Speculation Vs Investment

Is your “long-term investment” just another form of speculation.

You buy an apartment or a house to live in or to rent it out and earn some income. It may give you great pleasure to check about the resale value from time to time but you have not bought the house to flip it over in a hot property market. (If you tried to do that in 1992, you made a bad investment. Over the next 13 years, chances are that checking the resale value would have caused you distress.) You may buy an orchard to take a walk in it. Or for the income the fruits would fetch you. But not to flip it over when nearby railway tracks are broadened and the land value of your orchard goes up. But shares are another matter. It is the only asset that we buy to flip, even long-term investors among us.

Your apartment has a market-determined value. Your orchard has a market-determined value. How about stocks? The problem about using market prices to value stocks is perilous. The question is, which price? The one that was quoted three weeks ago or the one that your broker quoted two minutes ago? What if the shares were valued, not for what the market is paying for them just now, but just as another income-generating asset like orchards and houses? Talking about an income stream from stocks may seem ridiculous when they bob up and down like turbo-charged puppets. But like it or not, seeing stocks this way, helps us understand the difference between speculation and investment.

Stocks, like many other assets, generate an income stream - just as your orchard and rented out property. How to determine a stock’s stream of income and from there how do we derive its actual worth? In financial theory there is something called Dividend Discount Model (DDM), which values stocks by the income they are expected to generate. It says that the value of a stock is the present value of its future earnings. Such earnings for shareholders come mainly in the form of dividends. Now the rate of dividend itself may change, in which case the shareholders earn more. So, the value of a share simply ought to be Dividend Yield + Dividend Growth. Is this all theory that only seems intuitively accurate or does it make any sense in real life? Look back at the largest and the most liquid market in the world, where this theory had a chance of being played out over a 100 years. The Dow Jones Industrial Average earned a return of 9.89% between 1900 and 2000. Dividend yield from stocks during this period was 4.5%. Another 4.5% came from growth in dividend rate. That accounts from 9% of the 9.89% return. So, in the end, the giant real life laboratory of Wall Street did produce exactly what the theory said it would.

There are several problems with the DDM model. One, it is really a very long term valuation tool. It cannot predict the value of a stock even a few years from now. There are other flaws too, which your finance textbooks will not tell you. DDM does not take into account the hugely positive impact of buyback's, splits and bonuses that cannot be captured by dividends. Nevertheless, it helps us focus our attention on a boring but logical way of valuing stocks - as financial assets to earn income from and not speculative assets to be flipped over.

How does a long-term investment for, say, 3-5 years, look through the prism of DDM? It may sound incredible but there is no logical tool to forecast returns for such short periods of “long-term investment”. So, even a long-term investment made for any purpose other than solely for its stream of income, is really speculation. The implication of this is ominous.

The line between “long-term investment” and speculation is thinner than you think.

“The market can stay irrational longer than you can stay solvent” - John Maynard Keynes
“One of the world’s most famous speculators, Warren Buffet, … .”
- Victor Niederhoffer in The Education of a Speculator

In the above paragraphs , we had discussed a tool that helps us determine what should be our long-term expectation from stocks. Long-term return is captured by the idea of Dividend Discount Model, which essentially means that you should expect stocks to fetch a total return that is the dividend rate plus the growth rate in dividends. But this has worked only over a very long term. There is no tool to pin down expected return over, a ‘shorter’ long term, say, three years. Can anyone really say what a basket of equities should fetch by 2008? We mean, anybody with a sense of accountability, not the TV pundits who are never asked to face their confident predictions gone embarrassingly wrong.

But aren’t there many well-known ideas about projected valuation and expected returns? Here is one, for instance. Since India will record a growth of 8% and inflation may be about 5%, the nominal growth will be 13%. This will be the minimum growth for the Indian corporate sector and the better ones will grow at 20% and so…. What is left unsaid are three (untested) assumptions. One, GDP growth automatically means equivalent corporate growth and more. Two, this will automatically lead to a corresponding reflection in stock price. Three, market is always fairly valued.

All three are myths. A GDP growth of 4.5-7% between 1994 and 2003 did not reflect in the corporate performance. Stock prices during this period had no relationship to GDP growth. And with the great wisdom that comes from hindsight, pundits now say that stocks were undervalued for much of this period. Similarly, another market myth is that high P/E stocks will fetch lower returns and low P/E stocks. We have proven the irrelevance of P/E in expected stock returns in the July 7 issue.

This piece is not about the myths of popular valuation methods. We will throw light on valuation myths in subsequent issues. We highlight these myths here only to illustrate the fact that the valuation tools widely used and propagated by the media, fetch random results. Keep a track of all the forecasts you see today to know what we are talking about. The more important point is, returns in stocks can be expected in a general way but cannot be anticipated within specific time periods. US stocks have delivered great returns over decades but the broad market index was totally stagnant between 1965 and 1982. Now, 17 years is 2/3rd of the equity investing period of an average individual. It cannot get any longer term than that.

If for 17 years, the market goes nowhere in the most market-intensive country on earth, then what happens to the cherished idea of “long-term investing”? Is long-term investing then simply another kind of punt on the future? Is this why Victor Niederhoffer, one of the most erudite and legendary speculators of the world, calls Warren Buffet, the supposed God of long-term investing and value investing, a speculator? Speculation is betting on an outcome that is random and uncertain. Often, both the process and outcome of long-term investing ends up being so random and uncertain that there remains no difference with a shorter term speculative bet. This is because of the behaviour of market participants, level of liquidity and so on - factors that have little to do with calculations based on which the long-term investment bet was laid. As Keynes said, the market irrationality can override investment rationality. Indeed, the best of speculators are aware of such irrationality and change their position quickly as opposed to the fixed systems of long-term investing.