the result, but must be posited in advance and that it can only be useful if it is based on something more tangible than the psychology of the purchaser. The safety must be assured or at least strongly indicated, by the application of definite and well-established standards.

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

§  An “investment operation” is used instead of an issue because it is unsound to think of investment character as inhering in an issue since price is an essential element. So a stock may have investment merit at one price level but not at another. In addition, an investment might be justified in a group of issues, which would not be sufficiently safe if made in any one of them singly.

§  By “thorough analysis” Graham means, the study of the facts in the light of established standards of safety and value. As an example of analysis, paying 40 times its highest recorded earnings in 1929, merely because of its excellent prospects, would be clearly ruled out as devoid of all quality of thoroughness.

§  Graham notes that in “promises safety of principal” the “Safety” sought in an investment is not absolute or complete. It means, rather, protection against loss under all normal or reasonably likely conditions or variations. A safe stock is one which holds ever prospect of being worth the price paid except under quite unlikely contingencies. Where study and experience indicate that an appreciable chance of loss must be recognized and allowed for, we have a speculative situation.

§  “Satisfactory return” covers any rate or amount of return, however low, which the investor is willing to accept, provided he acts with reasonable intelligence.

§  An investment operation is one that can be justified on both qualitative and quantitative grounds. This is an additional criterion for investment.

·         Investment must always consider price as well as the quality of the security. Strictly speaking, there can be no such thing as an “investment issue” in the absolute sense, i.e., implying that it remains an investment regardless of price. In his opinion, the great majority of common stocks of strong companies must be considered speculative a good part of the time, simply because their price is too high to warrant safety of principal in any intelligible sense of the phrase.

·         It may be thought that sound analysis should produce successful results in any type of situation, including confessedly speculative i.e. those subject to substantial uncertainty and risk. Since if selection of speculative issues is based on expert study of companies position, should not this approach give the purchaser considerable advantage? Graham thinks that this argument is deceptive and notes several arguments for placing chief reliance upon analysis in speculative situations

§  The mechanics of speculation causes increased transaction costs.

§  Underlying analytical factors in speculative situations are subject to swift and sudden revision i.e. IV may change before market price reflects that value even more so in speculative situations.

§  Impact of unknown factors is skewed negatively in speculative situations. Those on the inside often have an advantage of this kind which nullifies and loads the dice against the analyst working with some of the facts concealed from him.

§  The value of analysis diminishes as the element of chance increases.

·         It would be prudent to consider analysis as auxiliary rather than as a guide in speculation. It is only where chance plays a subordinate role that the analyst can properly speak in an authoritative voice and accept responsibility for the results of his judgments.

·         For investment, the future is essentially something to be guarded against rather than to be profited from. If future brings improvement, so much the better; but investment as such cannot be founded in any important degree upon the expectation of improvement. Speculation, on the other hand, may always properly –and often soundly – drive its basis and its justification from prospective developments that differ from past performance.

·         A great deal of common stock buying is done with reasonable care and may be called intelligent speculation; a great is done upon inadequate consideration and for unsound reasons and thus must be called unintelligent; in exceptional cases a common stock may be bought on such attractive terms, qualitative and quantitative, as to set the inherent risk at a minimum and justify the title of investment.

·         It is possible to argue that issues with high degree of speculative risk individually may be made part of an investment operation provided (1) the changes of gain definitely outweigh those of loss and (2) there is ample diversification. Ex. Low priced common stocks meeting certain conditions and even long term calls to buy at prices much above their current levels. This is a marginal area in which distinctions between investment and speculation become blurred.

·         A proposed purchase that cannot quality as an investment automatically falls into the speculative category. But at times it may be useful to view such purchase somewhat differently and to divide the price paid into an investment component and a speculative component. GE selling at $38 in 1939 might have concluded a price up to say $25 was justified from the standpoint of investment value. The remaining $13 would represent stock market appraisal of company’s excellent long term prospects and would constitute the speculative component.

·         To regard investment quality as something independent of price is a fundamental and dangerous error.

·         Intrinsic value is by no means limited to the investment component of total value – but may properly include a substantial component of speculative value, provided that such speculative value is intelligently arrived at. Hence the market price may be said to exceed intrinsic value only when the market price is clearly the reflection of unintelligent speculation.

In order to take proper advantage of the margin of safety principle in investment operations it is almost always essential that the investor practice adequate diversification.

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