Geoff Gannon November 14, 2017

Why Smart Speculations Still Aren’t Investments

I got an email in response to my earlier post about the line between investment and speculation. It’s a good email, so I want to quote it in full:


Really interesting post today, but I was wondering how you would evaluate the Weight Watchers (WTW) situation. 


It seems like an investment that turned into a speculative situation.


I think there are a couple of cases like this where a seemingly safe investment turns into a very speculative situation. Fossil (FOSL) is another one that comes to mind. Even though it had some debt, nobody would think that it would have an existential crisis at some point due to changes in business and the weight of its debt. I don’t think anybody would have called it a speculation 3 years ago at over $100 a share. But on the other hand, it’s speculative now at under $7 a share.


On the other hand you have situations like Facebook (FB) which IPO’d at an extremely speculative price but the business turned out to be so strong that even at that price, it morphed into an excellent investment had the margins not expanded so much.


I’m not saying that’s the case for Amazon or Netflix today, but maybe it’s not so easy to distinguish between investment and speculation in some cases because there are factors that we cannot foresee or do not yet understand. If you have the knowledge that it’s almost certain the company will grow into and beyond the current valuation, then perhaps it would be a good investment at what others may consider to be a speculative price. 


If you know that a business could potentially come under hard times and the modest amount of debt it has could compound the problem, then a company with a very modest valuation may morph into a speculative stock at even 1/10th the original price a few years down the road.


In the end, a lot of it depends on what you really know I think.”


George Orwell wrote an essay called “Politics and the English Language”. One passage from that essay is helpful to quote here:


The word Fascism has now no meaning except in so far as it signifies ‘something not desirable’. The words democracy, socialism, freedom, patriotic, realistic, justice have each of them several different meanings which cannot be reconciled with one another. In the case of a word like democracy, not only is there no agreed definition, but the attempt to make one is resisted from all sides. It is almost universally felt that when we call a country democratic we are praising it: consequently the defenders of every kind of regime claim that it is a democracy, and fear that they might have to stop using that word if it were tied down to any one meaning.”


The word “democracy” has an actual definition, etymology, and history we can trace. The etymology is Greek. It means literally something like “people-power” or “people-rule” in the sense of “the people” as a group and not “people” as individuals (persons). The history is Athenian. The term “democracy” is first used to describe the government of Classical Athens specifically in opposition to monarchies, tyrannies, and “mixed” governments (what we’d now call “republics”) like Sparta, Carthage, and Rome.


In the modern, Western world the term “democracy” is almost universally considered positive. And two of the most commonly copied systems of government, those of the U.K. and the U.S., like to refer to themselves as democracies. But neither has much in common with the government of Classical Athens. And when being precise, we modify the “democracy” of the U.K. by saying it is a parliamentary democracy and we modify the “democracy” of the U.S. by saying it is a federal, democratic-republic.


The knee-jerk definition of democracy is “good”. The sloppy definition is “like the U.S., U.K., etc.”. The precise definition is “like the government of Classical Athens, only those elements of the U.K. government which are not specifically parliamentary, only those elements of the U.S. government which are neither specifically federal nor republican.”


In other words: we are capable of thinking about democracy very quickly and fuzzily (all heart no head), somewhat quickly and fuzzily, or very slowly and sharply.


We can think about investment and speculation the same three ways.


As value investors, our knee jerk definition of investment is “good, right, sound, what I do, etc.” and our knee jerk definition of speculation is “bad, wrong, risky, what everybody else does, etc.”


We equate speculation with gambling. But, true gambling is different from speculation just as true speculation is different from investing.


Let’s think slowly and sharply about “investing” and “speculation”. What is the definition, etymology, and history of these two terms?


In my last post on the line between investment and speculation I cited a post by Richard Beddard which in turn cited “The New Speculation in Common Stocks” by Ben Graham. You can google “The New Speculation in Common Stocks” and find a PDF of Graham’s speech.


