No. of Recommendations: 8
Sorry to rush on to Chapter 4, but I'm going to be traveling for three weeks, and wanted to get this posted before I left. Also, I don't mean to be monopolizing the "chapter summary" market. I just happen to take notes while I read anyway, and it's not hard to summarize the notes for this forum.

Anyway, in Chapter 4, G&D attempt to define the difference between investment and speculation. In doing so, they don't seem to be attempting to chastise those who fall into the "speculative" camp. Instead, they seem to want to provide a definition so people are more aware that some stock and bond purchases are much closer to pure gambling than others.

G&D first state that at the extremes, it's easy to tell investment from speculation. US bonds (presumably bought at issue to be held to maturity) are risk free (in that they have a guaranteed preservation of capital with a guaranteed return), and are therefore the purest form of investment. (Note: G&D do not address the idea of "inflation based risk" for such guaranteed-return investments.) On the other side of the spectrum, common stocks trading at stratospheric multiples to earnings, or not backed by any reasonably calculable earnings, are obviously speculative. Again, G&D don't say it's wrong or immoral to purchase such issues, just that it is speculative.

G&D point out that it is not so easy to categorize many transactions as "speculation" or "investment" as one might think. For example:

- Some bonds can be more speculative than some stocks.

- Some purchases on margin can be safe investments. G&D point out that, outside of the stock and bond markets, only the safest enterprises are allowed to obtain loans, while speculative enterprises must pay cash. They indicate that this can work for purchase of stocks and bonds also. Making extremely safe stock or bonds transactions on margin is not inherently speculative (of course, the word "safe" is loaded.)

- A "Long Term Buy and Hold" philosophy can be extremely speculative if there is not sufficient evidence that the stock or bond will provide adequate return in the future compared to today's price. How many times have I thought, "I'll just hold this until I break even." G&D are pointing out that, in valuing a stock or bond, the past matters almost not at all; only the present and future matter.

G&D also express what seemed then to be a radical idea - that holding an issue for price appreciation rather than current income can be a safe investment. However, they point out that this idea diverged from logic during the late 1920's runup. People began basing "safety" purely on future earning potential, without solid support for such earnings, let alone any reliance on dividends or income to determine safety.

G&D do agree that some purchases based solely on future earnings can be safe investments, but even then, they refer to such earnings "accruing to the shareholders' credit." I am not sure if G&D are advocating that a company actually should hold such earnings as cash, or if they are referring to reinvesting such earnings, and in that way growing the business in order to return value to the shareholder in stock price appreciation and/or increased future dividends.

G&D go on to state that safety must be based on something other than psychology. It must be based on some rational, objective determination of value. With this idea, G&D seem to be addressing the speculative "greater fool" strategy, in which one buys an issue because one feels there will always be a purchaser out there who will pay even more.

So, what is a rational, objective method of determining value? G&D only state that a purchaser must determine that the price is justified by the company's "resources and earnings power." If the price goes above such standard, one should sell (or not purchase). G&D object strongly to the notion that the value of a company is its current market cap, as was widely espoused in the 1920s runup (and can be heard echoing through the halls of MBA programs again today as "Efficient Market Theory"). G&D state that such thinking was misguided because "carried to its logical extreme, it meant that no price could possibly be too high for a good stock, and that such an issue was equally 'safe' after it had advanced to 200 as it had been at 25."

With that said, G&D propose the following definition of "investment": An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.

You said a mouthful there, brother.

Why "investment operation?" Because, G&D indicate, an investment is not as simple as, or limited to, the purchase of a great company's stock or bond. It must be a purchase at the right price. A purchase of a great company's stock at too high a price is speculation.

Furthermore, an investment can consist of a series of purchases, such as purchasing a basket of stocks from a particular class of company. G&D give the example of purchasing stocks selling at far below book value because of some distressed situation. Purchasing one of these can be entirely speculative, but purchasing a basket, knowing that logically one will receive an adequate return overall, can be an investment. It strikes me that the modern "Gorilla Game" can be viewed as this type of strategy. Diversify in an industry where you know there will be lots of little losers and one or two enormous winners (to radically oversimplify the "Gorilla Game" strategy).

G&D also mention arbitrage transactions as being sound investments, even though they are extremely short term. For a good example of an arbitrage strategy, see woozler's Berkshire A vs. B arbitrage methodology:

G&D go on to discuss what is meant by "thorough analysis." This is a part of the chapter that I felt was somewhat incomplete and unclear. G&D seem to say that if one's thorough analysis results in a company being worth a heck of a lot more than it ever has been before, or that a company is worth a price that is a large multiple of earnings, one's analysis must be faulty. I think it is this kind of statement that branded value investing as "low P/E only" investing. As Charlie Munger has stated so many times, if a high P/E (or growth rate, depending on how you want to phrase it) is supportable, then damn it, it's justified.

G&D go on to define "safety" as being an investment where the amount invested is almost certain to be protected except under extremely unlikely circumstances.

Finally, after stating that "satisfactory return" is a purely subjective criterion, G&D feel the need to justify their assertion that common stocks, and an expectation of price appreciation, can be sound and safe investments. It shows how conservative a market can become after a speculative boom and crash.

There, I hope I added some value, and didn't simply summarize. These notes are no substitute for the real thing.

See you in three weeks. I hope we're into Chapter 7 by that point. Looking ahead to the next sections, I see our hike is about to progress from gentle foothills to steep, craggy mountains.

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