Speculation in Stocks of Strong Companies
“The danger of paying the wrong price is almost as great as that of buying the wrong issue.”
Benjamin Graham
Who was Ben Graham? Many investors know him as the “father of value investing” or the “dean of wall street.” For those outside of the investment world, he is best known for the world-famous money managers who he has influenced. Similar to Bill Belichick’s coaching tree in the NFL, a number of the most successful investment managers of all time attribute the foundation of their core philosophy to Graham. There are many who he directly influenced, including Warren Buffett who took Ben Graham’s class while attending Columbia University and later went on to work for him at Graham’s investment firm before going out on his own. There are thousands of others who Graham has touched indirectly, including Sir John Templeton who spoke highly of Graham’s seminal work, Security Analysis, and the impact that it had on his investment style.
Ben Graham passed away almost 50 years ago, but his lessons documented in Security Analysis (1934) and The Intelligent Investor (1949) remain as relevant today as the day he wrote them. One of the main points that Graham lays out in the first part of each of his classic works is the difference between investing and speculating. In Professor Graham’s words, “an investment operation is one which, upon thorough analysis, promises safety of principal and adequate return. Operations not meeting these requirements are speculative.” It is important to note that Graham never said that speculation is something that should be avoided completely. Rather, the point is to simply understand under which mode you are operating, and those individuals who do chose to speculate should have the right temperament, financial knowledge and, most importantly, the money to lose.
It is not difficult to find assets in today’s environment that Ben Graham would consider speculative. Can anyone truly argue that cryptocurrencies promise safety of principal? How many people who have purchased Bitcoin or other cryptos have done so only after thorough analysis. Speculative excess is certainly not unique to the meta-verse or cryptocurrencies, but rather it is equally evident across stocks, bonds and all financial asset classes. Bond investors have gobbled up new issues of
junk bonds (issues from financially weaker companies) offering record low interest rates as compensation for an elevated risk of being repaid. Stock investors have lined up to buy new issues of EV (electric vehicle) companies and other high-tech startups that have captured our imaginations but do not project to have any actual sales for at least a couple of years. Clearly these are speculative. There is no safety of principal. There is no thorough analysis. They are simply bought today because the price went up yesterday with the hopes that it will go up again tomorrow. Speculators who end up suffering permanent capital impairment in some of these assets will at least understand that they were rolling the dice.
What about other areas of the stock market? What about the “safe bets” like the big technology stocks? Surely buying stock in Apple is considered an investment and not speculative, right? Apple is the largest of 506 companies that make up the S&P 500 index. It represents 0.19% (1/506) of the number of stocks, but yet accounts for almost 7% of the index given its size which touched $3,000,000,000,000 earlier this week. At a valuation of $3 trillion, Apple stock would be the 5th largest economy in the world, just topping out India at about $2.94 trillion and the almost 1.1 billion people living there.
Nobody would argue that Apple is not a strong company and a dominant leader within its industry. The market has clearly reflected that over the last 6 years ending 12/31/2021. During that period, Apple’s stock has appreciated 578% (37.43% per year) while the S&P 500 is up ONLY 133% (15.12% per year). Clearly Apple has been a great investment in recent past, but should it be treated as an investment (as opposed to speculation) going forward? A look beneath the surface raises some important questions. Below is a chart showing the growth of Apple’s stock price vs. the growth of its operating earnings for the 4 years leading up to the pandemic (Jan 2016 – Dec 2019).
As you can see, Apple’s stock enjoyed an increase of almost 180% during that 4-year period while the money the company made from business operations remained flat. Is the fact that Apple did not grow operating earnings over that period an indictment on the company or its industry position? Absolutely not. We believe it is more a reflection of the fact that trillion-dollar companies, operating in mature, saturated device markets typically do not grow at rapid rates. It is much harder to grow sales at 20% per year when you are a trillion-dollar company compared to a start-up with $100 million in sales.
As you might expect, the picture has changed dramatically over the last 2 years. From Jan 2020 – Dec 2021, Apple’s stock has grown an additional 130% and operating earnings (EBITDA) have skyrocketed by close to 50%. Nobody could have predicted the growth in earnings that Apple has enjoyed over the last two years, including the 44 professional analysts who follow the company and hang on every word from Tim Cook’s lips. Apple averaged an EPS (earnings per share) of $2.75 for FY 17 – 19. The company doubled that number in 2021 posting $5.61 per share. It is certainly open to debate as to why Apple (and many other companies in different industries) were able to manage such explosive revenue and earnings growth during such a tumultuous and difficult period. Our view is that the $5 trillion of monetary and fiscal stimulus from the government, $850 billion of which was sent to households in the form of checks, has something to do with it. Regardless, the analyst community believes the optimistic outlook will apply for many years to come. The average EPS estimate for years 2022 – 2024 is $6.14, or 120% greater than what the enormous, well established company, operating in largely mature industries, was able to generate just a few years ago. Are those projections based on fundamental analysis and rooted in reasonable estimates, or are they simply a prediction that the good times will keep on rolling?
To conclude, does Apple stock, valued at almost $3 trillion, promise safety of principal? We have our doubts, but ultimately, we cannot be sure as to what the future holds. To quote the master himself, Benjamin Graham, “our search for definite investment standards for the common-stock buyer has been more productive of warnings than of concrete suggestions.” In that spirit, we wish to caution investors about being aggressive in this environment. Beware of the stock, or group of stocks, that everybody loves. Beware of the “sure thing.” Beware of speculating in stocks of strong companies.
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