Graham’s point was that investors had bid up the price of some common stocks enough that though the firms themselves had been investments, they became speculations at this higher price. In that talk, Graham introduces the term speculation by saying:


“The dictionary says that ‘speculate’ comes from the Latin ‘specula’, a look-out or watch-tower. Thus it was the speculator who looked out from his elevated watch-tower and saw future developments coming before other people did.”


Graham had earlier defined investment and speculation in his 1934 book, Security Analysis:


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


The other definition that I would offer is that if investment is in some sense an antonym of speculation – if speculation is rooted in the future, then investment must be rooted in the present and the past.


In other words, an investment is a stock purchase that can be fully justified on the evidence provided by the current financial position (balance sheet) and past earnings record (income statements and statements of cash flows) of the business.


A speculation is an operation that can’t be fully justified on the evidence provided by the current financial position and past earnings record of the business.


I am not making a distinction between quantitative and qualitative factors here. I am making a distinction between a business’s recorded history and its projected future.


Let me quote from another email I received about the line between investment and speculation:


“…this was the worst (post) I ever read from Geoff…I don’t think he understands Amazon at all…and it is obvious that he has not tried to objectively analyze Amazon. I think there is a real chance that OMC is more speculative than Amazon…I actually think Amazon looks cheap and I consider myself a hardcore value investor. You probably think I’m crazy so I’ll stop right here.


I don’t think the person who wrote that email is crazy. And if he had said “I think there is a real chance that Amazon stock outperforms Omnicom stocks” instead of “I think there is a real chance that OMC is more speculative than Amazon” I’d agree with him. There is a real chance Amazon will outperform Omnicom. But, that doesn’t make Amazon an investment. And it’s possible for Amazon to “look cheap” and still be a speculation.


Let’s look at why I called Amazon a speculation. First, here’s what I wrote about Amazon in that earlier post:


And we would also say that Amazon (AMZN) and Netflix (NFLX) are speculations. The enterprises themselves aren’t speculative. They are proven money makers. But, the prices investors now put on these stocks make them speculative. There is no measure – P/E, P/B, EV/EBITDA, etc. – by which either Amazon or Netflix are within spitting distance of an average price. So, a buyer of either Amazon or Netflix stock is not just betting that these businesses are above average. He is betting that they are better enough to offset paying a higher than average price for the stock.”


The last two sentences are what defines Amazon as a speculation for me: “a buyer of Amazon stock is not just betting that the business is above average. He is betting that the business is better enough to offset paying a higher than average price for the stock.”


Buying Amazon stock is an exercise in handicapping. Let’s look at how much extra weight this horse is carrying.


I will take data from GuruFocus. Amazon shares now trade at $1,130. Revenue per share is $328. EBITDA per share is $29 a share. However, “cash flow from operations” is 16% higher. That’s not “free cash flow”. Just “cash flow from operations” before any cap-ex. As the email writer said, I haven’t tried to objectively analyze Amazon. So, it is possible “cash flow from operations” is a more accurate gauge of Amazon’s cash generating ability than EBITDA. Note that it is very difficult for a company’s “owner earnings” to be higher than both EBITDA and cash flow from operations. And also note I am starting by using a figure that is 8 times Amazon’s reported earnings for this last year. I know it is not appropriate to use Amazon’s reported earnings. I’m not using that number at all here.


So, we will start with Amazon’s “cash flow from operations” per share of $33 as the maximum possible proxy for current earning power. Let’s assume Amazon grows this $33 per share in “cash flow from operations” at a rate of 20% a year for the next 20 years. That gives you cash flow from operations per share of $1,265 at the end of 2037. Assume this is equivalent to EBITDA per share (it’s not, it’s lower). And apply a normal EBITDA multiple of about 8 times (an EBITDA of 8 times tends to roughly equal a P/E of 15 for an unleveraged company paying a 35% U.S. tax rate). This gives you a future share price of $10,121 at the end of 2037. The compound annual growth rate needed to get you from a share price of $1,130 today to $10,121 is 11.6% a year. So, Amazon stock would return something like 12% a year over 20 years if it grew its earning power per share by about 20% a year for the next 20 years.


How difficult is that to do?


