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Speculation - a flawed investing strategy

Long term investors like to loathe traders and speculators because the latter is often viewed for buying into something they have no idea what they are getting into. They see them as gamblers or investors in the biggest casino in the world. But for this hypocritical view, I will explain why investing can easily be viewed as a speculation and these investors are just bad as some of the stock gamblers.

To quote from The Intelligent Investor, Benjamin Graham wrote: “An investment operation is one which, upon thorough analysis promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.”

“I invested into this consumer stock that gives steady dividends and has a reasonable PE ratio."

As much as this may seem clear that this is Investing but it can easily be just another speculative investment. Too many investors have just based on simple analysis such as a company has been paying steady growing dividends in the past 20-30 years and using this as a reason for investment. Unfortunately the Great Recession or the credit crisis of 2008-2009 enlightened us that is far from the truth. Financial companies such as Citigroup, Bank of America and General Electric have all paid these steady dividends over the years, however during the last crisis, when all the skeletons have been shoved out of their closets, we can only learn that investing with the unknowns is just as speculative.

“I am buying into this stock that Warren Buffett owns a considerable amount in it”

The notion of investing alongside some gurus, well known hedge funds or great investors is no much less a Speculation than investing.It may be a feel good investment for you simply because someone you trust or has a great long track record. Unfortunately, these guru investors are just as faillible as we all are. It’s just human nature.

I can think of two recent stocks that have suffered badly. One is Kraft Heinz (KHC) from Warren Buffett and Bausch Health (BHC and formerly known as Valeant Pharmaceutical) from Bill Ackman. I greatly admire these two investors as they are geniuses in the world of investments. Unfortunately, both of them fell on their own traps of being complacent in trusting others to do their own investment due diligence. In the case of Kraft, Buffett trusted greatly in 3G’s Jorge Lemann’s track record and had previously profited handsomely in his Heinz’s investment. As for Bill Ackman, he was relying on insider information and not listening to warning signs that were presented to him. In both cases, these two investors have strayed away from their usual investing strategies.

“After doing my fundamental analysis of this company, I am investing into this solid company with a reasonable current PE ratio.”

Up until Covid-19, this would normally be viewed as a sound investing strategy but the pandemic has taught me a lesson about this flawed strategy. True investment or valuation of a company is to figure the value of a company from it’s discounted future earnings and often relying on heuristics, investors use a simplified form of it by using PE or price-to-earnings ratio as a quick rule of thumb. By using this quick rule, we have also eliminated the risk that future earnings can be lumpy and not easily predictable.

“This company is worth investing into as their projected earnings and sales are expected to rise by 15% and 5% a year respectively over the next 10-15 years.”

You have no idea how often I hear investors speak in such a manner before I start rolling my eyes. I am not sure how one person has the ability to predict what the sales or earnings would be in 10 years, let alone 2- 3 years from now. Unfortunately, this investing idea is deeply entrenched in our schools and financial books.

Take a look at Pfizer (PFE) or many of the major drug companies when these investments were considered as no brainers with sales and earnings growing at double digits annually during the 90s. Unfortunately, all these came to a halt after the dotcom bust in the 2000 after when the industry experienced a patent cliff. Drug makers saw their revenues fall off as their drug patents wore off and they did not have new multi-billion dollar blockbuster drugs in the sales pipelines while generic drugs were becoming a threat to their business models. Many investors fell into this trap as their expectation of these companies in the past 2 decades would be the same in the coming decade.

The lost decade of Microsoft. In the decade going into the millennium, Microsoft was a growth stock that has made millions millionaires. It was a no brainer growth company and yet from 2000 to 2013, this stock has just stagnated and went nowhere. Much of the blame was focused on the CEO Steve Balmer who has lost the vision of the company of sailing the ship into the 21 century. Yet he did a phenomenal job in growing the company into the server business, not withstanding the many unfortunate failed attempts to make money on the internet business. To his credit, during his tenure as a CEO from 2000 to 2014, he grew the earnings per share from $0.85 to $2.50 and sales from $23 to $75 billion (both at about 9% a year). Sadly, no institutional investors appreciated Balmer during his entire term and the stock traded between $25 and $30. As a consolation to those loyal investors, Microsoft started paying their first dividends in 2003 and by 2014, it was yielding 2.75%.

"A low-cost index fund is the most sensible equity investment for the great majority of investors...By periodically investing in an index fund, the know-nothing investor can actually out-perform most investment professionals" Buffett told Bogle in his book "The Little Book of Common Sense Investing.

As a food for thought before I end this blog, currently the entire tech sector within the S&P500 index represents close to 50% of the entire market capitalization of this index. Do you see how badly it can end for many of these “know-nothing investors”?

The moral of this blog today is the illusion we put ourselves sometimes to think that we are Investing and more so than we would like to admit, we are just as much as speculating with hopes than with reason.

Perhaps in my future blog, I would show what true investment means and it will not be taken from the usual off-the-self investment books or blogs of what investments are often defined as.

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