Chas Craig, BridgeTower Media Newswires
“But a pin lies in wait for every bubble. And when the two eventually meet, a new wave of investors learns some very old lessons: First, many in Wall Street – a community in which quality control is not prized – will sell investors anything they will buy. Second, speculation is most dangerous when it looks easiest.”
–Warren Buffett
Recent events have recalled the above excerpt from Mr. Buffett’s 2000 letter to Berkshire Hathaway shareholders. The most glaring recent example of the first lesson is the now-terminated (after SEC intervention) attempt by Hertz Global Holdings Inc., a bankrupt company, to sell fresh equity that, by the company’s own admission, was likely to be worthless in short order. This likelihood didn’t stop white-shoe investment banks from clamoring for the underwriting business.
Perhaps the best example of lesson two from this season was the enormous run-up in the share prices of airline companies from their lows earlier this spring despite the decimation in air travel that is unlikely to return to pre-COVID levels for a long while. In the a previous column, in addition to covering the Hertz saga in greater detail, my business partner, J.P. Szafranski, commented on the recent price action in airlines using American Airlines Group Inc. as a microcosm. Here is the conclusion to J.P.’s column:
“At this writing, American’s Enterprise Value (which accounts for total value of net debt and stock) is estimated at $41.8 billion. On Dec. 31 that same (pre-COVID) metric was $41.9 billion. Hmm. Weird.”
Regarding the above commentary, two things are worth noting. First, it seems as fashionable now as it was at the turn of the century to take pot shots at Warren Buffett and to write his career obituary.
Second, the share prices of Hertz and American have declined by 27% and 22% respectively since J.P. waved the warning flag two weeks ago. In the case of American, the decline came at least partially as a result of the company selling new equity to help shore up its balance sheet in the days following J.P.’s column going to print. It appears that the management of American agreed that their shares traded at an attractive price level to be a seller. Commenting on two-week share price movements is not really our style. However, I have done so here to illustrate the fact that stocks of a speculative nature tend to fluctuate wildly.
It is important to understand the difference between investment and speculation because they are often used interchangeably, most often by individuals who think they are investing when their activity is rank speculation. Benjamin Graham, the professor and one-time employer of Warren Buffett, and his co-author, David Dodd, had this to say on the subject in their seminal work, “Security Analysis” (1934):
“An investment operation is one which, upon thorough analysis promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.”
Below are my definitions of the two terms that have been, of course, significantly influenced by the writings of Graham and Dodd.
• Investment: When you purchase or continue to hold an asset at a discount to what you think it is worth after performing adequate due diligence.
• Speculation: When you purchase or continue to hold an asset based on what price you think others will soon pay for it.
Of note, the difference between these two terms interplays with our commentary on margin of safety previously shared in this space. While some stocks are speculative by the nature of the underlying business, a bankrupt rental car company for instance, purchasing or continuing to hold at too high a price for even the most fundamentally sound company can qualify as a speculation.
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Chas Craig is president of Meliora Capital in Tulsa (www.melcapital.com).
