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A multifaceted approach to value investing with stock valuation based on intrinsic value estimated from cash returns, appraised value of assets, and other facets of value.

 

 

Speculation versus Investment

The following is selectively exerpted from Part I "Speculation in the Stock Market" of The Theory of Investment Value, 1997, John Burr Williams.

Chapter I. The Difference between Speculation and Investment

1. Real Worth and Market Price. Separate and distinct things not to be confused, as every thoughtful investor knows, are real worth and market price. No buyer considers all securities equally attractive at their present market prices whatever these prices happen to be; on the contrary, he seeks "the best at the price." He picks and chooses among all the stocks and bonds in the market until he finds the cheapest issues. Even then he may not buy at all, for fear that everything is too high and nothing will give him his money's worth. If he does buy, and buy as an investor, he holds for income; if as a speculator, for profit. But speculators as a class can profit only by trading with investors, to whom they can sell only for income; therefore in the end all prices depend on someone's estimate of future income. Of investment value in this sense some men will make one estimate, others another, and of all the estimates only one will coincide with the actual price, and only one with the true worth.

2. Definition of an Investor. As will be shown later, the longer a buyer holds a stock or bond, the more important are the dividends or coupons while he owns it and the less important is the price when he sells it. In the extreme case where the security is held by the same family for generations, a practice by no means uncommon, the selling price in the end is a minor matter. For this reason, we shall define an investor as a buyer interested in dividends, or coupons and principal, and a speculator as a buyer interested in resale price. Thus the usual buyer is a hybrid, being partly investor and partly speculator. Clearly the pure investor must hold his security for long periods, while the pure speculator must sell promptly, if each is to get what he seeks.

In any science the choice of definitions is a matter of convenience. For reasons that will be given in due course, we shall see fit to define Investment Value, therefore, as the present worth of the future dividends in the case of a stock, or of the future coupons and principal in the case of a bond.

Chapter III. Marginal Opinion and Market Price

1. The Market for a Single Stock. Both wise men and foolish will trade in the market, but no one group by itself will set the price. Nor will it matter what the majority, however overwhelming, may think; for the last owner, and he alone, will set the price. The marginal opinion will determine market price.

7. Investors and Speculators. So far we have discussed a stock market for investors only. Bull or bear a man may be, and still be an investor rather than a speculator, so long as he looks to dividends rather than to price changes to justify the cost of his stock. There exists another large class of traders, however, made up of speculators, whose business it is to buy and sell for changes in price alone. To these speculators dividends are inconsequential because they hold for too short a time to receive many dividends.

To gain by speculation, a speculator must be able to foresee price changes. Since price changes coincide with changes in marginal opinion, he must in the last analysis be able to foresee changes in opinion. Successful speculation consists in just this. It requires no knowledge of intrinsic value as such, but only of what people are going to believe intrinsic value to be. Now opinion, when it changes, need not change for the right; it may change for the wrong, and the probability of a change for the wrong is about as great as of a change for the right. If opinion were not found in part on current dividends and changes therein, there would be nothing to prevent price and value from drifting miles apart.

How to foretell changes in opinion is the heart of the problem of speculation, just as how to foretell changes in dividends is the heart of the problem of investment.

Since opinion is made by the news, the task of forecasting opinion resolves itself into the task of forecasting the news. There are two ways to do this: either to cheat in the matter, or to study the forces at work.

Cheating has been outlawed, so far as can be, by the Securities Act of 1934, which tries to prevent insiders from gaining by foreknowledge of dividend changes, earnings statements, contracts let, etc., and requires these insiders to refund all short-term profits in their own stock to the treasury of their company. ... In having access to this inside information, officers and directors have a most unfair advantage over the host of ordinary stockholders. Only stupidity or indifference, on the one hand, or great scrupulousness or recklessness on the other hand, can prevent insiders from getting rich in the market, and all that the law itself can really do is to advertise the ethics of the problem.


No one man can hope to be an expert in everything, and if he ventures to speculate outside his own special field he takes the chance of finding that he has bet not with but against the experts, for which impudence he must pay dearly.

Note: A stock exchange that uses an open-outcry price auction system, such as the New York Stock Exchange with its specialists who keep a book of offers and bids on each stock issue, illustrates the intra-marginal buyer. The single highest bidder is just inside the margin and gets the number of shares of stock at the offered price in any true auction market. The next highest bidder for the same number of shares of the same stock at the same price is just outside the margin, the first extra-marginal willing buyer.


Greater Fool Theory

Another form of speculation is aptly named the Greater Fool Theory. It requires no information or at best information based on unscientific methods of divining movements in the prices of stocks. This theory explains those buy long or sell short transactions that are initiated by someone regardless of current quoted market price for a stock who believes that there is a greater fool somewhere who will take him out of his position at a price that will produce a profit for him. No deep analysis is required. A belief in any filter or other mechanical system to select stocks is sufficient to rationalize this manner of participating in stock markets.


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