Investment vs Speculation

A year and few months ago, I had a chance to meet Mr. Warren Buffett (The GOD of Investments) in Taj Palace, Delhi on March 25, 2011. It was the inauguration of his auto insurance agency business in India and whoever had purchased insurance on one’s car through Berkshireinsurance.com was eligible to be a part of the conference. Throughout the conference, Mr. Buffett was sitting in his chair with his reinsurance business head Mr. Ajit Jain answering questions about investments, economy and finance from journalists and audience. However, one of the interesting things to remark was the cans of coca cola on the table where he and his colleague were sitting. Buffett owns about 9% in coca cola and it is one of his most lucrative investments till date which he still owns since 1988 and does not mind advertising about it.

This is what I would call as an investment. The stock has withered through the recessions and the booms in the economy, has been overvalued and undervalued at times, but has made Buffett earn a great deal through dividends and appreciation in its value over time. Thus, investment can be defined as

An asset class being held for some amount of time and using that asset class as a source to earn sums in the form of interest, dividend or other forms of yield from that asset class along with safety of the purchase value of that asset class or appreciation in its value over the period of time held.

The above definition gives light to two most important aspects of investments –

·        Using the asset class as a source to earn interest, dividend, etc.

·        Safety of the principal value of the asset class along with reasonable chance of appreciation in its value (which is more important in case of asset classes not being fixed value investments).

Money put in any asset class not following the above two principles cumulatively would be regarded as speculation. Thus, investment and speculation are totally different galaxies in the universe of a financial market player. The two are as different as two sides of the same coin and should not be confused by the market player. In this article, we would restrict our focus on stocks and shares of the companies as the same are most highly traded financial instruments among retail players. Accordingly, as regards stocks and shares, we have to analyse few important factors in making sound investments viz. business stability and growth, asset structure, long term liabilities, cash flows and most importantly value at which the stock or bond is available. However, speculation would ignore all the above factors and concentrate on whole new set of factors like open interest, trend analysis, support and resistance levels, momentum in the market, etc.

One should not consider any bias towards investment or speculation while operating in financial markets as both give ample opportunities to make super normal profits in the long run. However, with speculation one has to be careful as it involves a degree of risk that an ordinary small market player may not be willing to take considering the small size of his portfolio and psychological fear of losses. Interestingly enough, these small market players are the ones that indulge in maximum “stupid” speculation and later on pay the price by suffering huge losses and vowing never to come back to the market (eventually the gambling streak in them makes them come back within 2-3 years).

One thing to note here is that speculation is not always “stupid”. “Stupid” speculation takes place when one intends to rely on intuition, rumours and advice from uneducated brokers (whose only job is to make you crack that deal so that they can earn their meal for that month). Speculation may also be intelligent speculation where the speculator takes the risk after weighing the pros and cons of the same. Eg. A stock falling for 3 straight sessions while its open interest has shot up would be in for a trend reversal in the fourth or fifth session and thus, an intelligent speculator would buy the stock and offload the same from his portfolio the moment his target is achieved. Unlike an investor, he would not enter into a relationship with the stock but would be fine with a short term fling and take the profits off the table. However, intelligent speculation usually involves vast amount of experience in the market and acumen to understand complex financial facts and figures much faster than ordinary crowd.

Thus, investment and speculation turn out to be two different fields. What is important is to segregate the portfolio and keep money aside for 3 things –

1.     Investments

2.     Intelligent and careful speculation (short term trades)

3.     “Stupid” speculation or gambling

Though as a focussed financial market player, I would not advice the last part but it is human tendency to gamble and ride on luck which cannot be avoided at any cost. However, what can be done is minimal amount should be kept for the same which should not affect the market player in any manner (psychologically or emotionally) if the same is lost due to “stupid” transactions. The market player should strive to be an intelligent speculator and investor both.

I would like to reiterate the fact that intelligent speculation would need vast amount of experience, skill and IQ level and thus, should be restricted to a few people only. Intelligent investment, on the other hand, is more of an art rather than an exact science. It would need a fair ability to analyse the following –

·        Business dynamics of the company,

·        Comparison with peers,

·        Understanding the financial health of the company (through analysing cash flows, long term liabilities, investments made, etc.),

·        Organic and inorganic growth prospects of the company,

·        Quality and integrity of the management,

·        Political and economic scenario in which the company is operating

After analysing the above, we should consider a situation as if we owned the whole company and wish to sell the company to some outsider (without considering the brand value and goodwill that we may have earned over time). Accordingly, we should arrive at a value for the Company and by dividing the same by the number of shares, we can arrive at a per share value. If the stock is trading at a value lower than that analysed, we should go ahead and buy the same.

While making sound investment decisions, the two main problems people encounter are the following –

1.     They first look at the value of the stock and then start analysing the company critically. This leads to bias in the mind of the investor and leads to his finding a value that is not commensurate with the analysis mentioned above.

