FSU Editorial: "The Difference Between Stock Market Investment and Speculation" by Christopher M. Quigley 03/13/2007

THE DIFFERENCE BETWEEN STOCK
MARKET INVESTMENT AND SPECULATION
by Christopher M. Quigley, B.Sc., M.M.I.I., M.A.
March 13, 2007

The issue of successful stock market investment affects us all. Even if we are not directly engaged in the industry, all of us will need some form of pension to fund our retirement. Whether we like it or not most of our retirement funds will find their way into the financial markets. For this very reason, the issue of pensions has moved politically centre stage, in particular the investment strategies used to direct pension funds. Due to mismanagement over the last seven years, many retirement portfolios have become under-funded at best, or, at worst, totally bust. This situation is a direct result of the managed funds having been speculated rather than invested. Many cynics will say that the whole investment environment today has more of the characteristics of a casino than of a professional market of equities and, therefore, they doubt that one can ever achieve a faithful and fair return on capital. However, this view is erroneous as there is a distinct difference between speculation and investment. This essay sets out to explain some simple rules for successful long-term investment.

Benjamin Graham, the father of security analysis, and mentor of Warren Buffett, long believed in the stock market as a means to achieve financial freedom. The wealth he accumulated and the school of successful investment gurus he educated are testament to his insight and genius. The key to his formula has always been one simple concept: VALUE. His central message never changed and in a financial community which bores easily, his conservative investment style became "classical" and then "old fashioned". Graham ultimately derided the fads and trends that engulfed Wall Street and he eventually gave up trading and managing funds. However, his "baton" of value was spectacularly taken up by his acolyte, Warren Buffett, who went on to become the most successful investor of all time.

Buffett, like Graham, believes the policy of investing does not require high qualities of insight or forethought, as long as some simple rules are applied. In essence these simple rules are:

1. Safety of Capital
2. Adequacy of Return

An operation that does not seek both of the above is not an investment but a speculation.

Now in today's complex, volatile, media-driven and fast-moving market environment how does one actually apply these simple rules? The essential thing to realise is that when you buy an equity, you are purchasing part of a business. "Investment is most intelligent when it is most business like". The best way to achieve this business-like goal is to focus on price, and through systematic analysis of this factor, the grail of value will be discovered.

At Wealthbuilder, for pension purposes, we educate clients in how to review up to three thousand stocks every quarter. Using a number of filters, equity prospects are identified and compiled into watch lists. Then, through the use of basic technical analysis, appropriate buy-in and sell-out points are pinpointed. The main criteria that are used to filter these stocks are:

1. Dividend Yield
2. Financial Strength
3. Price/Earnings Ratio
4. Dividend Growth
5. Sales/Earnings Growth
6. Return On Capital
7. Business Model Strength & Sustainability

Of these seven elements, dividend yield, dividend growth and P/E ratio are the most important. Let me explain.

A study of monetary theory will show any scholar that money is a measure of value and that value is derived from one action alone; comparison. "Money is the mathematics of substitution". By comparing companies using the three fore mentioned criteria we are have a very simple process in place to quantify value to its most important element: SUSTAINABLE INVESTMENT INCOME RECEIVED. This investment income can then be re-invested to increase the investment base over many years. Through the power of compound mathematics, superior investment income creates a truly powerful total return and therefore should be at the core of pension strategies. The P/E ratio is important in that it should be a low as possible to indicate a fair value. The low P/E ratio is an indication that the investment income receivable is sustainable. Such long-term sustainability is necessary when one is dealing with the perspective of managing a pension portfolio. Ideally the target companies

should therefore be financially strong and engaged in large markets that have the potential to offer solid long-term growth.

In summary, the investment formula is as follows:

Financially Strong Businesses + Growing Earnings + High Dividend Yield + High Dividend Growth + Low P/E Ratio = Superior Value

In terms of value one cannot really compare a company that fits into a high dividend, low P/E model with a company that offers no return, other than potential capital gain. Unfortunately, the majority of equities traded on the financial markets fit into this latter category. These stocks, in the main, benefit only stock exchanges and brokers who obtain commissions and fees through trading activity. This is why we classify such stocks as "speculations" and not "investments".

Despite appearing to be a complex matter, the path to investment success is quite simple, as pointed out by Graham all those years ago. The financial achievements of his students: Warren Buffett, Charkie Munger, Ed Anderson, Bill Ryane, Rick Guerin and Stan Perlmeter, are testament to the enduring power of his investment philosophy. By applying this value perspective the average investor, using discipline and patience, has within his or her grasp the power to earn superior returns in the stock markets and thereby win for themselves and their families financial freedom and independence.

Reference:
"The Intelligent Investor" Benjamin Grahamm 1973 Harper & Row

Contact Information
Christopher M. Quigley, B.Sc., M.M.I.I., M.A.
www.wealthbuilder.ie
Dublin, Ireland
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