Philosophy of Markets

Introduction

Speculation in equities has been around since the establishment of Nederlandse Oost-Indische Compagnie in 1602. Whether there is more speculation on average today than say 50 or 100 years ago is an open question I think. However, with the advances of daily leveraged ETFs, Robinhood, meme-stocks and quantum computing companies that go 10X without noteworthy revenue, it’s fair to say that it's rather prevalent in today’s market. In recent times, speculation has been viewed with some skepticism by the wider investing community. But many books - especially prior to the 1950s - actually took a more nuanced and positive view of speculation. Maybe these books have been proved wrong by the returns of successful value investors, maybe they have been proven right by the continual rebirth of profitable speculation. I don't know, but it's interesting to read outside the current consensus. One classic that wholeheartedly recommends speculation is The Battle for Investment Survival (The Battle) by Gerald Martin Loeb from 1936. The Battle was published only two years after Security Analysis by Benjamin Graham and David Dodd. Both books came out in the wake of The Great Depression where market participants had gone through unprecedented losses on Wall Street, and both books revolved around the same theme: the building of wealth through participating in public markets. The authors of the books however, came up with an almost diametrically opposite set of recommendations as to how to achieve the common goal: value investing and speculation.

Margin of Safety in Value Investing

Before looking at speculation through the lens of Loeb, let's distill the value investing classic, Security Analysis which basic tenets today still has a profound influence on the investment community. In the book Graham and Dodd famously coined the expression "margin of safety", which I believe lies in the heart of value-investing:

... the "margin of safety" resides in the discount at which the stock is selling below its minimum intrinsic value ...

This obviously begs the question of what constitutes "intrinsic value". However, the meaning of these terms is carved out through usage throughout Security Analysis. So let’s look at a key passage:

In 1929 nearly all public-utility systems showed a continued growth of earnings, but the fixed charges of many were so heavy—by reason of pyramidal capital structures—that they consumed nearly all the net income. Investors bought bonds of these systems freely on the theory that the small margin of safety was no drawback, since earnings were certain to continue to increase. They were thus making a clear-cut prediction as to the future, upon the correctness of which depended the justification of their investment. If their prediction were wrong—as proved to be the case—they were bound to suffer serious loss.

Here we see that margin of safety designates the inverse of the fixed operating costs of a company. High fixed cost is equal to low margin of safety, since if revenue should drop, then margins would deteriorate and the company may go bankrupt. On the contrary, if revenue goes up, and operating costs are kept constant, then we have free cash flow. So in general, according to Graham and Dodd, one should hold a diversified portfolio of companies with high margins of safety. This translates to a group of companies who has the ability to generate consistently high free cash flows. Furthermore, Graham and Dodd directly contrast their preferred way of deploying capital, investment, with speculation. They define investment such that:

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

If according to Graham and Dodd "speculation" is a deployment of capital that is not preceded by a thorough analysis that promises safety of principal and satisfactory return. Much then hinges on what exactly are satisfactory returns. But that I think, is up to each individual to decide.

Loeb's Perspective on Investment and Speculation

With the value-investing perspective outlined, let's turn to speculation according to Loeb. Loeb defines investment and speculation somewhat differently than Graham and Dodd. In the Battle, investment is defined as the deployment of capital where the satisfactory returns are market returns, so let’s say 6-10% annually. Speculation on the other hand is deployment of capital with the goal of doubling one’s money within 6 months to a year. And already from this difference in ambition, speculation stand above investment. Loeb writes:

... I am personally completely convinced of the inevitability of loss when attempting to secure a safe income of small returns, that I constantly suggest speculation rather than investment as the policy less apt to show a loss and more apt to show a profit.

It's important to note that Loeb does not prefer speculation to investment because he has a shorter time horizon—indeed, he was active in the market for more than 50 years. It's because he believes it offers advantages similar to those that according to Graham and Dodd make value-investment attractive in the long run.

Active Market Presence

Throughout The Battle, he provides various arguments to support the claim that speculation is superior to investment in the long run. One is presence, the simple awareness of the market that it requires to reach such lofty goals as to double one’s money in a year or less, which stand in stark contrast to the potential passivity of investment:

In a sense there is no direct comparison. Trying to invest for 6% is like trying to retire. You are the "absentee" creditor or part owner as the case might be. You sit back and stop thinking, letting the money work by itself. Trying to double your money requires your active presence and a lot of work.

This active presence and work in itself provides a safety for the speculator. He will notice and therefore have the ability to take advantage of opportunities in the market that the investor who is happy with his market returns will never be able to. One critical comment we might add here is that following the markets intensely may make the participant way too reactive to short term news-driven market fluctuations. Furthermore, for many people, caring a lot about intraday price movements is a recipe for burnout.

