Value Investing vs. Business Investing

July 10, 2008 by Joe Ponzio

In his 1934 book Security Analysis, Benjamin Graham laid out the definition for investing versus speculating. In the 74 years since he and David Dodd penned the book, nothing in the definition has changed. That said, BPal asked a very interesting question. I answered it in the comments, but I figured I should post about it as well.

Ben Graham’s Definition

An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.

Let’s pick it apart.

An Investment Operation

As investors, we hope that everything we touch turns into gold. When a single investment turns sour, many people run back to the drawing board – buying books and scouring the internet for a new way to look at things. Buffett said,

You’re right because your facts are right and your reasoning is right – that’s the only thing that makes you right.

When speaking of “investment” versus “speculation”, Ben Graham was talking about an investment operation – the entire portfolio strategy, regardless of any particular investment therein. And look closely at Buffett’s quote. He doesn’t say, “You’re right because the price will go up and you’ll make money on every investment.” Instead, Buffett admits that some investments will go bad.

Good poker players know that it is crucial to make the right decision, regardless of how the cards fall or what the outcome would have been. Investing is no different.

Upon Thorough Analysis

You and I will invariably have different analyses. I look at the price of oil, and I have no idea whether it’s going to go up, down, or sideways. I don’t invest in oil. On the flip side, I had bought Graham Corporation at a price that I believed was well below its value. The markets had a very different analysis, which is why I was able to buy in the low-$30s.

A “thorough analysis” can only happen in your sphere of competence and confidence. That said, you are not wrong buying XYZ even if I don’t see the value, and vice versa. Prime example: A lot of Mohnish Pabrai fans followed him into Delta Financial which later went sour. Mohnish conducted a thorough analysis and invested. His investment operation is sound, regardless of the performance of Delta Financial or his recent price volatility. His followers bought with little more analysis than a “hey, if it’s good enough for Mohnish…”

It’s a silly strategy that leads to losses because you may end up as that follower that made every wrong move. When Pabrai bought Delta, or when Buffett was selling puts against the S&P, it was part of an overall investment operation based on how those investments fit into the portfolio upon a thorough analysis. Following them blindly and investing 20% of your portfolio in Delta, and then selling those S&P puts to recapture your investment would have been a double-whammy of big losses.

If, upon a thorough analysis, you have a reason to short oil, go long in gold, and stuff 50% of your portfolio under your mattress, you are not right, wrong, or speculating if your data and reasoning are right (and the conclusion leads you to believe that you are meeting Graham’s definition).

Promises Safety of Principal

Nobody likes to lose money; still, it happens. This is where a lot of people begin to get confused with Graham’s definition. Graham was speaking of an “investment operation” that promises safety of principal, even if some of the investments turn sour.

When Buffett lost more than a billion dollars recently selling puts against the S&P, it was part of his investment operation. The fact that a single investment – one made upon thorough analysis – went bad does not change the fact that he and Munger are the greatest investors of all time.

Graham’s “safety of principal” concept needs to be applied to the portfolio strategy as a whole. Otherwise, Buffett would never engage in workouts or other short-term strategies – there simply isn’t enough reward versus potential for loss when looking simply at the dollar-for-dollar gain/loss potential. But when you factor in the odds and make this a part of an overall strategy (that is, don’t put all your eggs in one basket), workouts and shorting bad businesses are no more or less “speculative” than buying discounted businesses when the markets hate them and there is blood in the streets.

And a Satisfactory Return

This also goes back to the “safety of principal” discussion. Why would you put all your money into two or three companies…or ten…or fifty…or a mutual fund that owns thousands? If your idea of a satisfactory return is beat inflation while minimizing volatility, a portfolio of bonds and index funds is wonderful. If you don’t see price volatility as risk and you can look at the big picture – the investment operation – beyond the performance of a single investment, you may hold just a few stocks and/or invest in workouts.

So, What Is “Speculation”?

There is no such thing as a speculative stock, just a speculative investment operation. If you do not know what to expect from your investment approach, you are speculating. While buying shares of General Motors at today’s price may or may not be speculative, it doesn’t mean that an investment in General Motors is necessarily speculative at any price. (At $100 a share, it’s speculative; at $0.00015 a share, it might be a real bargain. Hence, no stock is speculative; speculation and risk is in the price you pay.) I liken it to no limit texas hold’em: When you have pocket Aces against a single opponent before the flop, you are never wrong putting your money into the pot. That said, you will lose with that hand about one in three times over the long-term. And if you lose seven times in a row, does that mean you will win the eighth?

