Principle One: What is Investing?
“An investment operation is one that, after thorough analysis, promises the safety of the principal and an adequate return. Operations not meeting these requirements are speculative. Never speculate. Aim to do what is financially sound and rational.”
Benjamin Graham, author of The Intelligent Investor and teacher of Warren Buffet, defines investing as follows. “An investment operation is one that, after thorough analysis, promises the safety of the principal and an adequate return.“ I would not debate this definition, but I will supplement it with a description of the most widely accepted fundamental valuation principle. ”Every financial asset is worth as much as the present value of all its future cashflows.”
With these two definitions, anyone can start to value companies who understands the basics of finance and accounting. However, I must recommend humility. The painting above serves as a cautionary tale. It depicts the South Sea Bubble of 1720, the first market crash in history. An interesting aspect to note from the story is that Sir Isaac Newton himself lost the equivalent of over 4 million Pounds in today’s money. This shows that it is not simply a question of intellectual ability whether someone becomes a successful investor or not. To use Buffet's words, it is a question of Temperament over Intellect. The Investment Principles in this series aim to build the foundational mindset and temperament needed for prudent and rational investing.
The world is very complex, and those who play fortune teller sometimes fail spectacularly. This is why they are so often presented as thieves. The analogy of the fortune teller as a thief works well in today’s investment field. The fortunes they tell take the form of projections and trends.
What is a Stock Market Bubble, and what is the Responsibility of Good Investors?
Fundamental analysis of stocks as companies can prevent or weaken stock market bubbles. A stock market bubble is an occurrence of stock prices increasing to an unsustainable level. When, eventually, the unsustainable price level of the stock market collapses (the bubble bursts), the prices get closer to a rational level or even below that. One of the earliest examples of a market bubble forming occurred in 1720 with the famous case of the South Sea Bubble (Dale, Johnson and Tang, 2005). This bubble occurred 229 years before the initial publication of The Intelligent Investor. However, it would have been beneficial for investors in the South Sea Company to know what Benjamin Graham and his followers preached. “A company is worth as much as its future cash flows discounted to present value.” That way, the investors would have realised that there was a widening difference between valuation and stock market capitalisation before the burst of the bubble.
The 1929 stock market crash was one of the most devastating crashes in the world (Klein, 2001). The devastation was also enhanced with very little protection for many investors. The Wall Street Crash of 1929, too, could have been less devastating if investors had followed a policy of fundamental analysis and, as little speculation as possible, merged with an attitude of prudence.
The DOT-COM Bubble was a more recent example of a financial crisis that destroyed significant value. The explosion of internet-based companies started this bubble. Investors expected all companies with .com in their name to become very valuable, or at least they expected that they could sell the stock they purchased for a higher price than what they paid. (This is also called the bigger fool theory. “I expect that someone will be a bigger fool than I am.”) This was enhanced by the dangerous activities of venture capital firms primarily based in California’s Silicon Valley, who followed the get big fast strategy. This strategy meant pouring capital into Internet companies to quickly increase their market share, which could be followed by an initial public offering (IPO). This way, venture capital firms could get the return on their investment from the general stock market investors who wanted to get rich quickly. A second factor of the DOT-COM bubble was a marketing and financing feedback loop. The issue with this bubble, as is the case with all stock market bubbles, is that the balance sheet and income statement of the companies do not warrant the market capitalisation of the company. This was true for many DOT-COM companies (Crain, 2021). The internet bubble was safely avoided by investors like Warren Buffet who followed the strategy of prudence based on the fundamental analysis of companies.
The mercurial attitude of the market causes a lot of harm to the economy overall. The graph above shows the annual GDP growth in the United States over the past three decades. The bad years in the economy were repeatedly caused by some market bubble that investors have some responsibility for, except for 2020 and the COVID-19 pandemic. The DOT-COM bubble of the early 2000s pushed GDP growth down to 1% from almost 5% years before. The housing bubble crashed the economy to a stage where it had negative growth of 2.6%. Overall, investors should stay focused on value investing and not let stocks get overvalued, as this is the only way to avoid substantial bubble bursts on an individual and societal scale. Of course, this isn't easy to mandate and follow, and investors should always expect more bubbles to come.
(PS: Note how few years of negative growth you have seen in the past 30 years in the US economy. List all the horrible things that happened to the US in the last 30 years and note that there was negative growth in only 3. Find some comfort in this. Betting on the US economy to work well seems to be safe.)
A clear definition of investing and an articulated valuation method is a good start at money management. Having humility, avoiding fortune tellers and learning from history are all practices to be followed.