Amazon would have to grow its size relative to the economy by about 12 times if the economy grew at about 6% a year for the next 20 years while Amazon grew 20% a year. So, however much clout Amazon has today – imagine it has 12 times more clout.


The path I’ve laid out here is difficult for Amazon to accomplish. The company is too big already to easily achieve that. Once a company has meaningful market share in an industry, it becomes more and more difficult to grow faster than that industry. Within 20 years, things like online retail and probably cloud computing as well will be mature industries. They won’t be growing much faster than the economy.


Are there other ways Amazon stock can return something like 12% a year over the next 20 years?


Yes. It can buy back stock to allow it to grow slower companywide – but the stock is too expensive for that to work right now. In fact, Amazon has historically diluted its share count. So, I’ve actually underestimated the necessary increase in the size of the overall enterprise in my example above. To achieve a 20% annual growth in earning power per share – companywide earnings would have to grow even faster. Maybe all of the company’s spending on research and development is really profit. It’s necessary to spend $42 a share on research and development right now – but maybe in 20 years, Amazon will no longer have to spend a penny on R&D if it’s done growing.


The stock could also pay less in taxes, trade at a higher EBITDA multiple in 2037, etc. These are all possible.


But they’re speculative. The only potentially non-speculative argument here is that Amazon is expensing items which are actually profits that are being re-invested in future growth. So, for example, what if all of the company’s R&D was treated more like growth cap-ex on the cash flow statement.


If you count all of the company’s cap-ex and all of the company’s research and development as being purely for the purpose of further growth – none of it is needed to maintain the current sales level – you can get to a price on the company today that is about 15 times this adjusted free cash flow figure. That’s a leveraged number. But, the number including debt wouldn’t be much higher.


So, the stock could actually be trading at about 15 times (heavily adjusted) owner earnings right now?


There’s a problem with that assumption. The company is spending on research and development. So, it has to grow at the sorts of rates I laid out to justify the investment in R&D for as long as it keeps making those investments. As long as you are spending $15 billion a year on cap-ex and $21 billion a year on R&D, you have to grow sales by $36 billion a year.

Let me explain why this is.


For an “investment” in R&D or cap-ex to be worth as much as profit you have in cash today, you would need to get something like a 10% after-tax return on that money. Otherwise, shareholders would be better off receiving a dividend and finding another stock that can return 10% a year. Even if you add back Amazon’s R&D expense, you still only get an adjusted operating margin of about 15% which works out to about 10% after-tax. For Amazon to grow its earnings – before R&D expense – by about $3.6 billion a year, it needs to grow sales by about $36 billion a year. That’s because $36 billion of added sales creates $3.6 billion of added profit (before any R&D expense but after taxes), which is about 10% of the $36 billion Amazon is investing in cap-ex and R&D right now. The company has $161 billion in revenue right now. So, adding $36 billion to that would be an increase of about 22%.


Once again, we come to about the same conclusion. To guarantee a 10%+ return in the stock, Amazon has to grow at about 20% a year.


Of course, that’s only if the company keeps investing in R&D and capital spending. It could stop investing in those things and slow its growth considerably and generate similar returns for shareholders. But, it either has to reduce investment in R&D and cap-ex and grow slower or grow at 20% a year or so and keep investing. It can’t keep investing and grow slower while delivering adequate returns for shareholders. That’s the one combination it’s not allowed.


Let’s compare this to the example I gave of an investment: Omnicom (OMC) at $68 a share. Right now, the stock has a P/E of 13, a 3.25% dividend yield, and a 2.25% annual rate of reduction in shares outstanding. A P/E of 13 is a smidge below the long-term historical average of around 15 for U.S. stocks. A 3.25% dividend yield and a 2.25% share buyback rate combined give you a 5.5% annual return if the company itself neither grows nor shrinks and the P/E multiple neither expands nor contracts. If you consider a 10% annual return adequate, the math works out as follows: 10% – 5.5% = 4.5%. The stock can deliver a 10% annual return if the company itself grows at 4.5% a year. The economy is likely to grow – in nominal terms – at something like 4% to 5% a year. So, if Omnicom as a company grows at the same rate as the economy and the stock becomes neither more or less expensive over time – investors who buy the stock today should expect a 10% annual return for as long as they hold it.


