One of my pet peeves is how so many people have a penchant for not distinguishing the important differences between investing and speculating. I see it in the mainstream financial press, on numerous articles published in financial blogs such as Seeking Alpha, and extensively in the comment sections of published articles. In my humble opinion, the portfolios that people rely on to provide and support their financial futures are too important to lack precision. This is especially relevant to people in retirement.
Frankly, there are numerous differences between speculating versus investing in the purest sense. Moreover, based on my last statement, the subject is also too complex and extensive to comprehensively cover in the context of this one article. Therefore, I will limit my discussions to one primary differentiation that specifically applies to investing in common stocks (the stock market). I will apply this limitation because my primary purpose for writing this article is to discuss why I believe it's a mistake to hold cash in this market, or any market for that matter.
Consequently, I offer the following limited perspective on long-term sound fundamental investing in wonderful businesses versus attempting to guess where the price of a stock, or the stock market, may be heading in the short run. In other words, my distinction between the two concepts primarily applies to whether you're focusing on stock price or the intrinsic value of a publicly traded business. More simply put, speculators will focus almost exclusively on where they believe the price of a stock (or the stock market in general) is headed in the short run, while investors will concern themselves more with the True Worth™ of the businesses behind their stocks.
Speculating in Stocks
Perhaps the best place to start is by looking at the definition of speculate in the Merriam-Webster dictionary: "to think about something and make guesses about it; to form ideas or theories about something usually when there are many things not known about it; to invest money in ways that can produce a large profit but also involve a lot of risk." Or better yet, my favorite definition especially as it relates to my subject matter: "to take to be true on the basis of insufficient evidence."
To me, the bottom line about speculating, especially with the short-term movement of a stock's (or the market's) price is that it is analogous to merely guessing. In truth, there are too many things that speculators do not, and cannot know about short-term price movement. For starters, much of what will happen to a stock price in the near term will be emotionally driven. Mr. Market possesses all the classic psychological disorders to include schizophrenia and bipolar disorder. Since the market's mood can change in the blink of an eye, short run price behavior is often quite irrational, and therefore unpredictable.
The following five-day and one-day price graphs on the blue-chip Procter & Gamble (NYSE:PG) vividly reveal my points. Simply by noticing how jagged price movement can be from one day to the next or even one hour to the next, speaks loudly to how unpredictable short-run price movements can be. The jagged and erratic nature of a price only graph represents the epitome of nervousness.
Procter & Gamble 5-day Price Action
Procter & Gamble 1-day Price Action
Therefore, I contend that speculation about short-term price movement is in truth a game of chance or gambling. However, perhaps a more important point is that no one can truly know which direction or to what magnitude the price of the stock may move next, at least in the short run. Consequently, I further contend that it's important that speculators fess up to the reality that they really don't know. I will address this final point in more detail later in the article.
Sound Fundamental Investing in Wonderful Businesses
In contrast, investing in a business that you would like to be a long-term partner of is an entirely different endeavor. Excluding any opinion on what the stock price might do in the short run, it is far easier to evaluate the fundamental strengths of a business than it is to guess where its price might go. The venerable Marty Whitman had this to say on this important subject:
"I remain impressed with how much easier it is for us, and everybody else who has modicum of training, to determine what a business is worth, and what the dynamics of the business might be, compared with estimating the prices at which a non-arbitrage security will sell in near-term markets." Martin J. Whitman, Chairman of the Board, Third Avenue Value Fund.
Therefore, I will argue that it only makes sense that individuals deal with things that they can know something about, over attempting to do what simply cannot be done. I believe that what Marty Whitman is telling us is that we can rationally identify the sound underlying fundamental characteristics of a good business. We can accomplish this by examining the company's financials such as their balance sheets, cash flow statements and income statements. We can also review their historical operating records of earnings, cash flow growth and dividends, etc. In short, sound fundamentals are enduring whereas short-term price movement is erratic and unpredictable.
