…to suppose that the value of a common stock is determined purely by a corporation’s earnings discounted by the relevant interest rates and adjusted for the marginal tax rate is to forget that people have burned witches, gone to war on a whim, risen in defense of Joseph Stalin and believed Orson Welles when he told them over the radio that the Martians had landed. ~ James Grant
An investment operation is one which, upon thorough analysis promises safety of principal and an adequate return. Operations not meeting these requirements are speculative. ~ Benjamin Graham and David L. Dodd
In general, Americans feel pretty darned smart when it comes to handling money. Since the stock market crash of October 19, 1987, the Dow Jones Industrial Average has gone from 1,738.40 to a March 14, 2005 closing price of 10,804.51. Granted, many people lost money when the dot.com and telecom bubbles burst, yet Americans remain unshaken in their collective belief that staying in the stock market will make them wealthy in the long run. To be sure, you will hear the mantra that "stocks always go up in the long run" from diverse sources ranging from star Wall Street analysts (such as Abbey Joseph Cohen) to your next-door neighbor. What a dream world America has become where we can read the business pages, watch CNBC, "invest" in can’t-lose stocks, and then grow wealthy, over time, without much thought or effort. When examining this prevalent mindset, using Graham and Dodd’s distinction between investing and speculation, I must conclude that most Americans are speculators not investors. This position is easy to defend.
An important aspect of investing is to have the mindset of a business owner. In 1983, Warren Buffett conveyed 13 owner- related business principles for Berkshire Hathaway’s shareholders to embrace. The first principle is potent yet simple in that Warren Buffett and Berkshire’s vice chairman — Charlie Munger — view Berkshire Hathaway "…as a conduit through which our shareholders own the assets." Mr. Buffett further explains that
Charlie and I hope that you do not think of yourself as merely owning a piece of paper whose price wiggles around daily and that is a candidate for sale when some economic or political event makes you nervous. We hope you instead visualize yourself as a part owner of a business that you expect to stay with indefinitely, much as you might if you owned a farm or apartment house in partnership with members of your family.
Indeed, having an ownership mindset is a step toward becoming an investor, yet, on a stand-alone basis, does not quite get you there. For if an individual is truly an investor in a business, he would have a basic understanding of its operations, its assets and liabilities, its profitability, and its cash flow. Moreover, an investor would quickly grasp the power of the following quote from Ludwig von Mises’ magnum opus Human Action:
Monetary calculation is the guiding star of action under the social system of division of labor. It is the compass of the man embarking upon production. He calculates in order to distinguish the remunerative lines of production from the unprofitable ones, those of which the sovereign consumers are likely to approve from those which they are likely to disapprove. Every single step of entrepreneurial activities is subject to scrutiny by monetary calculation. The premeditation of planned action becomes commercial precalculation of expected costs and expected proceeds. The retrospective establishment of the outcome of past action becomes accounting of profit and loss. (Emphasis added)
A tool businessmen use to determine the success or failure of past actions is a financial statement. A businessman and an investor should have a firm understanding of all the entries in a company’s balance sheet, the income statement, and in the statement of cash flows (which are the three key components of a financial statement). Via analyzing the company’s financial statement, a businessman can directly correlate whether his company’s capital base (i.e., the company’s net worth as reflected in the balance sheet) is expanding or contracting depending upon if the company turned a profit or made a loss. Such monetary calculation assists a businessman in deciding to maintain or change a business plan based upon satisfying the ever-sovereign consumer.
The analysis doesn’t stop here. Businessmen and investors will also take a keen interest in deriving the following (among others) from the financial statement:
- Working capital
- Quick ratio
- Debt to equity ratio (i.e., leverage)
- Return on equity
- Total debt service coverage
- Inventory turnover
- Accounts receivable turnover
This may look complicated and, to a certain extent, it is. Yet, to be a true investor, such "thorough analysis" — as mentioned above by Graham and Dodd — is essential. Conversely, if someone cannot read a financial statement (i.e., a balance sheet, an income statement, and a statement of cash flows), then when it comes to purchasing common stock in publicly traded companies, such a financially illiterate person is inherently a speculator, not an investor. After all, such a speculator has no idea how to value a business and merely owns a "piece of paper whose price wiggles around daily." With financial illiteracy being the overwhelming norm in America (let’s face it, public schools have miserably failed at teaching basic accounting, finance, and economics), I believe I have successfully defended my position that most American "investors" are simply speculators.
Now to bring a bit of politics into the picture here. President Bush is touting an "ownership society" in which Social Security reform is a cornerstone — thereby allowing for personal Social Security accounts where individuals can "invest" funds into the stock market. I would counter that President Bush is, not surprisingly, abusing the English language. After all, with a financially illiterate populace (thanks again public schools), I assert that President Bush is essentially doing nothing different from CNBC, the stock brokerage firms, and the Wall Street Journal in that he is promoting a "speculator society." Of course, the key difference here is that the federal government will be coercing Americans to speculate at gunpoint.
For those who feel that they fit the mold of being a speculator, yet want to make the effort to become an investor, there is hope. Let me give you a crash course. The first step to take is to read Benjamin Graham and David L. Dodd’s classic book Security Analysis. This book will teach you how to read a financial statement. The next step is to read The Intelligent Investor by Benjamin Graham. As Warren Buffett stated, it is "By far the best book on investing ever written." Enough said. Finally, you must gain an understanding of Austrian economics. Two excellent introductory books are Economics for Real People: An Introduction to the Austrian School by Gene Callahan and The Austrian Theory of the Trade Cycle and Other Essays produced by the Ludwig von Mises Institute. Keep in mind that it was the "Austrians" who correctly identified and explained the dot.com and telecom bubbles that left so many stock portfolios in tatters. By combining Graham and Dodd with Austrian economics, you will have the tools necessary to become a successful investor. After all, long-term wealth accumulation requires a great deal of thought and effort — not the opposite as promoted by America’s financial pop culture.