News & Updates

Lesson 2 – Always understand the difference between speculating and investing

By Anton Tagliaferro, IML Investment Director |  26 July 2018

Anton

Whilst many people will claim to fully understand the difference between the words “speculating” and “investing”, it is amazing how often people seem to confuse the two and use the words interchangeably.

An investor buying speculative Resource stocks on the stockmarket that they may have read about in a tip sheet or the newspaper, will often claim that they are “investing in the sharemarket”. The truth is that the value of these types of companies is very nebulous and virtually impossible to measure. In addition, the vast majority of these types of companies do not generate any income and are thus unable to pay any dividends to shareholders. In fact, what the owners of these sort of companies are hoping to do is to trade these shares for a short-term profit… and rather than ‘invest’ in the company, the owner of such shares is really just speculating on the stockmarket.

This sort of behaviour is based on ‘the bigger fool theory’ – buying an asset where there is no basis for measuring the value of the asset but hoping that a bigger fool buys it off you for a higher price. We saw this type of behaviour again recently in Bitcoin where people were ‘investing’ in Bitcoin – when really all they were doing was speculating that they can sell an item of dubious value at a higher price.

Investing, on the other hand, is about buying an asset that generates sustainable cash flows and where these cash flows can be used to either pay an income to the owner or used to grow the asset’s value over time by reinvesting in the business.Investing in the sharemarket is all about patiently accumulating a diversified portfolio of quality companies that can grow their profits over time and that can generate a sustainable and growing income stream. With competent management at their helm, good quality companies will use the cashflow generated and retained in the business to grow their value, and subsequently the wealth of their shareholders or to pay a solid sustainable dividend yield to shareholders. Good quality companies can generally both grow shareholder wealth and pay dividends to shareholders over the long term.

To clearly illustrate the difference between speculating and investing let us consider the performance of two companies over the last ten years – Lynas and Amcor.

Back in 2007 Lynas was a company that was planning to construct a new mine in WA to extract ‘rare earths’ and then build a plant in Malaysia to extract the different elements from the ore mined. These unusual commodities are required in miniscule amounts for producing goods such as mobile phones and laptop batteries and as demand for these items grew the rare earth price soared and the Lynas share price followed. At its peak Lynas was valued at around $2.5 billion as speculators pushed the share price to this level in a relatively short time. The reality is that contrary to the name ‘rare earths’, there was no shortage of supply of this mineral and the price of rare earths fell quickly from its peak. Within six months of Lynas share price hitting a peak of over $25 in April 2011, the shares fell over 50% and within two years was trading at less than $1. Speculating on Lynas seemed like a good ‘investment’ to many at the time and certainly some traders made money in the short-term, however those shareholders who held onto their shares lost a significant amount of capital.

$100 invested in Lynas
Source: IRESS, 28 Dec 2007 – 29 June 2018

On the other hand, a good investment over the same period was Amcor. Amcor is the largest packaging company on the ASX. Amcor generates strong recurring free cashflows from over 140 plants in over 60 countries which produce packaging mainly for its food, beverage and pharmaceutical clients around the world. Amcor’s main customers are large consumer goods companies that sell products which are in demand all throughout the economic cycle – this clearly helps to makes Amcor fairly resilient in economic downturns. Amcor has been a good investment in the last ten years as it has used the cashflow generated from its operations to make several accretive packaging acquisitions around the world while also paying a healthy, growing dividend to its shareholders.

So in summary, it pays to always clearly understand the difference between speculating and investing.

Speculating is all about buying almost any asset, often with a short-term focus, with the intention of making a capital gain by selling quickly which also brings with it a much higher risk of losing capital.

In contrast, investing is all about buying an asset (eg shares) where the underlying business generates a sustainable, recurring cashflow and where this cashflow can be used to grow the value of the asset as well as pay regular dividends to shareholders from its underlying earnings over time. All of which helps underpin and enhance the value of that asset

Source: www.iml.com.au