Every investor is speculating at some level. That’s Philip Carret’s argument in The Art of Speculation and he’s right. Rarely does an investor know everything about an investment (when they do it’s usually too late). There is always an unknown element just out of grasp.
Accepting that is the broadest lesson from the book. Carret dedicates the rest of it to help investors deal with the unknown in the hopes of coming out ahead.
And in that, there are some good lessons worth learning. Let’s get started.
- “The road to success in speculation is the study of values. The successful speculator must purchase or hold securities which are selling for less than their real value, avoid or sell securities which are selling for more than their real value… There are styles in securities as there are in clothes. A security may be undervalued, but if it is also out of style it is of little interest to the speculator. He is, therefore, compelled to study the psychology of the stock market as well as the elements of real value.”
In the short term, the market is a giant popularity contest, where the crowd throws money at the cool, hip, trendy thing today. So stocks, sectors, industries, countries, and strategies go in and out of favor.
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But it never lasts.
So it’s not enough to know that something may be undervalued or overvalued. You also need to know whether the crowd believes a thing to be undervalued or overvalued.
That’s the hard part. To paraphrase Howard Marks, undervalued is not the same as going up tomorrow.
- “For the purposes of the stock speculator who is seeking some guide to tell him when to buy and when to sell it is somewhat unfortunate that the turn in stocks…precedes the turn in business thus does not forecast the course of stock prices except in the apparently paradoxical fashion that great prosperity affords an advantageous time for selling stocks, extreme business depression an opportunity for purchase.”
For all the time we spend studying the past looking for a clue as to what might happen next, it’s important to remember that the stock market looks forward. Turns in the stock market typically precede the business cycle. Not the other way around.
The best we can hope for is to recognize when things look frothy or depressed and take advantage of the opportunity expecting that it will always be earlier or later than the exact turn.
- “It is usually a much simpler matter to forecast a bull market than to call the turn at its end.”
This is true just based on the last ten years (and the ten decades before that). How many times has a big name on Wall Street called the next bear market? It’s happened multiple times every single year since 2008.
I have no idea when but eventually, someone will be right. The bear market will come.
But until then, it’s easy to be pessimistic. It’s hard to be pessimistic and right.
- “The average trader is naturally a chronic bull. It is human nature to prefer optimism to pessimism. Moreover, fortunes are usually made by expansion of values, not by their destruction. The man in the street associates the acquisition of wealth with rising markets; failures, ruin, depression, panics with falling markets.”
Carret kicked off his discussion on the difficulties of short selling with this. It takes a special kind of mentality to short anything. The short-term randomness of markets makes it far too risky for my taste.
Beyond that, markets are naturally biased to the upside. But that is not a reason to overlook downside risks. Investing is all about risk management. To keep the gains you have to manage for possible losses.
- “To be successful, then, the speculator must know a great deal more than merely enough of general conditions to determine the trend of the general markets. He must be a student of values in individual securities. To appraise values in individual securities he must know something about a great many different businesses… Above all he must know something of accounting… The question of ascertaining trend of the market is important to the speculator, but it should not rank any higher in importance than the question of intelligent selection of his vehicles.”
I see it said sometimes that investing today is harder than it was in the past. Maybe. This would suggest it was never easy.
Knowing where you are in the market cycle, knowing what stocks might benefit the most based on that, knowing which ones offer value, and understanding the language of business (accounting), tell the tale of the time and commitment needed to invest in the ’20s and today.
I’ll admit that there certainly is more competition for knowledgeable investors today, than in the past. But human nature is still the same. Opportunities exist for the disciplined, dedicated, knowledgeable investors.
- “Stocks often sell at ridiculously low levels for considerable periods merely because few people know anything about them. The speculator who discovers a stock in this situation does not need to foresee future growth in the company’s earnings. If the stock is selling well below the level which current earnings and position justify, and there is nothing in sight to impair its position in the near future, he may be sure that others will discover it and that in time it will rise to a reasonable price level.”
I’m reminded of a 1955 Senate Committee hearing in which Ben Graham offered up “the mysteries” of the stock market.
But this goes beyond that. All of the focus that goes into earnings growth, profit margins, and Buffett style wonderful businesses, ignores the fact that perfectly not great businesses exist.
And some of those not great businesses can become extremely undervalued (deep value). Mostly, it’s because nobody cares about them. Nobody looks at them. Nobody hypes them on CNBC. Yet, investors make money from them. Because, as Graham said in 1955, “Eventually the market catches up with value. It realizes it in one way or another.”
- “Perhaps the best sort of speculation, and the kind that is most likely to be successful, is that which regards it as the business management of a fund.”
Ben Graham taught us to treat stocks not as pieces of paper, but as pieces of a business. Carret says you should treat your portfolio like a business too.
It’s an interesting way to look at it: to minimizes losses, maximize profits, and do what’s in the best interest for the long-term success of your “business.”
One way to do this is to “hire” CEOs/management, fund managers, funds, strategies, or advisors that align with your standards and goals and “fire” or avoid those that don’t. And do it in a cost-effective, tax efficient way.
But it also means not taking any unnecessary short-term or catastrophic risks that could threaten the life of your “business.”
Carret specific mentions margin loans, which were ridiculously excessively used in the ’20s to the detriment of many investors. Debt — under right circumstances and in a minimal way — can be a net positive for returns. However, the downside — in excess — can wipe you out.
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That fact didn’t stop people from doing it in the ’20s. It won’t stop people from doing it today either. The draw of higher returns often blinds us to potentially debilitating outcomes. Unlikely things happen often enough that it’s not worth risking your “business” over.
To sum it up: thinking in terms of a business reinforces the idea that any changes to your portfolio should improve your “business” overall.
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