This is why I call Omnicom an investment. The most common-sense way of looking at the company based on the present situation and the past record suggests the stock will return about 10% a year.


The Amazon case is trickier. It assumes that large amounts of money spent on research and development and cap-ex will continually generate after-tax returns in excess of 10% a year. That’s a speculation. Is it a good speculation?


Up to a point, I think it is. I don’t think it’s an unreasonable speculation to say that Amazon can commit $20 to $40 billion a year on projects that will generate 10%+ after-tax rates of return in 2018 or 2019.


The problem is the 18 years after that. I don’t know of any historical examples of R&D on that scale that have generated adequate returns for the company doing them. At the rate Amazon is going, it would be spending $50 billion a year on R&D in 5 years and $120 billion a year on R&D in 10 years. Or…


Or, it would stop.


And here is the other part of the speculation: Jeff Bezos.


You could speculate that management is focused on return on capital rather than just growth. Amazon spends on growth now because it gets good returns on capital by doing so. But, it’ll stop spending in the future when it stops getting good returns on that spending.


I wouldn’t bet against that kind of management-based speculation. I wouldn’t bet against Amazon either as a company or even as a stock (and even at this price level).


But, I would call Amazon a speculation. Amazon can be a good enough speculation and Omnicom can be a bad enough investment that Amazon outperforms Omnicom. But, that doesn’t mean in hindsight that Amazon was an investment.


Let me return to the email I started this all with:


“…but maybe it’s not so easy to distinguish between investment and speculation in some cases because there are factors that we cannot foresee or do not yet understand….”


If we cannot foresee or do not yet understand factors, those are speculative factors. They’re important factors to consider if you’re speculating. And I’m not saying people shouldn’t speculate. If you think you have really sound reasons for believing the world will be different in the future than it is now – you can make such a speculation.


For example, several years ago – when Brent was at about $110 a barrel – I was interested in researching companies that used fuel as a commodity input but were otherwise pretty stable, understandable businesses. I looked at oil prices and couldn’t come up with good reasons for why oil should be at $110 a barrel instead of $70 or less per barrel. So, there was a speculation here on my part that might uncover a potential investment.


Likewise, there is a speculative element any time you are considering an investment with a “catalyst”. So, when I was researching Barnes & Noble (BKS) in 2010, the investment case was the high free cash flow from the stores versus the low market cap of the company. The speculative element was the proxy battle between Ron Burkle and Len Riggio that might serve as a catalyst which would re-direct the free cash flow to uses that I favored. I was wrong on that speculation. Riggio stayed in control of the company. And Barnes & Noble directed the free cash flow from the stores into the Nook. I sold out once I saw the profit from the stores would not come in the form of cash but rather would come in the form of R&D and start-up losses on the Nook. I could evaluate what cash was worth. I couldn’t evaluate what the Nook was worth.


And then there is the point about investments turning into speculations:


If you know that a business could potentially come under hard times and the modest amount of debt it has could compound the problem, then a company with a very modest valuation may morph into a speculative stock at even 1/10th the original price a few years down the road.”


This is the “fallen angel” concept. And it relates to Graham’s talk on “The New Speculation in Common Stocks”. There have always been high yield bonds. But, during Ben Graham’s career high yield bonds were “fallen angels”. The bonds had good credit ratings at one time, adequate interest coverage, and could be considered “investments”. But then the enterprises who issued these bonds fell on hard times and the bonds fell in price. In hindsight, the bonds were bad investments when initially issued but could often be good speculations when bought when the company was distressed and the bonds sold at pennies, dimes, or quarters on the dollar. Later, after Ben Graham retired from investing, bonds began to be issued as high yields from the start. This was speculative grade stuff. Not because the company issuing the bonds was distressed, but because the amount of debt issued made the situation speculative. Bond investors were willing to speculate as long as the potential returns were greater (the yield was higher).


