Gary Smith writing for the American Association of Independent Investors in an article entitled “Three Value-Investing Benchmarks” has a nice definition of investing verses speculating:
Decades ago, investing was haphazard. Investors figured that a stock was worth whatever people were willing to pay. Then John Burr Williams unleashed a revolution by arguing that investors could use something called present value to estimate the intrinsic value of a company’s stock.
Think of a stock as a machine that generates cash every few months—cash that happens to be called dividends. The key question is how much you would pay to own the machine in order to get the cash. This is the stock’s intrinsic value. People who think this way are called value investors.
In contrast, speculators buy a stock not for the cash it dispenses, but to sell the stock to others for a profit. To a speculator, a stock is worth what somebody else will pay for it; the challenge is to guess what others will pay tomorrow for the stock you buy today. This guessing game is derisively called the Greater Fool Theory: Buy stocks at inflated prices and hope to sell to even bigger fools at still higher prices.
Legendary investor Warren Buffett has this aphorism: “My favorite holding period is forever.”
If we think this way, by never planning to sell we force ourselves to stop speculating about stock prices and focus on the cash generated by the money machine over an indefinite horizon. If you do, you will be a value investor—and glad of it.
It is easy to confuse a promising company (whose stock has been bid up too high) with a good investment. It is also easy to under value a company that quietly continues to print money for its shareholders.
Smaller companies that you have never heard of usually have a better return than the better known larger companies. And value companies generally do better than growth companies. And better still is using a dynamic valuation tilt to over invest in the categories which are currently undervalued.
And of course that often means the contrarian action of buying more of the category which has gone down and selling some of the category which has gone up.
Photo by Scott Rodgerson on Unsplash