Security Analysis Chapter 4 Summary

Reading: Chapter 4—Distinctions Between Investment and Speculation

One Minute Summary:

The chapter distinguishes the differences between investment and speculation operations. Acquiring an asset will only be considered as an investment when the reasoning to purchase is based on “the study of facts in light of established standards of safety and value.” The standards of safety and value should be based on tangible data with assurance that the purchased asset will have sufficient resources and earning power to promise the safety of the initial investment, with any amount of return that the investor is willing to accept.

Chapter in Detail:

The chapter analytically examines the common distinctions between investment and speculation and offers a sound concept for the definition of investment.

The following chart summarizes the commonly accepted distinctions between the two terms; however, these criteria should not be applied as the difference between the two:

Investment	Speculation
1. In bonds.	In stocks.
2. Outright purchases.	Purchases on margin.
3. For permanent holding.	For a “quick turn.”
4. For income.	For profit.
5. In safe securities.	In risky issues.

Why they should not be used to generalize the two terms:

1. Bonds vs. Stocks. – Poorly secured bond could be categorized as one of the most utterly form of speculation; common stocks can be rated as investment quality.

2. and 3. Outright vs. Marginal Purchases; Permanent vs. Temporary Holding. – The purchase method or intention does not make the transaction an investment. The speculator could be buying a penny mining stock outright and plan to hold it permanently; such operation is still speculative after all.

4. and 5. Income vs. Profit; Safety vs. Risk – A focus solely on income does not make the transaction an investment because profit for strong enterprises could rise steadily over the years and compensate the investors by higher share price. With the fifth distinction, safety should be judged in tangible data, as well as time tested standards, and not based on the current market psychology. An overpriced security is risky no matter how safe it appears relative to its comparables.

The proposed distinction between investment and speculation is as follows:

“An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.” This can also be coined as an “Analyst’s investment.”

And

“An investment operation is one that can be justified on both qualitative and quantitative grounds”

Any planned purchase that cannot qualify as an “analyst’s investment” is automatically considerate as a speculative operation.

New terminology / Concepts / Ideas / Technical Items / Useful Examples:

1. Analyst’s Investment – Operations that, upon thorough study, promise safety of principal and an adequate return.
2. Sheltered Investment – Securities regarded as subject to small risk by reason of their prior claim on earnings or because they rest upon an adequate taxing power.
3. Intelligent Speculation – Taking of a risk that appears justified after careful weighing of the pros and cons.
4. Unintelligent Speculation – Risk taking without adequate study of the situation.
5. Standards of Safety – Resources and earning power of an institution is sufficient to cover the investor’s contribution.

Issues Disagree With:

If a business has demonstrated outstanding relationship with its customers, labour, and/or suppliers, an analyst should consider this intangible qualitative factor as part of his or her test for standards of safety.

Practical Application:

1. Avoid the Chinese stocks that are trading at multiples of 50 and above.

2. Utilize online resources such as Capital IQ and EDGAR to access industry and company profiles for fact findings.

3. Document the analysis and the reasoning of safeness.

Three Quotes:

1. “It is important to recognize that such value (“intrinsic value”) is by no means limited to “value for investment”…, but may properly include a substantial component of speculative value, provided that such speculative value is intelligently arrived at. Hence the market price may be said to exceed intrinsic value only when the market price is clearly the reflection of unintelligent speculation.”
2. “The concept of safety can be really useful only if it is based on something more tangible than the psychology of the purchaser. The safety must be assured, or at least strongly indicated, by the application of definite and well-established standards.”
3. An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.

Three questions to the group to test understanding:

1. What are the types of “investment”?

2. What is the relation of the future to investment and speculation?

3. What would be considered as standards of safety?

Clarifications & Group Discussion:

1. Is speculation wrong?

2. How to determine if an operation is an “intelligent speculation”?

3. What should be considered as “Standards of Safety”?

4. What would be considered as an adequate or “thorough” analysis?