No. But you are still right in putting your money in, and it is a no-brainer.

What if you are dealt 9-8 against three players and a pot-sized raise? Doyle Brunson might choose to play it; I might fold. Is he speculating by playing, or am I speculating by not playing? I look at 9-8 in this situation, and I don’t know what the right play is;; so, I choose not to speculate and I pass. Doyle looks at 9-8 and knows what the right play is; so, he throws his money into the pot.

Speculation is 100% personal, and it arises when someone makes an investment in a manner that disqualifies his/her investment strategy from Graham’s definition.

Trading versus Value Investing versus Business Investing

Most people tend to see just two sides of investing – trading and value investing. In their definitions, traders seek to profit from short-term swings in the markets; value investors buy-and-hold stocks for many years (or forever). For traders, there is no tomorrow; for value investors, there is no today. The two should never cross; each views the other as speculative or ignorant.

There is a third school to investing: business investing. Business investors approach the markets as though everything was a private deal, and seek to profit from the foolishness and folly of others. We hold stocks for the long-term like value investors, but we also look for other business opportunities.

Workouts. We don’t look at workouts as “here’s a quick trade” situation. Instead, we play banker. All the paperwork is in order, the deal is about to go through at $30, but someone really needs to dump their stock today at $27.50. This late in the deal, very little is left to upset the applecart; so, we’re more than happy to loan out $27.50 if we can be paid $30 in short order. It’s like finding pocket Aces – they don’t always work, but they don’t always have to.

If you review the articles on Workouts, you’ll find that I don’t like uncertainty in the deal. I like virtually done deals offering attractive premiums. From Buffett’s 1986 Letter to Shareholders:

We continue to periodically employ money in the arbitrage field. However, unlike most arbitrageurs, who purchase dozens of securities each year, we purchase only a few. We restrict ourselves to large deals that have been announced publicly and do not bet on the come. Therefore, our potential profits are apt to be small; but, with luck, our disappointments will also be few.

Shorting. I don’t look at a $50 stock, value it at $35, and short it. (I’ve said it before – Don’t Go Short on Overpriced Companies) As a business investor, I look at a company on the brink of failure – a failure that Wall Street hasn’t yet recognized – and I make a business decision. When Buffett began shorting the US dollar in 2002, he saw a currency that was doomed to fall when the economy turned. If not for the real estate boom, he would have profited much sooner. Buffett:

I have no idea on timing. It’s far easier to tell what will happen than when it will happen.

Again, think of it in terms of the private business world. A small business owner comes to you and says, “My business is failing; we’re burning through way too much cash. To make matters worse, my credit is shot, I have no access to capital, and I’m up to my eyeballs in debt. To get out of this mess, we need to land $500 million in business in the next twelve months or our home-based VCR repair shop is going under.”

Then, he says something truly amazing: “Here’s $100,000. If I can turn this business around – if I can land $500 million of new VCR repairs – in the next twelve months, you give me $200,000. If not, just give me $10,000 and we’ll call it even.”

As a value investor looking to profit solely from long-term upward movement in business value and stock price, you’d pass. As a business investor, you’d look at this situation and weigh the odds – can a home-based, one-man, VCR repair shop go from $50,000 a year in revenue to $500 million in revenue in one year, particularly when nobody owns VCRs anymore?

Then, you ask him if he’d like to increase the offer.

Clearing Up The Misconceptions

If I lead people to believe that I was a value investor, I apologize. I am not. Nor am I a trader. I am a business investor. The goal of my investment operation is to seek long-term capital appreciation. Part of my strategy is realizing that price volatility is not risk (for portfolios or portions of portfolios invested for long-term growth). Running an investment operation outside your sphere of competence, with anything less than a thorough analysis, a promise of safety of principal and a satisfactory return, is risky.

We’re all going to see value (or no value) in different things, and we’ll all agree or disagree on a lot of things. Don’t worry if your data and reasoning does not agree with my data and reasoning, or vice versa. If you are not comfortable with workouts or shorting, don’t do it! But recognize that investing in workouts or shorting failing businesses is not speculative just because you may not feel comfortable with it. I have a friend making 100+% returns a year trading futures. He has explained his system to me and I know that he’s not speculating – he’s investing. I don’t understand it; so, I can’t do it. Furthermore, it scares the hell out of me; so, I can’t even bring myself to give him money to invest for me.

Remember: Investing is not about big returns; it’s about safety of principal and satisfactory returns – investing comfortably and confidently. Do that, and you’ll be amazed how delighted you can be with your portfolio.

A Note From Joe Ponzio

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