Investing vs Speculation

I’ve had several conversations around the current market valuation, “Wall Street Bets” or “Meme Stocks,” Cryptocurrency and NFTs etc. I’d like to spend more time on each in the future as they all have their unique aspects, but for now, a good place to start is the difference between investment and speculation.

At the most basic level it’s a simple question of, “Where’s the cash?”

An investment is something that can be valued based on the cash that it generates/is reasonably anticipated to generate, while speculation relies solely on an estimate of what someone will be willing to pay in the future.

Investments

Investments include:

Stock in earnings/cash producing companies

Bonds

Income-producing real estate

Royalties or mineral rights

Others, but you get the idea

Net Present Value: The Gold Standard of Valuation

The gold standard for valuing an investment is Net Present Value (NPV). An investment’s NPV is the sum of cash flows that an investment will generate into the future discounted back to the present for a number of factors (such as the timing of receipt, risk level etc). While it sounds scientific, there is a significant amount of art in this process as it requires estimates, but at least there is a logical basis on which to derive a value.

This may be in the weeds, but it’s important to differentiate between a company’s cash flow and its earnings. A company generating earnings is a good start, but most operate on the accrual basis of accounting which includes things like sales that have been booked, but not yet paid (so no cash inflow) and non-cash expenses like depreciation (no cash outflow). These items, among other things, make a company’s reported earnings significantly different than its actual cash flows.

Cash is what pays the bills and what were interested in. Luckily publicly traded companies are required to include a statement of cash flows with their quarterly accounting package. The cash flow statement provides a historical basis and a place to start with future estimates for valuation.

Understanding the characteristics of a legitimate valuation model is more important than being able to put one together for the purpose of this illustration.

Speculation

Items broadly include:

Stocks of companies that do not produce earnings or cash flow

Gold, diamonds and commodities in general

Non-income producing real estate (raw land that you don’t plan to develop or a non-rented vacation home)

Cryptocurrency

Non-Fungible Tokens (NFTs)

Classic cars

Sports cards

Comic books

Lottery tickets

Drivers of Speculative Asset’s Value

Without cash flow for valuation, speculative assets derive their value from other things like “use value” and supply and demand (yes supply and demand is a component of valuation of an investment as well).

Use Value

A good example for use value is gold. Gold is worth what someone is willing to pay for at a given point in time, but its not pure speculation because it also has use value in jewelry and some manufactured items underpinning its value. The custom of buying engagement rings isn’t likely to end anytime soon, so gold will always have some floor underneath it’s price due to its use value.

Supply and Demand

Particularly for items with use value, speculative assets rely heavily on the supply of that item compared to demand for it at any given time. A great current example is lumber. The price of lumber is up something on the order of 300% in the past year. This is largely due to unanticipated demand for housing, reduced production during the pandemic and tariffs we’ve put on Canadian imports.

Going back to gold, the demand for gold wedding rings isn’t likely to subside, however significant additional found deposits or significant reductions in the costs to mine it will result in additional supply therefore reducing its value. Productivity enhancements are a relative constant, therefore increases in supply is a risk of holding commodities.

Hybrids; The Investment and Speculation Cocktail

Some, probably most, investments have at least an element of speculation. None more clearly illustrated than real estate.

As those of you who own rental properties know, we evaluate their quality as an investment based on the amount of cash they generate after expenses.

However, there is also a speculative aspect to real estate. In addition to the ongoing cash flow from operating the rental “business”, there should some level of price appreciation realized at sale absent an extenuating circumstance like a lack of maintenance resulting in a state of disrepair or local event that results in a loss of value like the closure of a major employer in the area.

Summary

“Is speculation bad” is a question that often results from this conversation. Just like anything else, if you must, moderation is the key. Some speculation is OK and possibly beneficial.

The key is knowing the difference between when you are investing and when you are speculating and basing the majority of your future on the former (like a diversified portfolio of cash producing companies) rather than the latter (a lottery ticket or equivalent).