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The difference between
investing & gambling
What is the difference between investing and gambling? Some people feel that there really is no difference. These are usually people who have done poorly in the stock market.The late Benjamin Graham defined an investment as a security purchase which promised safety of principal and a reasonable return. Any purchase not meeting this test, he regarded as a speculation (gamble).
His definition has two requirements: (1) the money you invest should suffer little loss even if the company fares poorly after purchase and (2) the investment return must be reasonable.
A bet in a casino violates the first requirement because you can lose all of the principal wagered. It also violates requirement two because a casino bet can return many times the sum gambled, which in the business world is an unreasonable return. Remember the average U.S. corporation earns about 12% on owner's money in a typical year. If an investment promises to return say 60% to 70% in one year, in Mr. Graham's view, that is too good to be true meaning that the risk is probably unacceptable.
A reasonable return, in recent U.S. experience, probably means an expected return of 5% to 30% a year. By the way, this idea is especially valuable when discussing bonds. If the average corporate bond is yielding 8%, one yielding 11%, with the same maturity, is probably a speculation. Retirees have really been hurt going for the highest yield available.
How can you be reasonably sure that an investment promises safety of principal?
There are several ways. The price paid must be low in relation to historical prices paid for that company's earnings, low in relation to other companies with similar earnings and low in relation to other similar bench marks. The idea is buy shares so cheaply any good news will drive up the stock price and any bad news will have little downside effect. This notion is sometimes called the margin of safety principle and is the most important idea in investing.
As the great investor, Warren Buffet (the only person to make billions of dollars investing in the U.S. stock market) says, some people understand that investing is about buying $1 in company value for 50 cents and some people don't. Several years ago, Bill Ruane, a founder of Sequoia Fund (and a friend of Buffet's) told a story about a securities analyst who when asked about a particular stock replied that there was nothing to recommend the company except it was cheap. I don't think this analyst really understood investing even though he made his living in the investment business. Finally, in my view, a proper subject for investing always involves purchase of an asset which either produces a stream of income or can be made to produce a stream of income.
You will note that this definition eliminates such assets as: collectibles, stamps, art and gold. I am not saying that you should never buy these things but rather they are not normally suitable as investments. In time of severe currency inflation, as recently happened in Mexico, gold would be an ideal hedge against the loss of purchasing power. People wanting to get their money our of Rhodesia, when currency controls were put in place, bought yachts, sailed away on "vacation" and upon arriving at their destination sold their boats and used the money to start a new life elsewhere. (Note: Currency controls limit the amount of money you can take out of a country.)
In these two examples, gold and the yachts represents efforts to store value or retain purchasing power rather than efforts to invest. It is interesting to consider an asset which does not always produce a stream of income but which can be made to produce a stream of income.
Farmland, which may lie fallow, can nevertheless be planted and produce an income stream. An asset which produces an income stream can be valued and compared with other income producing assets like stocks, bonds and timber tracts.
Let's assume a $100,000 investment in farmland can be made to produce an income stream of $5,000 (5%). This can then be compared with a U.S. Treasury bond paying 8% or $8,000. If we assume that farmland and U.S. Treasury bonds have the same degree of risk then they should have the same yield of 8%. In order for this to be true, the farmland would have to be priced at $62,500 ($5,000 divided by $62,500 equals 8%).
You may feel that the return on farmland should be adjusted for probable price increases due to inflation. Let's assume the average expected price gain is 3% per year so that the total return on the income producing farmland is also 8% (5% income plus 3% appreciation).
In this example, the farmland would be priced at the same price as the Treasury bond. Most people would feel that, in reality, investing in farmland is riskier than investing in Treasury bonds and therefore the farmland investment should return more.
Maybe the total return on farmland should really be 11% (5% income, 3% price appreciation and 3% for added risk). Under this assumption, an investor would still only be willing to pay $100,000 since we are assuming the farmland investment is riskier than Treasury bonds and the investor wants another 3% cushion for this added risk.
You will note that every income producing asset can be valued and compared with other income producing assets using this and similar methods. In each example, the asset in question is valued by making some kind of judgment about: the size of the income stream in relation to the investment, the likelihood that the income stream will be produced and the estimated future growth of the income stream (I ignored this last complication for the sake of simplicity in the discussion above).
The margin of safety concept always forces us to seek a price well below the estimated value determined by calculating and estimating income streams. Investing, then, is about buying income producing assets at what we feel are bargain prices.
Let's finish with a current example of a what appears to be an undervalued asset. The common stock of Frontier Insurance Group is selling on the New York Stock Exchange at $22 per share. Although earnings were reduced in 1994 by losses on medical malpractice insurance, I estimate current normalized earnings (stream) at about $2.20 a share. If this was an U.S. Treasury bond yielding 8% and the risk was the same, I would be willing to pay $27.50 per share ($2.20 divided by .08) for Frontier shares. Note that this calculation makes no adjustment for any future growth in Frontier's earnings. Value Line Investment Service estimates that Frontier earnings will grow at an average rate of 22.5% over the next five years.
Based on the industry and Frontier's profitability and growth, the common shares should probably sell for 14 times earnings per share. 14 times the current normalized earnings of $2.20 yields a price of $31. At a price of $22 this stock appears to be a bargain. THERE IS NO GUARANTEE THAT THIS INVESTMENT WILL WORK OUT AS PREDICTED.
Buying a portfolio of undervalued common shares like Frontier usually gives an investor an exceptional investment return.
About the Author
Marshall Delano is an experienced money manager. After working for serveral years as a stock broker, he managed private hedge funds investing in the U.S. stock markets for seventeen years. As a hedge fund manager, Mr. Delano shared in profits made from investing in the stock market. Since 1993, he has managed clients on a fee basis as a Registered Advisory Representative.
Mr. Delano has served as the Managing Partner of partnerships organized to invest in the stock market. He has also served as President of Registered Investing Advisory firms and is currently President of the Advisory firm, S.G. LONG & Company. His education includes a Bachelor's Degree in Economics and a Masters Degree in Business Administration.
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