September 4, 1998

An Investment Opinion
by Dale Wettlaufer

On Investing and Speculation

Have you been wondering why over the last couple weeks the Fool has been paying so little attention to the market's decline? Where are the splashy graphics and the huge number of articles on the market being down? Hmm, how to describe our attitude, or my attitude at least, without really angering all of those people that "called" this downturn? And how to satisfy all those that are concerned with the market drop who view statements on not being worried as hopelessly Panglossian and Pollyanna-ish?

First, if one takes the long view of owning publicly traded companies and doesn't indulge in the apocalyptic view of some commentators, the recent decline is understandably worthy of concern but not worthy of a freak-out. For instance, one market commentator that has been popping up on Yahoo! said about ten days ago something to the effect of "yes, now is the time to panic!" Congratulations, you called the big market downturn. For that matter, there are lots of bears around -- Jimmy Rogers being one -- who have been calling for a market downturn for years. Well, we've finally had a year in which stocks have turned down, worse so if you want to look at a smaller-cap index such as the Russell 2000.

What good is this market advice, though, when the market tops out 130% higher than when they first started yelling "Fire!?" and is now trading 105% above where the alarms started sounding? The answer is that it's not any good -- it's worse than no good. The utility of such prognostications about the market is negative because it distracts one's mind from the job of being an investor. Such prognostications also seek to predict the outcomes of a complex adaptive system, which in the short run are chaotic and unpredictable on a regular basis.

What is an investor? A prognosticator of what will happen next with the market overall does not qualify. That's what speculators do. Not that one can't be an investor and a speculator at the same time, but one has to make up one's mind whether one is making a trade or an investment. If I think the Fed will lower rates and then sell the November Fed Funds futures contract, that's a speculation. If I go long a certain company that I see as selling 25% beneath intrinsic value, that can either be a speculation or an investment. But just as one shouldn't change one's mind about whether one is going to hit a draw or a fade at the top of the backswing, one shouldn't change one's mind about whether something is a speculation or an investment in the middle of things.

An investor is someone who commits to being a business owner and searches for the opportunities that offer the best return on capital that he commits to investing. For instance, if the year is 1970 and you buy McDonald's as an investment, it doesn't serve any purpose to sell it if it hits your broker's predetermined rule to sell something after it's gone up 50%. If your tax bracket is 35%, then your after-tax return on what has turned into a speculation is 32 1/2%. And then you have to determine what you're going to do with that cash next. If you have a rule that you don't invest in that company again unless the stock comes down 25%, then you might never see that price ever again. No matter what the intrinsic value of that company is and what the price offered by the market is, if you pay more attention to market prognostications, arbitrary rules of buying and selling, the fast-moving oscillator, the cup-and-handle, and whatever else, your thinking on price and value will be muddied.

Market technicians and commentators will pull out the charts on the indexes and tell you that market timing works. Don't listen. As our friend Randy Befumo pointed out in his acclaimed "Buy and Hold Apocalypse" series, the revisionists are wrong. All too often a market guru will haul out a chart, Ross Perot-like, and appeal to our rational senses with a chart showing that an index did such-and-such over such-and-such a period. For instance, one could haul out a chart showing that the Dow Jones Industrial Average slid from 300 in 1929 to 177 at the beginning of 1949. That's an annual return of negative 2.6% per year. Pretty bad, huh? Whichever prognosticator had predicted that must have felt pretty good in 1949.

The introduction of Security Analysis author, professor, and investor Ben Graham's book The Intelligent Investor points out the fallacy of the index and of that prognosticator's good feelings. Graham writes that $15 invested every month in good common stocks -- with dividends reinvested -- would produce an estate of $8,500 at the end of 20 years. That's an average annual return of 8% over that period, which is below the historical total return of stocks during this century, but is actually very much in-line with the real rate of return on stocks in the 20th century. Esteemed Wharton Professor Jeremy Siegel took this same hypothetical investor ten years further down the line from that. In his excellent Stocks for the Long Run, Siegel picks up where Graham leaves off: "...and after 30 years [his stock portfolio would have accumulated] over $60,000.... [which] represents a fantastic 13 percent return on invested capital, far exceeding the returns earned by conservative investors who switched their money to Treasury bonds or bills at the market peak."

A simple numerical index doesn't show the effects of reinvested regular or special dividends and spin-offs. While the indexes make an adjustment to the cost basis of the individual components, they don't take into account the compounding effects of those dividends going forward. For instance, one might conclude looking at the chart that AT&T hasn't done that well over the last three years. Well, one would have to also consider that during that time the company spun off both Lucent and NCR Corp. Adding those results back to the AT&T results demonstrates the fallacy of the index.

The investor in good common stocks can outperform the index. What is a good common stock, though? Those attributes have been well-outlined in the Intelligent Investor and in other Graham writings. When we on the Fool's News and Analysis team write about things like return on equity and return on invested capital, we are trying to help investors acquire the tools to identify what makes for good common stocks. One can point to the 1970s and say, "Look at the Nifty Fifty." But I can say, "Fine, look at what Wal-Mart did over that time period." But that is in retrospect. What we want to do going forward is to identify the new Wal-Marts, McDonald's, Berkshire Hathaways, Travelers, Cokes, Gaps, Fannie Maes, BANC ONEs, etc. The current mania on calling where the market will go next is a waste of time that could otherwise be devoted to finding those companies, learning about them, and figuring out what you would pay for them.

Unless you need to sell your stocks to fund your retirement, this downturn shouldn't be that big of a deal. Unless you just started investing in the last two years, you're probably ahead of a rational annual return target of 11%. Sure, it's no fun coming down from having accomplished 17% annual return at the peak of the market, but one has to be guided by a compass that has something to do with economic reality. Markets won't grow 20% per year 'til the day you die, especially if you're 30. Certain portfolios might achieve returns like that over a number of decades, but that's a rare accomplishment of the highly skilled investor. Nonetheless, it can be accomplished if one can just ignore the noise of those freaking out around them and concentrate on value and price. Trying to figure out where the market is going is best left to speculators.