At this point, I would like to interject that I am not endeavoring to offer a value judgment here. Instead, I'm simply trying to point out that there is a vast difference between positioning yourself as an investor in contrast to that of a speculator. Some might argue that gambling or speculating with your money is inherently evil, however, I am not. What I am saying is that they are very different practices. But more importantly, I'm saying that individuals should be clearly cognizant of how they are in truth behaving. If speculating, call it that. But don't call yourself an investor unless you are actually behaving as one.
Hording Cash in Fear of a Market Correction Is a Mistake
The above introductory remarks lead me to the following discussion dealing with the primary thesis of this article. It is my humble opinion, based on almost five decades of experience, that holding cash based on either a belief or fear of a pending market correction is a mistake. First of all, no one can know whether the stock market will rise or fall over the next day, month, quarter or year - no one. Regardless of what your opinion is, it is at best only a guess. Personally, I eschew basing my investment decisions on mere speculation about something that I cannot possibly know. My wealth is simply too important to me to do that.
Moreover, since I know that it is a market of stocks and not a stock market anyway, I see little or no reason to speculate or worry about what the market might or might not do in the short run. Mary Buffett and David Clark in their book Buffettology expressed it like this:
"Warren's Solution to all this Bear/Bull market twaddle is to totally ignore it. He can do this because he buys into a business on the basis of price (Value). Where the market is on any given day doesn't really matter to him."
Warren Buffett himself offers up these words of wisdom:
"(Partner) Charlie (Munger) and I never have an opinion on the market because it wouldn't be any good and it might interfere with the opinions we have that are good."
"The market is there only as a reference point to see if anybody is offering to do anything foolish. When we invest in stocks, we invest in businesses."
"If we find a company we like, the level of the market will not really impact our decisions. We will decide company by company. We spend essentially no time thinking about macroeconomic factors. In other words, if somebody handed us a prediction by the most revered intellectual on the subject, with figures for unemployment or interest rates, or whatever it might be for the next two years, we would not pay any attention to it. We simply try to focus on businesses that we think we understand and where we like the price and management."
The last Warren Buffett quote essentially summarizes the thesis of my article. Stated in my own words, I realize that attempting to forecast markets or stock prices in the short-run is an exercise in futility. Short-term market movements are driven and dominated by emotion and not rational thought. At any given moment in time, the powerful emotions of fear or greed can and will overshadow reason. However, in the longer-run, lucid thinking prevails. Therefore, I say invest for the long run.
Debunking a Common Market Timing Myth
Perhaps my favorite excuse (translate: the one I hate the most) for holding cash relates to many people's beliefs in the importance of government's role and its potential impact on the stock market. Frankly, although I am personally as irritated with our federal government's out-of-control deficits and economic policy in general as anyone, I see it as an entirely separate issue from the stock market or the general economy for that matter. More importantly, political issues are not something that I allow to defer or alter my investment decisions. Moreover, I am not alone in my thinking. Fellow Seeking Alpha author Jeff Miller has written extensively on the same subject, his most recent installment can be found here. I highly recommend that readers check out Jeff Miller's work.
Additionally, for those readers interested in additional insights into other contrarian views, I suggest following this link.
Here is an excerpt:
"We act like there is some limited amount of money available," says Kelton, "and that government competes for savings with the rest of the economy, and that too much competition for savings drives up interest rates, and higher interest rates crowd out all productive private investment. We act like the federal government is walking a fine line between solvency and insolvency - that if the debt gets too big, our creditors may begin to get nervous, downgrade our debt, our interest rates go up, and suddenly we end up like Greece."
Yes. So? "That picture has no economic meaning whatsoever," says Kelton. "None."
And for even more in-depth analysis on the subject and the fed's role check out more from Stephanie Kelton, PhD, Department of economics, University of Missouri's work here (especially her MMT Coloring Book):
Now I am not naïve enough to believe that anything I have said in this section will alter the views of those with a fierce belief that the market will soon crash based on fed action or policy. However, I do at least hope that many will at the very least realize that these beliefs are not absolute facts, they are just opinions. But most importantly, I hope that many can at least consider the possibility that these issues are not directly related to investing in common stocks, especially blue-chip dividend growth stocks.