Market Volatility and Pyramiding

Another argument that Loeb presents is that large swings in stock market prices are the norm rather than the exception. This has since been well documented by research using historical data, and we today know that market returns have so called fat tales, meaning they're not distributed along a normal bell curve. And most experienced market participants probably have probably seen stocks rise 25% only to drop 25% later simply due to shifts in market sentiment. Since such changes are rooted in sentiment rather than fundamentals, a value-oriented investor, all focused on the quality of the business, might struggle to capture gains from these fluctuations.
When it comes to deploying capital and position sizing, Loeb again goes against conventional value investing wisdom. According to Loeb the best time to buy a stock is when you already own it and it has gone up. He calls this method "pyramiding":

The right way to do it is to pyramid. I have a buying power of 1,000 shares. I think Studebaker is going up. I buy 100 shares. It doesn't go up when it should, or worse, goes down. I sell it out. The loss can be charged to insurance, or experience, or as necessary cost of getting started right. Next, I buy 100 Chrysler. It begins to advance as I anticipated. So I buy 200 more. It still does well, so I buy another lot. And so on. First thing you know, if it's good I am long a big line of the right stock with a small initial risk. I lost only on 100 shares in Studebaker; I risked only 100 in Chrysler.

The pyramiding strategy stands in sharp contrast to value investing principles and is more in line with a trading strategy that has later been known as trend-following. According to trend-following, one should focus primarily on riding the waves of the market, whereas in value investing, one shouldn’t pay much attention to short-term price fluctuations caused by the delirious Mr Market. Interestingly though, pyramiding is also exactly the underlying methodology of index investing. In an index fund, if a company makes up a higher percentage of the index at the time of rebalancing, then the fund will buy more shares of that company, and likewise sell shares of companies whose stock has performed relatively worse. So even though we might perceive pyramiding as a speculative strategy, since it doesn’t take fundamentals into account, it is exactly how a large part of the so-called passive investments are managed today.

Diversification: Benefits and Limitations

Back when The Battle was written, the low-cost index funds as we know them didn’t exist. Given their low fee structure, and implicit pyramiding, I believe that Loeb would agree that they have a rightful place in a balanced portfolio, akin to cash or other liquids. The real returns however, could never be achieved by a diversified portfolio. One should take on a substantial risk and then manage it well:

The greatest safety lies in putting all your eggs in one basket and watching the basket.

So obviously, Loeb is not a fan of diversification for the seasoned money manager:

... overdiversification acts as a poor protection against lack of knowledge.

But he is also a realist, in the preface to a later edition, he clarifies:

Diversification is a necessity for the beginner. On the other hand, the really great fortunes were made by concentration. The greater your experience, the greater your capability for running risks, and the greater your ability to chart your course yourself, the less you need to diversify.

So according to Loeb, diversification might be a necessity for the beginner, but not for the skilled speculator, as it will ultimately stand in the way of absolute returns.

Modern Market Considerations

How do the ideas in The Battle align up with deploying capital in the current market? Since 2009 we have had a situation where US large caps have for the most part outperformed the rest of the world. Simultaneously there has been a significant inflow into US equities. In that environment holding a diverse portfolio such as an S&P 500 ETF would have meant both diversification and satisfactory returns. In the same environment, due to innovations and a surplus of capital in the US market, the participants that have specialised in speculation have also done well. On the other hand, mirroring the large cap outperformance, value investing as a category has underperformed. Now, at least within the last couple of months, it seems we’re heading towards a more fragmented return profile. In that scenario it’s likely that index investing will underperform active management, and that value investing as a category will start delivering the returns that it promises in theory. Whether speculation will also do well in this new environment depends as Loeb would also likely agree upon first and foremost on the discipline and skill set of the individual manager. If one wants to invest speculatively, one should look for markets with a high net inflow of capital and innovation among its constituents ready to soak the capital up into their stock prices.

Active Management and Diversification Challenges

With regard to diversification, for the active manager, a diversified portfolio comes with less risk understood as a higher degree of uncorrelated price movements. However, it may indeed come with more risk understood as higher knowledge requirements about a variety of companies and their related pocket of market sentiment. This is very similar to diversification in business lines within a single company, collectively it may produce uncorrelated revenue streams, but also collectively it may be more difficult to efficiently manage each individual revenue stream for the company, hence potentially hurting the overall, combined profitability. So diversification is not a cure-all, and could lead to lower returns in the long run if the inherent risks are not managed well.

Conclusion

Speculation and value-investing are two ends of the spectrum of investing. What works best for any one participant depends on skill and proclivities, and as with most other things in a competitive landscape, discipline and the ability to execute on a strategy.