Over the last while I’ve been thinking deeper on the differences between investing and speculating. It’s easy to say that whatever goes up is investing, and whatever goes down is speculating, but there’s more to it than that. I think a better understanding directly creates better returns over time, so this is not a topic to gloss over. Lately I’ve been re-reading Warren Buffett’s shareholder letters for Berkshire Hathaway, and Jason Donville’s excellent ROE Reporter notes from his Donville Kent Asset Management, two investors who I consider have mastered investing over speculating. So by no means are my thoughts unique, but for the sake of collecting this multi-generational wisdom it’s important to share.
Investment is about cash flow. We want to own a company that produces positive cash flow and is expected to grow that cash flow over time. The best way to measure how well management produces cash flow is by looking at return on equity. I’ve written about this here and here. We expect management to take that positive cash flow and invest it back into the company’s operations to compound earnings, use it to buy back shares, or distribute it as dividends to shareholders. Any of these should propel a company’s price higher over the long term. That means regardless of valuation, as long as a company can grow cash flow over the long term, we should expect a higher share price to follow.
If we talk about a company’s price as being the balance of its supply of cash flow and the public’s demand for that cash flow, an investor should look for a sustainable and growing supply of cash flow before making their investment decision. Getting just this one idea right can protect investors from almost every other mistake you can think of.
Speculation is a very different idea. Instead of relying on positive cash flow to increase share price, speculation relies on investor psychology. In essence, speculators hope to find someone who’s willing to pay more for a company than they are, regardless of the company’s financial reality. That’s why Buffett has a hard time buying things like barrels of oil, bars of gold, or anything that doesn’t produce a cash flow. In those cases, it’s simply too difficult to figure out true economic value.
Luckily, staying on the right side of investing isn’t as hard as it seems. Comparing what a company shows on its earnings statement to what it shows on its cashflow statement speaks volumes about quality. At the end of the day, cash in hand always trumps earnings on paper.
Ben Kizemchuk is a Portfolio Manager & Investment Advisor with Altus Securities Inc. in Toronto. He offers financial planning and investment management for high net worth Canadian investors. Ben focuses on high quality investments, the Growth and Income Portfolios, low risk investing, and reducing tax.