My Primary Reasons for Not Holding Cash
Consistent with my - it's a market of stocks thesis - it's important that investors recognize that there is no direct relationship between the stock market's performance and the performance of any given individual business. Individual companies create and generate shareholder returns based predominantly on the successful operating results of their businesses. Evidence of this critical fact is easily found through examining the individual performance of specific businesses and benchmarking that performance against the S&P 500 (a widely-accepted proxy for the market).
The following examples are presented one year prior to the Great Recession to current. Note how the performance of each is vastly different and independent of the performance of the S&P 500. I have circled the performance comparison table and highlighted the total annualized rate of return for each company versus the S&P 500.
TJX Companies Inc. (NYSE:TJX)
McDonald's Corp. (NYSE:MCD)
DaVita Healthcare Partners (NYSE:DVA)
Consolidated Edison Inc. (NYSE:ED)
Consequently, rather than trying to time the market, I believe it makes more sense to focus your attention on individual businesses when you can find them at attractive valuations. Clearly, the long-term performance of the above examples had virtually nothing to do with the stock market, and everything to do with how each of the individual companies performed as businesses in their own right. Or as I like to say, the stock market in the general sense has nothing to do with investing.
It is absolutely a market of stocks not a stock market. Therefore, unless you plan on owning an index fund, considerations about what the overall market might or might not do should be of little concern. On the other hand, your views of the individual companies you own or are interested in owning should be of paramount importance to you.
Good Value Can Be Found in All Markets
This next section is primarily oriented to my friends and followers in the Dividend Growth Investor community. Experience has taught me that good value can be found in all market environments. Whether we are in a bull market or in a bear market, or about to enter either one, there always exist overvalued stocks, undervalued stocks and fairly valued stocks.
I recently penned a series of articles covering fairly valued dividend growth stocks found on fellow Seeking Alpha author David Fish's lists of Dividend Champions, Contenders and Challengers. My following sets of examples features one company from each of the CCC lists that I believe is worthy of further consideration today. With each set, I also provide the link to my article that presents other candidates that are fairly valued or close to being fairly valued currently.
Dividend Champions in Value
Stanley Black & Decker Inc. (NYSE:SWK)
For more information on Stanley Black & Decker, follow this link to an article recently published by my associates at FAST Graphs™.
Dividend Contenders in Value
What Stock Market? These Dividend Contenders Are Not Overvalued - Part 2 Silgan Holdings Inc. (NASDAQ:SLGN)
Dividend Challengers in Value
Philip Morris International (NYSE:PM)
My Next Most Important Reason for Not Holding Cash: Market Corrections Are Temporary
As I previously pointed out, I contend that forecasting the market is an exercise in futility. But even more importantly, if and when a correction does occur, it is most assuredly temporary. There is a simple truth and a historical fact that argues against holding cash for fear of an imminent market correction. Eventually, all bull markets end with a bear market, and all bear markets end with a bull market. Therefore, the prudent long-term investor that understands this also recognizes that time in the market is significantly more important and valuable than attempting to time it.
My point being that even if a correction does occur immediately after you invest in a quality business, in most cases it will not hurt you unless you panic and sell. Sadly, this happened to many investors that were panicked during the recently passed "Great Recession" of 2008. During the 2008 recession all we heard about was how so many people had lost approximately half of their retirement savings during the horrific and scary stock market crash.
Unfortunately, for those that did sell at the bottom, it was true. However, for those with the foresight to have confidence in the great businesses that they owned, these horrible losses were avoided. Moreover, not only did these more levelheaded investors recover their losses, for the most part their portfolios are now worth significantly more than they were even at their peaks prior to the crash. Also, for the most part, blue-chip dividend stalwarts raised their dividend each year. Consequently, price volatility caused no loss of income as these investors were paid handsomely to wait it out.
This speaks loudly to the importance of focusing more on the business you own instead of reacting to the often irrational volatility of stock price movements. If you own the right businesses, price volatility can only hurt you if you react to it and let it. In the longer run, it's the operating results of the business that rewards shareholders and not the day-to-day gyrations of stock or market prices. I offer the following examples of blue-chip dividend growth stocks that support what I have just stated.
