Between September 1946 to February 1947, Benjamin Graham gave a series of lectures at the New York Institute of Finance. The transcripts of these lectures were recorded in full and were published in the book, The Rediscovered Benjamin Graham: Selected Writings of the Wall Street Legend. This article is devoted to the 10th lecture in the series in which Graham focuses on the topic of investment vs speculation.
Benjamin Graham On Investment vs Speculation
Investment and speculation are separated by a blurred line. Trying to discern between investment vs speculation is relatively easy for some investments/speculative activities, but for others, it’s more difficult. Generally, an asset that generates a stream of cash flows can be called an investment where as buying an asset in the hopes that its price will rise can be defined as speculation.
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Graham begins his lecture by stating that there are three points he plans to make throughout the hour. Firstly, that "speculative elements are of some importance in nearly all the work of the security analyst." Secondly, he notes that there is a real difference between "intelligent and unintelligent speculation." And thirdly, Graham comments that in his view, the current attitude (of the late 40s) towards speculation is "unsound and unwholesome" because emphasis tends to be placed on "the rewards of successful speculation rather than on our capacity to speculate successfully."
After setting out his goals for the rest of the lecture, the godfather of value investing goes on to describe the difference of investment vs speculation as detailed in his first book, Security Analysis:
“An investment operation is one which, on thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.
That is a very brief reference to speculation. We could amplify it a bit by saying that in speculative operations a satisfactory result cannot be predicated on the processes of security analysis. That doesn’t mean that speculation can’t be successful, but it simply means you can’t be a successful speculator in individual cases merely by following our methods of security analysis.
Speculative operations are all concerned with changes in price. In some cases, the emphasis is on price changes alone, and in other cases, the emphasis is on changes in value which are expected to give rise to changes in price. I think that is a rather important classification of speculative operations.
I think it is clear to you that in a converse sense nearly all security operations which are based essentially on expected changes, whether they are of price or of value, must be regarded as speculative, and distinguished from the investment.”
After laying out these ground rules, Graham goes on to give some examples of investment vs speculation, one of which is General Electric which he first valued in 1939. An analysis of the company showed that it was worth around $25 share, however, with the stock trading at $38 in the market, Graham believed there was a $13 per share speculative element attached. As the lecturer described:
“Hence in this very high-grade issue, about one-third of the average price in a more or less average market represents a speculative appraisal.”
Investment vs Speculation: The world has changed
Graham first arrived on Wall Street in 1914, when the investment world was very different to what it is today. Even in the late 40s, the differences between when Graham first arrived and the current period were significant. In the lecture, he notes that when he first came to Wall Street, there was almost no speculative element in securities instead, the security’s price was based on, “an established dividend. It fluctuated relatively little in ordinary years. And even in years of considerable market and business changes the price of investment issues did not go through very wide fluctuations.” With such bond-like traits, it was “quite possible” for investors to “disregard price changes completely, considering only the soundness and dependability” of the dividend return and “let it go at that.”
Today, the market is a world away from what it was more than 100 years ago. Indeed, based on the above criteria, Amazon and Berkshire Hathaway, probably the two best investments in the market today, would be considered speculative due to the lack of a dividend. With this being the case, today Graham’s first point in the lecture “speculative elements are of some importance in nearly all the work of the security analyst” is more relevant today than ever. His second point, distinguishing intelligent from unintelligent speculation, is also more relevant today than ever.
On this topic, the godfather of value investing offers the following guidance:
“Intelligent speculation presupposes at least that the mathematical possibilities are not against the speculation, basing the measurement of these odds on experience and the careful weighing of relevant facts.”
What Graham is saying, is that intelligent speculation can be justified if is backed up by sound reasoning, such as the expectation that the company can continue to compound earnings at a steady rate for the foreseeable future. If probabilities of success are “definitely in favor of the speculation”, then the intelligent speculative activity can be transformed into “investment by the simple act of diversification.” Put simply, Graham believed speculation was all right, as long as the odds are on the side of the investor.
Graham’s third and final point on investment vs speculation is also still highly relevant today. The final subject is the attitude of security analysts towards speculation. Even though Wall Street analysts know they need to incorporate a degree of speculation in their forecasts, they can be swept up by the prevailing market sentiment and forget what experience has taught them.
“We all know that if we follow the speculative crowd we are going to lose money in the long run. Yet, somehow or other, we find ourselves very often doing just that. It is extraordinary how frequently security analysts and the crowd are doing the same thing. In fact, I must say I can’t remember any case in which they weren’t.”
Graham goes on to say that the reason why he believes the so-called speculative crowd ends up being misled is because each investor and analyst believe that their growth projections are better than everyone else’s. Unfortunately, this is just not true. The problem is, with so many highly skilled people working on Wall Street, the market “already reflects, almost at every time, everything that the experts can reliably say about its future.” This is a hat tip to what later would become known as the efficient market theory.
Instead of trying to forecast what the future may hold for the market and its constituents, Graham tells his students that they should instead focus on “the purchase and sale of securities by the method of valuation.” Such an approach “requires no opinion as to the future of the market; because if you buy securities cheap enough, your position is sound, even if the market should continue