Editor’s note: This is another response to the question posed here last week: what is the difference between investing and speculation? If you are compelled, we invite you to comment below, tweet us @cfainvestored, or reach out to us via email.
The most famous attempt to distinguish between investment and speculation was by Benjamin Graham, of Graham and Dodd fame, who wrote in The Intelligent Investor that investment “upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.”
That seems fairly clear, but leaves substantial room for interpretation around “safety” and “satisfactory.” So much room, in fact, that as clear as it seems it does not really define anything. What is needed, I would argue, is some kind of analytical framework that looks at the underlying economic facts of the case.
The Minsky criteria provide just such a framework. Hyman Minsky has become famous in the aftermath of the financial crisis for his characterization of the three phases of markets – hedge finance, where the borrower can repay interest and principal out of cash flows; speculative finance, where cash flows can repay interest but not principal, and therefore need to roll over any financing; and Ponzi finance, where cash flows cannot pay either principal or interest and therefore must either borrow more or sell assets to support those costs.
The Minsky moment in a crisis is when Ponzi finance becomes the most common. My colleague John Rooney aptly compares these to a fully amortizing mortgage, an interest only mortgage, and a negative amortization mortgage – images from the housing collapse, which was the most recent Minsky moment.
While this analysis, strictly speaking, applies more to the debt side, it is obviously relevant to equity investors as well, and perhaps more so as they get paid after the debt holders.
The Minsky criteria provide a good metric for assessing whether something is an “investment” or a “speculation.” Using the Graham definition and the Minsky criteria, investment would seem to fall in the “hedge finance” realm, where the underlying business can repay its existing debts as well as a return to the security holder on a sustainable basis.
Fixed income, at least in the more highly rated areas, is a natural match for this definition, as the return on and of capital are specified at the start. The equity of stable and profitable firms would also seem to reasonably fall in this category. Anything beyond these would be considered speculation.
This would seem to give a clear nod to value managers, which makes sense since it is based on the Graham definition – but it also seems a bit restrictive, as growth managers can also invest, but with the expectation of repayment coming from reasonably foreseen growth, rather than existing cash flows. Could the next step up the Minsky ladder, speculative finance, also be considered “investment” in the Graham sense? This is where the distinction starts to get a bit fuzzy.
Suppose, for example, that a stable and profitable firm (hedge finance) is growing faster than its current cash flows will support. In order to support that growth, it issues debt or equity based on the expected cash flows from that growth. Now remember, the firm is stable and profitable, and the existing operation could pay interest but not principal on the new obligations – speculative finance – but the principal payments on the new securities will be based on the expected growth. Now, for both the existing and new securities – investment or speculation? Are they different?
The decision is not so clear, and moreover is not fixed – for the existing securities and the new ones, it can change over time with the fortunes of the firm. Investment versus speculation becomes an ongoing decision process, rather than a one-time call. The status can also change based on market prices, even as the firm continues to do well. What is a good investment at $10 may be a rank speculation at $100, as the ability to repay clearly depends on the price paid. If markets bid up a security, what was an investment may become a speculation to the new purchaser.
Beyond looking at individual securities, the other interesting component of this analysis is what it implies for investors in the market as a whole – and this also relates directly to the price paid. While I talk about Minsky’s analysis in the context of individual investments above, he was really talking about systemic risk levels, and the development of financial instability, which is obviously relevant to the markets.
Taking a look at the market as a whole from a Minsky perspective, we can therefore start to consider whether putting money into an asset class is investing or speculation. Given the Graham definition, and the Minsky hedge finance criterion, you would be hard put to justify “investing” in any market where earnings are insufficient to pay for both debt and equity costs, given reasonable growth assumptions.
The key to that sentence, of course, is what is reasonable. I write this not to argue numbers, but simply to state that at some valuation for the market as a whole, the underlying cash flows will not support the price paid, and equity investment moves from a hedge state to a speculative state – or even to a Ponzi state. At some point, placing money in any market becomes speculation, not investment. Think back to the 2000 era Nasdaq.
The historical record also supports this conclusion. Research by many analysts, notably Ed Easterling and Crestmont Research, as well as my own work, shows that at higher valuations in equity markets, going forward returns are lower – in many cases, below what a typical investor, ex ante, would require for an equity investment. While it is difficult to prove that any investment is speculation based on estimated future returns, it surely is indicative that hope is overcoming analysis when history says going forward returns rarely or never meet the target levels from the starting point. Some would say we are at that point now, based on Graham Dodd P/E ratios, while others would argue current P/Es are reasonable. No way to determine which is right, but again at some valuation level equity investment as a whole becomes speculation.
The question of investment versus speculation is typically asked with respect to an individual security, and the answer has value in that context. What is not typically asked, but should be, is how the question applies to markets as a whole. As a way of quantitatively framing the question, based on cash flows generated by expectations and assumptions, the Minsky criteria provide a very clear way to determine exactly what you have. If it pays for itself, it is an investment, if not you have a decision to make about how “safe” you think the assumptions are.
The Minsky criteria can therefore act as a base for asset allocation models as well. By looking at the implied growth rates for a market based on current pricing and a target return rate, and comparing them to historical growth rates, we can see just how much of an “investment” an asset class is, and just how much “speculation” is already included in the price.
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