Caveat: These are examples of blue chips that remained profitable during the recession, and consequently grew their dividends through the recession as well. They are not recommendations for purchase today, as many of them are currently overvalued. Pardon the redundancy; however, I want to establish how commonly this occurred.
I will let the Earnings and Price Correlated F.A.S.T. Graphs™ on each tell the story. Therefore, I ask that the reader focus on the orange earnings justified valuation line on each company and the dividends (the pink line prior to dividends paid out, and the blue shaded area illustrating after dividends are paid out). But most importantly, note how price initially fell, then eventually recovered in each case. Additionally, many of these examples were actually overvalued in 2007 just prior to the Great Recession yet have still reached new highs today.
Recession Proof Blue-Chip Dividend Growth Stocks
Automatic Data Processing (NASDAQ:ADP)
Colgate-Palmolive Co. (NYSE:CL)
Clorox Co. (NYSE:CLX)
Coca-Cola Co. (NYSE:KO)
Procter & Gamble Co.
Johnson & Johnson (NYSE:JNJ)
Kimberly-Clark Corp. (NYSE:KMB)
3M Co. (NYSE:MMM)
Wal-Mart Stores Inc. (NYSE:WMT)
It Is a Market of Stocks
However, in the spirit of balance and fairness, I feel it's only prudent for me to point out that not all stocks recovered as we saw with the examples above. It is a market of stocks, and therefore, it is the individual stock selection that is most important. Not the market in general, but the individual stock or company that you invest in that matters most. Therefore, I include the following example on Diebold Inc. to illustrate how the individual company you invest in is more relevant than what the stock market may or may not do or did.
Interestingly Diebold had one of its best earnings years during both the recession of 2001 and again in 2008. In other words, it wasn't the economy going into recession that hurt earnings. The problem was obviously company specific.
Diebold Inc. (NYSE:DBD)
I am only including Diebold's performance for the year prior to the Great Recession to current in order to be consistent with the performance results in the section above. The point is that Diebold ruefully underperformed the market over this timeframe.
For The Growth Investor
Perhaps more than any other type of common stock, growth stocks epitomize the principle that it is a market of stocks, and not a stock market. The following examples of powerful growth stocks vividly illustrate that the stock market in the general sense has absolutely nothing to do with their long-term performance. In each of the examples below, we discover long-term shareholder returns that are orders of magnitude greater than what the S&P 500 delivered over the same timeframe.
Frankly, if these examples do not convince the reader that the stock market has little to do with investing, then I feel nothing possibly could. The shareholder returns that each of the following companies generated are closely correlated to the business results that each of these growth stocks generated. In the long run, earnings drive market price and represent the source of shareholder returns. Not the stock market, but the specific company's operating results. Holding cash when you can find companies like this at fair value is a mistake, in my humble opinion. But more importantly, I believe the following evidence supports my thesis.
Carters Inc. (NYSE:CRI)
FactSet Research Systems Inc. (NYSE:FDS)
Green Mountain Coffee Roasters (NASDAQ:GMCR)
Questcor Pharmaceuticals Inc. (QCOR)
LKQ Corp. (NASDAQ:LKQ)
Google Inc. (NASDAQ:GOOG)
Apple Inc. (NASDAQ:AAPL)
Summary and Conclusions
As I come to the end of this article, I want to make one thing perfectly clear. This article is written for the serious long-term investor. These are true investors who desire positioning themselves and their portfolios as shareholder partners in wonderful businesses because they admire the companies. True investors do not concern themselves with worries about what the overall stock market or even the economy may or may not do in the near term. Serious long-term investors recognize and understand that best-of-breed businesses are capable of performing in all markets and all economies. Yes, there will always be short-term price volatility, but it can be ignored when you own excellent companies.
On the other hand, I do not mean to imply that I consider traders or speculators as second-class citizens. Instead, with this article I have endeavored to point out that there are significant differences between investing and speculating. I believe that it is imperative that the individual has a clear understanding and recognition of which they are. Because, how you should behave or react to stock market volatility is functionally-related to whether you are an investor or a speculator. What is prudent behavior for an investor may be entirely different, or even the opposite, of how you should behave if you are a trader. Know thyself - is a vital aspect of intelligent portfolio management.