The potential upside in Amazon stock is much, much greater than the potential upside in Omnicom stock. But, the likelihood of an adequate return in Omnicom stock is higher than the likelihood of an adequate return in Amazon stock. This is not because Omnicom is a safer business than Amazon. It’s because Omnicom is trading at a much lower price relative to actual free cash flow – cash that will (this year) be used to buy back stock and pay dividends – than the price Amazon trades at.


Amazon may be reasonably priced versus some form of adjusted earnings. But consider the form these adjusted earnings come in. They are R&D and capital spending. The certainty that $1 of money spent on additional R&D and capital spending is worth at least $1 in market value is much less than the certainty

that $1 of cash spent on buybacks and dividends is worth at least $1 in market value.


Graham speculated.


He bought – as a group operation – into a variety of arbitrage situations and other “workouts”. Some of the workouts were investments in inherently cheap businesses. But, some weren’t. Sometimes he was buying into a stock purely on the odds that an acquirer would successfully close the deal at the announced price. That’s speculation. It’s smart speculation with a calculable “edge”. But it’s still speculation.


Warren Buffett has speculated too. In his 1988 Letter to Berkshire Hathaway Shareholders he described his arbitrage operation in Arcata:


Arcata Corp., one of our more serendipitous arbitrage experiences, illustrates the twists and turns of the business. On September 28, 1981 the directors of Arcata agreed in principle to sell the company to Kohlberg, Kravis, Roberts & Co. (KKR), then and now a major leveraged-buy out firm.  Arcata was in the

printing and forest products businesses and had one other thing going for it: In 1978 the U.S. Government had taken title to 10,700 acres of Arcata timber, primarily old-growth redwood, to

expand Redwood National Park.  The government had paid $97.9 million, in several installments, for this acreage, a sum Arcata was contesting as grossly inadequate.  The parties also disputed the interest rate that should apply to the period between the taking of the property and final payment for it.  The enabling legislation stipulated 6% simple interest; Arcata argued for a much higher and compounded rate.


Buying a company with a highly-speculative, large-sized claim in litigation creates a negotiating problem, whether the claim is on behalf of or against the company.  To solve this problem, KKR offered $37.00 per Arcata share plus two-thirds of any additional amounts paid by the government for the redwood lands.


Appraising this arbitrage opportunity, we had to ask ourselves whether KKR would consummate the transaction since, among other things, its offer was contingent upon its obtaining “satisfactory financing.” A clause of this kind is always dangerous for the seller: It offers an easy exit for a suitor whose ardor fades between proposal and marriage.  However, we were not particularly worried about this possibility because KKR’s past record for closing had been good.


We also had to ask ourselves what would happen if the KKR deal did fall through, and here we also felt reasonably comfortable: Arcata’s management and directors had been shopping the company for some time and were clearly determined to sell. If KKR went away, Arcata would likely find another buyer, though of course, the price might be lower.


Finally, we had to ask ourselves what the redwood claim might be worth.  Your Chairman, who can’t tell an elm from an oak, had no trouble with that one: He coolly evaluated the claim at somewhere between zero and a whole lot.


We started buying Arcata stock, then around $33.50, on September 30 and in eight weeks purchased about 400,000 shares, or 5% of the company.  The initial announcement said that the $37.00 would be paid in January, 1982.  Therefore, if everything had gone perfectly, we would have achieved an annual rate of return of about 40% – not counting the redwood claim, which would have been frosting…”


I have also made speculations. Years ago, there was a case in which a state government took land belonging to a publicly traded company. The issue went to trial. And I started following the story. At that point: it was possible to figure out what other pieces of land in the same area sold for per acre, it was possible to see what compensation the company was seeking for the land, etc. But, I didn’t have faith in my ability to predict an outcome at trial. It was just too hard to tell if the company had a 45% chance of winning or a 95% chance of winning. Once the company won the trial, the stock jumped a great deal. But, it didn’t jump to anywhere near the actual level of cash the company would eventually be awarded once the state had exhausted its appeals. At that point – although the potential upside was now much lower – it was possible to see the company’s chance of winning the appeal was much closer to 95% than 45%. So, I was now ready to buy the stock.


