Investment vs. Speculation

Published on 02/05/21 | Saurav Sen | 1,704 Words

The BuyGist:

  • It’s never clear where investing ends and speculation begins, not even for the legends of investing.
  • All investing involves some level of speculation.
  • The best we can do is minimize the amount of speculation involved in each investment.
  • This article depicts a simple framework, with the right questions to ask before investing (or speculating).

Pumpkins and Mice

The line separating investment and speculation is blurry. These aren’t my words. Here’s a nugget of wisdom I’ve engrained in my prefrontal cortex:

“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. After a heady experience of that kind, normally sensible people drift into behavior akin to that of Cinderella at the ball. They know that overstaying the festivities that is, continuing to speculate in companies that have gigantic valuations relative to the cash they are likely to generate in the future will eventually bring on pumpkins and mice. But they nevertheless hate to miss a single minute of what is one helluva party. Therefore, the giddy participants all plan to leave just seconds before midnight. There’s a problem, though: They are dancing in a room in which the clocks have no hands.”

- Warren Buffett

Here's the truth: All investments include speculation. Even Buffett speculates to some extent. Occasionally, however, we find investment opportunities wherein speculation makes up a small part of the price of the asset. At The Buylyst, we work hard to look for these opportunities, so we’re never nervous about the clock striking midnight.

So, how do you determine whether you’re investing or speculating? You can’t. The best you can do – to remain in the game – is to minimize the speculative part of investing. It’s important to remain in the game to make massive returns. Remember, it’s not about timing the markets but about your time in the markets. That’s why we’re having this discussion. Otherwise, we can just bet of 20 WallStreetBets names and call it day. Chances are that unless you’re betting most of your net-worth on that “portfolio”, you won’t be very wealthy. At least I won’t. I’ve got to stick it out for a few decades.  

Insane run-ups like Gamestop, Tesla and Bitcoin will happen time and again. Most “investors” in these assets are speculators – they’re dancing in the dark because they’re looking for multi-baggers in the short-term – get in, get out, and buy a lambo. They don’t know when the clock will strike midnight. That’s a dangerous game that usually doesn’t end well for 99% of people – like gambling. We find it best to avoid these parties altogether.

The Price Stack

At The Buylyst, we’ve honed our process to find the blurry line between investment and speculation. Sometimes, this line eludes us but most of the time we find it.

Of course, there is a difference between investment and speculation – on paper. Investment means taking a long-term bet on an asset, betting that its price will increase proportionately with its fundamental value over time. Speculation is about bets on perceived value, betting that one should buy because others will think this is more valuable – classic FOMO. The difference between the two is in the layers of analysis. Speculation depends on number of votes. Investment is about weight.

“I have always found it easier to evaluate the weights dictated by fundamentals than votes dictated by psychology.” - WB

We’re not claiming that investing is superior, or that gambling is bad. We’re nobody to judge speculators or gamblers. If they make money, more power to them. But most don’t. Most are not looking for an adrenalin rush.  Most of us prefer to sleep well at night, and that means having a good enough idea about what an asset may be worth. FOMO is not our investment strategy. We’re not good at separating good FOMO from bad FOMO. But we are generally good at separating investment from speculation – as much as possible.

I thought pictures would make things clearer. I’ve drawn up some rough sketches that may help you out the next time you make an investment decision. We need to remember that this is not a science. It’s a framework. But it should inform you whether you’re primarily investing or primarily speculating. At a minimum, you should be asking the right questions.

Here’s how we see a typical market valuation (price) of a stock, any stock:

We’ve simplified this “Price Stack”, if you will, but these are the most important components. All market prices have these components in different proportions.

  1. Liquidation Value is just what’s left the firm is worth if all its assets are sold off and all its debts are paid off. The company shuts down and calls it a day. The closest metric we have for this is Book Value of Equity, which is found in the Balance Sheet.
  2. Present Value of Cash Flows is the slab that assumes the firm is a “going-concern” – that it will muddle along into eternity, not really growing all that much. Stocks of mature companies tend to This is stacked on top of the Liquidation Value because now we’re assuming the firm won’t have a “closing soon” sale but will continue to operate at current levels.
  3. Present Value of Growth is where we start stepping into Speculation territory. Estimating future growth of free cash flow is an investor’s main task. It’s hard. It’s quantifiable, but highly subjective. It’s always debatable. No two investors will agree 100% on this slab.
  4. Now, if we stack those 3 components on top of each other, we should have an approximation of the market price. But we often find stocks trading much above any conceivable sum of the previous 3 components. We call this part – the excess over Liquidation Value, PV of Cash Flows with no growth, PV of Growth – Speculation.  

Obviously, the most debatable component is #3 – Growth. Nobody knows how much and how fast any company’s free cash flow will grow into eternity. We all make our best judgment and estimate a “fair value” for a business and its stock. This is partial speculation – partial because it’s inconceivable that some companies won’t grow, so some growth must be factored in. It’s unrealistic to assume that Spotify, for example, will not grow over the next few years. But one can be very aggressive or very conservative in making these growth assumptions. Aggressive assumptions veer into Speculation territory.

Here’s a Price Stack of a stock that Mr. Market thinks will grow exponentially for a long-time:

At The Buylyst, we avoid these type of Price Stacks. We prefer the red, speculative component to be as small as possible. We prefer a Price Stack such as this:

This is as good as it gets. So, how do we pick out such a Price Stack from the, um, haystack? Recall that component #3 – growth – is the most debatable slab in the stack. This is our focal point. At The Buylyst, we try not to impose our estimates of future growth onto the company. Instead. we back-solve into the level of revenue growth we’d need to believe in order to buy the stock. This is called Expectations Investing. We’ve discussed it detail here.

An example may help. We had recently estimated that “we need to believe that Pinterest’s revenue will grow 440% for us to buy the stock”. This estimate was just the result of some algebra but when we initially saw it, we were almost sure that its Price Stack would have a lot of red in it. But when we dug into the story and broke down the numbers a little more, we (surprisingly) found a 440% revenue growth scenario (cumulative over the next few years) quite believable!

Here’s a page out of our Pinterest Thesis that depicts our belief in the Pinterest story.

In other words, Pinterest’s Price Stack, in our view, is predominantly green, not red. It’s more palatable. It looks something like the last one we had shown earlier:

Yes, all the lines between investment and speculation in the Price Stack are blurry. It’s hard to pinpoint exactly where investment ends, and speculation begins. The best we can do is to dissect what’s baked into current market prices and ask ourselves, “can we believe this?”. Our suggestion is to avoid big, red, speculative Price Stacks. Avoid FOMO. Avoid dancing in the dark. In the long run, you will sleep better, and you won’t be left holding the bag with pumpkins and mice.

Let us know how we can help you separate investment from speculation. The lines are blurry but over the last 2 decades, we’ve got better finding the thin line.

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