I would like to close this article by sharing an excerpt from a Value Line Investment Survey educational article that I feel summarizes many of the points I was trying to make nicely. I include a link to the entire article here.
"Trading: Going With The Flow
Traders are close kin to speculators, but with two important differences. As we just alluded to, speculators have an idea, hope, or belief where things should go and they're making their moves accordingly. Traders, on the other hand, aren't trying to guess (see ahead) where things might go. They're more interested in where things are going now. Basically, a trader will look for a trend (up or down) and then follow it. When it ends, peters out, or reverses itself, he or she is onto the next trade. This may transpire over a variety of time spans, all the way down to the level of milliseconds in the case of programmed trading. There is no fundamental analysis required. No need to do extensive research and assessment of a company's past operating performance and prospects. Indeed, in all too many cases, business trends, economic environment, and even the company name may not matter. A stock is either moving or it isn't. In fact, methods which largely rely on price action (technical analysis), have long-been streamlined to the point where computers can do it better and faster than humans. Thus, automated trading now accounts for the lion's share of daily stock market activity. At the risk of oversimplification, the markets are dominated by systems following instructions. When "X" happens, do "Z".
Another important difference between traders and speculators is that the former are usually looking to make small profits on a lot of little trades, while speculators generally seek bigger profits on fewer transactions.
So Which Style Fits Your Type?
If you're of the sort that listens to and watches the market's behavior, seeking out an existing trend or situation, and attempting to extract some profit from it while it lasts, then you're a trader. Or, if you prefer, a momentum-based investor. Time frames and frequencies will vary, of course, according to taste and temperament. You might be looking at issues that have done well over the last few months, weeks, or minutes. Either way, you're looking to hop on a train that's already moving, and preferably at a decent clip.
On the other hand, if you buy a stock with the expectation that it will, should, or even "can't help but" go up, whether in five years, five months, or five days, then you're speculating. You believe that the market has it wrong and your information or foresight is correct. You are, in a sense, telling the market what it should do. Under the classic nomenclature, you were undoubtedly a speculator. Now, you're a growth, value, special situation, or turnaround investor.
Finally, with all the above held under consideration. If you only buy carefully selected stocks to collect their dividends with the thought of holding them now and forever (with perhaps a little appreciation down the line), then you, sir, are an investor in the classical sense of the word. That is, until conditions change. Indeed, it would be foolish to continue to hold on to even well-chosen issues if they no longer make financial sense. If the dividend is eliminated, for example, then it no longer fits our definition. If the dividend gets cut, we need to reevaluate whether it's still worth holding. And, if the price has taken a big hit (relative to the broader market or its industry peers), we need to look into whether it's worth buying more or selling out altogether. Thus, the classic investor category has morphed into what's more-commonly referred to today as "Income" investing."
For all the reasons stated above, and others, I believe it is always a mistake for true investors to hold cash based on an expectation of what the stock market might do in the near-term future. Instead, I recommend building portfolios whether it is for growth and income, income or growth alone, one company at a time. Study and analyze the businesses you are interested in and make your long-term investing decisions on those merits. You don't have to buy at perfect bottoms, and you don't have to sell at perfect tops, in truth, that cannot be accomplished except by chance. Identifying great businesses at sound valuations is not only all you can hope to accomplish, it is something that you can accomplish with a little work, effort and intelligent thought. Invest wisely.
Disclosure: Long AAPL, CL, CLX, KO, PG, TJX, MCD, ED, GOOG, LKQ, JNJ, KMB, WMT and GMCR at the time of writing.
Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. We do not recommend that anyone act upon any investment information without first consulting an investment advisor as to the suitability of such investments for his specific situation.
Disclosure: I am long AAPL, CL, CLX, KO, PG, TJX, MCD, ED, GOOG, LKQ, JNJ, KMB, WMT, GMCR. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.