2.     Sometimes the stock tends to remain undervalued for a long time (maybe for years on end) and the investor loses patience. No doubt market sometimes tends to ignore good stocks and they remain hidden gems for long but this should not be the reason to shun sound investment analysis and look for momentum driven and speculative stocks. The market player should be patient enough as investments require a very long time horizon which may, many a times, run into years.

In the end, I would like to conclude that while making any financial market decisions, one should remember the concept of Mr. Market in the famous book “Intelligent Investor”. The concept is stated as below –

Imagine you are partners in business with someone named Mr. Market who is very obliging indeed. Every day he comes to your door and tells you what he thinks your interest in the business is worth and furthermore offers to buy you out or to sell you an additional interest on that basis. Sometimes his idea seems justified by the business developments and prospects while at times, he lets enthusiasm or fears run away with him and propose absurd value. The fun part is that if you refuse to trade your business interest with him or buy more interest from him, he would come back to you the next day with a different value for it. Thus, you may be very happy if the business interest is sold at the value you want to sell it or if Mr. Market is enthusiastic, at a higher value. Without doubt, you will be happier to buy some interest in the business from Mr. Market if he is sad and depressed and want to sell you the same at a very low value. However, the rest of the time you will be wiser to form your own ideas of the value of your holdings, based on full reports from the company about its operations and financial position.

Exactly the same is stock market; a place where not the market, but the financial market player has to make the right choice of buying, holding or selling the stocks while speculating or investing.

Structural Problem with Eurozone (Currency Crisis)

Euro, the official currency of Eurozone, is the second largest reserve currency and the second most traded currency in the world after the United States Dollar. The Euro is managed and administered by the Frankfurt-based European Central Bank (ECB) and the Eurosystem (composed of the central banks of the eurozone countries). As an independent central bank, the ECB has sole authority to set the monetary policy. The Euro has been adopted by 17 out of 27 member states of the European Union (EU) and the rest of the states have chosen to retain/ adopt their independent currencies.

However, despite the huge amount of planning by several economists and financial market experts alongwith the European lawmakers that led to the creation of Euro, Eurozone is now witnessing one of the worst currency crisis that could not have been imagined at its inception. This crisis had its seeds sown way back when the EU was created.

The currency Euro was never intended to be created keeping in mind the different political and social landscape of the countries participating in it. It was created as a facilitator in trade between the nations of the union and also with other countries of the world. In other words, it was a monetary union without a fiscal union (consisting of common taxation, pension benefits and treasury functions). Fiscal related law-making and monetary policies have to go hand in hand to create conducive atmosphere for a stable economic climate in the country. Seeing the situation of Greece and Spain on one hand and Germany and Netherlands on the other hand show us the vast difference in the economic landscape post the introduction of Euro.

Besides above, there is also no banking union to support the troubled banks in downgraded economies or banks owning huge amount of toxic debt from countries like Greece. However, a proposal for the same is under way to create a proper banking union to support the monetary union. Banking union would create an agency or body which would create greater integration among the member states of EU in the sense that the following can be introduced viz. bank deposit insurance, bank oversight, joint means of recapitalisation (injecting funds to meet short term obligations and resume the cycle of lending) or wind down of failing banks. Thus, a failing bank of Cyprus having huge exposure to Greek debt can be recapitalised. This way, the creditors of the bank in Cyprus do not have to worry a great deal and can settle for a minor haircut rather than an all out default. In other words, the financial contagion can be averted greatly. However, inflationary pressures can be a major risk due to excess liquidity.

Furthermore, the 17 nation currency union suffers from a problem of quick response. Every decision making process entails a unanimous agreement and not just a majority vote. This is quite justified also as a majority vote in the favour of easy monetary policy by many troubled EU nations can spell havoc for a current account surplus economy like Germany (which is one of the few nations in the EU at an extremely favourable position with long term interest rates less than 1.5%).

Among the other structural problems with the Eurozone is the inflexible single monetary policy. Individual member states cannot print money independently. In other words, they cannot create excess money supply in the economy leading to devaluation of their currency to make exports competitive and improve trade balance leading to higher and stable tax revenues. This is evident due to 17 nations following one single unit of currency. Though structurally, if the countries had different currencies, the Greek drachma would be trading at less than half the value of the Euro while the German Deutsche Mark would be far higher than Euro considering the stability of the economy and one of the lowest yields on its bonds.

Thus, the above mentioned problems clearly cast a doubt on the stability of the Euro as a currency. However, it is not only in the interest of Greece and Germany but in the interest of the entire world that Euro is not broken and no member nation exits the currency. This is because the exit would not only create huge financial ramifications and uncertainty in the foreign exchange market throughout the globe but also would hamper the confidence of an investor in global financial markets leading to a situation where Lehman collapse would seem like a walk in the park.