Placing a bet on something that has at least as much chance of losing money as it does making money is called gambling. In stock investing, it’s called speculation. Very few people have built their wealth on stock speculation.
On the inauspicious occasion of April Fool’s Day, Lyft Inc. (NASDAQ: LYFT) made a public offering of its shares. I cannot remember an IPO in the last 25 years that has sent such a public, yet unintentional, message about its prospects to potential investors. The company, which went public at $72 a share, lost more than $900 million in 2018 and it doesn’t even hide the fact that it doesn’t expect to generate profits in the foreseeable future. As of April 16, the stock is trading at $57, down 35% from its high of $88 on April 1. To even pretend that Lyft, or any stock like it, is an investment is foolhardy. At best, it is pure speculation.
Is it Investing or Speculation?
It seems that profits have little to do with determining the stock value of some of these companies. It has more to do with what investors, or speculators, are willing to pay based on how they imagine the company’s stock price will fare in the future. And, it is nearly impossible to predict what people will pay for them in the future. That’s not the kind of foundation on which investors want to build a serious investment portfolio. Placing a bet on something that has at least as much chance of losing money as it does making money is called gambling. In stock investing, it’s called speculation.
It’s clear that some investors have forgotten the lessons of, or maybe never experienced, the catastrophe remembered as the “dot com bubble” in the late 1990s when valuations on hundreds of dot com companies were based on earnings that wouldn’t occur for many years – that is if the business model actually worked. Companies that had yet to generate revenue, let alone profits, and in some cases didn’t even have a finished product, went to market with IPOs that saw their stock prices triple and quadruple in one day, creating a feeding frenzy among speculators and day traders. At one point, there were more than 370 publicly traded dot com companies valued at $1.5 trillion, nearly 10% of the total stock market capitalization.
By the end of 2001, a majority of these companies folded, and the whole technology sector imploded. It would take the NASDAQ more than six years to reach half of its peak valuation. Many experts say that the lessons of the dot com bubble have been learned and it is not likely to be repeated. I’m not so sure.
Investing with a Margin of Safety
Very few people have built their wealth on stock speculation or trading. Building true wealth is a process that occurs through adherence to proven investment principles and practices, patience and discipline. The most successful investors of our time follow the fundamental principle of “margin of safety.” Introduced by the “father of investing,” Benjamin Graham, the principle is based on a simple truth. Graham figured that a stock priced at $1 today, is just as likely to be valued at 50 cents as it is $1.50 at some point in the future.
He also understood that the valuation of a $1 stock could be wrong, which means he might be exposed to unnecessary risk. But, if he could buy a stock at a discount to its intrinsic value, he could limit his downside risk. Although the stock’s price was not guaranteed to increase, the discount provided him with the margin of safety he needed to know that his loss would be minimal. Investing legend Warren Buffett likens this to “buying 50 cent dollars.”
The challenge is, when investing in stocks, something is almost certain to go wrong – typically as a result of external factors. That’s why Graham and Buffett always looked for an even steeper discount to the stock’s intrinsic value for the largest margin of safety possible before purchasing it. It takes patience and discipline to wait for the right pitch, but the payoff can be huge.
A Fundamental Principle for Protection
You and I apply the margin of safety principle every day in circumstances where we want to maximize our upside while minimizing our risk. For example, when you look for a parking space in your new car, are you going to pick the one where the cars on either side are parked right on the line? You might have to drive further out to find a spot with the right margin of safety, so you don’t have to worry about your car getting dinged.
The same concept is applied in investing where you buy stocks with enough room around them to protect them during periods of market turmoil. Investors who recognize the difference between a stock that is an investment, where a margin of safety is present, and one that is speculative, can avoid losses attributed to known or unknown emerging risks. By building a portfolio of stocks with a margin of safety, you can rest easier knowing your potential upside is much greater than your downside.
Few in the media and, seemingly, fewer investors understand the essential concept of what constitutes an investment. They tend to see blurry lines instead of bright signs where investing stops and speculation begins. When navigating the road of investing, heed the warning signs where a margin of safety is not present, such as “Danger: One Lane Road Ahead.” Although there may be an adventure ahead, the trip could go very badly.
