Security Analysis: Chapter 4 Summary
Security Analysis is a "must have" book for any serious investor written by Benjamin Graham, David Dodd and recommended by Warren Buffett
Welcome back to the Security Analysis series. In the chapter 4 of “Security Analysis”, Graham and David present the distinctions between investment and speculation to help readers understand whether they are investing or speculating, and if it is the latter, make sure their speculation is justifiable. Check out the preceding chapters if you’d like to get caught up:
Chapter 1 Summary: The scope and Limitations of Security Analysis. The Concept of Intrinsic Value
Chapter 3 Summary: Sources of Information
Chapter 4: Distinctions between Investment and Speculation
Distinctions commonly drawn between the two terms are listed in the following table:
Bonds vs Stocks: it is commonly viewed that bonds are investments and stocks are speculation, however, this is logically unsound because a poorly secured bond can be speculative and an investment rated stocks may be a great investment. We should not deny that stocks are investment merely because it possesses profit possibilities.
and 3. Outright vs Margin Purchases; Permanent vs Temporary Holdings: it is unsound to conclude that securities bought on margin are speculation because sometimes safer issues would be more suitable for marginal purchases and riskier ones would be paid in full. In terms of permanent and temporary holding, some short-term investment is well-established practice, and long-term speculation is equally well established.
and 5. Income vs Profit; Safety vs Risk: it is unsound to accept the idea of income as the central motive in investment, leaving the goal toward capital appreciation as speculation. For example, bank stocks pay a smaller dividend yield than the high-grade bonds, but bank stock investors purchase these stocks on the expectation that the company will grow and earnings will lead to capital appreciation. Safety and risk are also subjective. A gambler could bet on “sure thing” and believe that his commitment is safe.
A Proposed Definition of Investment:
An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.
The authors speak an “investment operations” rather than an issue or a purchase because investment may include a group of issues, arbitrage and hedging.
By “thorough analysis”, the authors mean the study of the facts and establish standards of safety and value.
The term “safety” means protection against loss under all normal conditions.
Finally, “satisfactory return” allows for profit or capital appreciation as well as interests and dividends.
Two Real Examples of Investment vs Speculation:
Speculation
In December 1934, General Electric preferred stock is traded at $12.75 per share. It paid 6% on $10 par and was callable (callable means the stock can be “taken back” by the issuer at the pre-determined price) on any dividend date at $11. A buyer at $12.75 per share was speculating to the extend of more than 10% of his principal. In fact, the issue was called for redemption at $11 on April 15, 1935.
Investment
After the same issue was called, the price dropped to $11. The authors believed that at that time, the stock offered an unusual opportunity for profitable short-term investment on margin. Buyer at $11 could have borrowed the money to fund this investment with 2% interest annually. This operation would have give the investor a 40% return on the capital he committed in. See calculation below:
Finally, the authors describe the types of investment and types of speculation.
Types of Investments:
Business investment which refers to money put and held in a business
Financial investment which refers to securities investments
Sheltered investment which refers to securities regarded as subject to small risk by reason of their prior claim on earnings
Analyst’s investment which means operations that, upon thorough study, promise safety of principal and an adequate return
Types of Speculation:
Intelligent speculation means taking risk that appears justified after careful weighing of the pros and cons
Unintelligent speculation is when taking risk without adequate study of the situation.