That purchase was a speculation – not an investment. It was purely based on my belief that I could more correctly judge the odds of a decision being upheld on appeal than other investors could. I think it was a sound speculation. I read the decision, I talked to lawyers, I looked for examples of similar decisions being overturned on appeal, etc.


This was not gambling. But, it was speculating.


To understand the difference, we have to think about: subjectivity and edge.


If I play a hand of blackjack at a casino, I am gambling because I’m certain the house has an edge. It’s a small edge – but it’s against me. As long as I knowingly put money down in which I know the edge is against me – not with me – I’m gambling, not speculating.


Speculating is when I believe I have an edge. However, I believe that edge has to do with a future event. When Buffett thought the redwood claim could be worth somewhere between “zero and a whole lot” he thought he had an edge about a future event: a court decision. Likewise, when I bought stock – after the trial but before the appeal – in the company that had land seized, I thought I had an edge about a future event: the appellate court decision. If I had believed that Ron Burkle would win the proxy fight with Len Riggio at Barnes & Noble, I would have been betting on an edge I thought I had in predicting a proxy election. If I had invested in a company that was now trading at 20 times earnings when oil was at $110 a barrel but would be trading at 10 times earnings when oil was at $65 a barrel, I’d be betting on an edge I thought I had in predicting a future event: at some point oil prices would fall.


Subjectivity means that – in judging whether an action would be a gamble, a speculation, or an investment – I am not omniscient. I am limited by my lack of knowledge of future events. I am limited by only being able to consider information that is accessible to me at the time.


It may be that Amazon is – today – an investment from God’s perspective. However, it’s still a speculation from my perspective. An investment is an action that I (the subject) take. We can’t consider whether something is gambling, speculating, or investing apart from when I’m making the decision and what I’m capable of knowing. In hindsight, it may be that I will know things about Amazon that weren’t possible for me to know now but which – had I known them now – would have made me realize Amazon was an investment rather than a speculation. Those things don’t count. If they did, we’d simply call all decisions that were right in hindsight “investments” and all decisions that were wrong in hindsight “speculations”. By this logic, hitting on 17 could be an “investment” if we later learned the next card was a 4.


You can judge whether something is an investment or a speculation by keeping those two concepts in mind: edge and subjectivity.


What do I (the subject) believe my edge comes from? Do I have a positive edge? If I have a positive edge: I’m not gambling. If my edge comes from predicting a future event: I’m not investing. I’m speculating.


Now, some people reading this will be saying “wait: isn’t every stock purchase a speculation? Aren’t you always betting on future events?”


The outcome always depends on future events. However, saying that the outcome depends on the future is very different from saying your edge in an investment comes from a future event.


There’s a simple way to think of this: “invert”. Flip your analysis. Don’t ask: what has to happen for this investment to work out for me? Ask: what has to happen for this investment not to work out for me?


Are the risks “investment” risks or “speculative” risks?


The risks in Omnicom at today’s price are all speculative. For you to be wrong, we have to speculate that Omnicom will grow slower than the overall economy.


The risks in Amazon at today’s price are all investment risks. For you to be wrong buying Amazon, you simply have to be wrong about the long-term return on the company’s spending on R&D and cap-ex. If Amazon was to grow at the same rate as the overall economy, you’d lose a lot of money. If Amazon was to get the same returns on its R&D and cap-ex as other companies do, you’d also lose money.


Now, you could say this is the wrong way of looking at it. All Amazon needs to do is to continue its present trend.


This is usually the argument made for why speculative stocks are really investments. If they continue at the current rate of growth, they will justify today’s prices. If they continue generating the same returns on capital, they will justify today’s prices. It’s possible for returns on capital to be persistently high. It’s also possible for growth rates to be persistently high (though only for a time). But, it’s very hard to maintain high returns on capital at high rates of growth for long periods of time.


No high growth trend can continue indefinitely.


Assumptions about stocks maintaining a certain dividend level, stock buyback rate, and growth in line with the economy can, in fact, continue indefinitely. There’s nothing about those assumptions that isn’t infinitely repeatable.