On Investment vs Speculation

I have mused in the past on the differences between investment and speculation. Some refer to the contrast as follows: an investment has the overriding attribute that growth in the underlying cashflows will generate a return for the investor; whilst a speculation has the overriding attribute that a change in asset price, mostly from other people’s appraisals of the value of the asset, will generate a return for the speculator. This is a nice summary, but there are grey areas in between, and it may over-simplify the (never entirely clear) differences.

In this post, Jason Zweig cites the following excellent quote from Fred Schwed to illustrate his view of the difference, “Speculation is an effort, probably unsuccessful, to turn a little money into a lot. Investing is an effort, which should be successful, to prevent a lot of money from becoming a little.” He goes on to make very valid points that the same asset can be an investment for one person and a speculation for another; the reasoning behind an investment decision is what differentiates an investment from a speculation.

I have been pondering the above as this year has been a very good one indeed. The portfolio grew by 89.3% over the year - from a still concentrated portfolio of 6-8 stocks. The nature of the investments could be accurately termed ‘unconservative’, but I do not believe that they were entirely ‘speculative’, even though the underlying future cashflows are subject to a high degree of uncertainty.

The reason that I do not deem either the individual investments to be entirely speculative, and more particularly the portfolio as a whole, is that - in my mind at least – for a reasonable range of future scenarios, the weighted expectations of fair values were all far above the share prices when the shares were acquired. Some factors left investors focused more on the downside risks, than the upside potential, to the point where, in my estimations, the probability-weighted fair values made the investments compelling.

And the next part is where I wonder if I may have an edge over the majority of other investors. It barely occurred to me, as far as I can recall, that concentrating my bets in investments with uncertain future cashflows and therefore uncertain future share prices was a particularly risky strategy. Quite the opposite, in fact. By owning shares in businesses that I deemed to be worth a lot more than I was paying, I felt that I was reducing the risks of losing money in the event that my analysis would be proved wrong; the essence of Graham’s ‘Margin of Safety’.

The other dilemma that this poses, is that having generated a return in a single year of close to 100%, it seems that I have truly entered the realm that Keynes termed ‘unconventional’, as part of the phrase that, “Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.”

In any case, and for whatever reasons, 2017 worked well. The risky stock mentioned in my last post tripled over the year. A reasonably large spread-betting business with a 24% FCF yield growing at over 20% a year almost tripled, including dividends (a bit less after withholding taxes) and other investments added to the overall return also.

And as to whether this may constitute the last year of writing on the topic of investment gains, the jury is out as ever. It would certainly be no bad thing to apply skills learned from my personal account investing to much larger pools of capital, helping institutions to achieve returns that compensate them for equity market risks. In fact it would be doing more for society than simply compounding the assets of my own family. However, it is hard to escape the idea that making outsized gains (20%+) over a long period of time would generate gains (even after appropriate fees) that should be highly attractive to those able to tolerate the vicissitudes of Mr Market’s fluctuations.

Using the Buffett fee model (no fees on the first 6% gain, 25% of gains above this paid as performance fees), a 20% underlying asset growth would translate to 16.5% gains after fees. Over 20 years of compounding this would generate profits on a £1m investment of £20m; an enormous sum vs expected returns on most equity funds. Perhaps this could be the plan, with 20% gross gains targeted over 20 years, starting in 2020. As at 28 January 2018, the portfolio has grown at an annualised rate of 29% over three years and 33% over five years, so even with less concentration, the idea of a 20% annualised gains doesn’t seem so far fetched.