A common misperception among many individual investors, financial market commentators, and investment professionals is to refer to any individual or institution participating in the common stock market as an “investor.” Seemingly nowhere in this accepted definition is there any regard to the price paid, purpose of the investment, or level of due diligence conducted.
My observation, however, is that most stock market participants, even the so-called “smart money” — fund managers and other professional investors — are in fact “speculators” seeking to profit from short-term price fluctuations. Given that short-term price fluctuations largely represent factors other than changes in underlying business values, speculation is largely an attempt to deduce the perceptions and actions of other market participants — a game seemingly few, if any, can win.
Investors, on the other hand, are those who view stocks not as pieces of paper to be traded back and forth, but rather as pro-rata interests in companies. An investor recognizes that the benefit of stock ownership lies in the proportional claim that an owner has on the earnings and net asset value of a company, and seeks to profit from the eventual reflection of the company’s fundamentals in the market price.
The distinction between investment and speculation can at times be unclear. The best definition, in my opinion, of investing as distinct from speculation comes from Benjamin Graham, who is considered the father of value investing — an investing philosophy we follow at Tortuga Capital. In his 1934 book Security Analysis, co-authored with David Dodd, Graham wrote: “An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.”¹
Readers who want to learn more about the broader framework behind this distinction can begin with this guide to fundamental investing from the Fundamental Investing Institute.
The rest of this essay focuses on how we at Tortuga Capital think about the Graham and Dodd framework in our own investment approach.
Criteria 1: Thorough Analysis
Graham and Dodd’s “thorough analysis” criterion is a reference to the level of due diligence an investor must conduct before committing capital to an investment. At Tortuga Capital, we seek to thoroughly understand a company’s financial position and earnings generation, management and governance structure, competitive position, and industry.
Although the research process changes somewhat from company to company, we follow a general blueprint when conducting company due diligence.
We start by reading at least the last three years of a company’s annual reports, and possibly more for cyclical companies. While reading through the annual reports, we seek to understand the company’s various business, product, and service lines. We also spend a substantial amount of time on the company’s financial statements, accompanying footnotes, and Management’s Discussion and Analysis section.
In reviewing these materials, we are specifically trying to understand:
- What the company owns and owes, including assets and liabilities in approximate market values;
- The company’s free cash flow for the period; and
- Management’s record in allocating the company’s cash flow and managing its financial resources.
We make a number of analytical adjustments to a company’s financial statements to aid us in assessing the above considerations.
We then read the proxy statements and shareholder letters for the corresponding period of time. With proxy statements, we pay particular attention to how management is compensated, the company’s overall corporate governance, whether the company has a truly independent board of directors, and any related-party transactions.
With shareholder letters, we want to get a feel for how management communicates with shareholders and to see how management’s claims reconcile with the company’s operating performance as derived from the financial statements.
We also try to identify the company’s most relevant competitors to see how the company compares. In addition, we review earnings call transcripts and investor presentations. We spend a great deal of time on the company’s website to further understand the business, and we may contact competitors, customers, or suppliers in an effort to gain additional insight.
All of the above efforts culminate in an attempt to value the company. The purpose of this work is to compare our valuation estimates to the company’s current market price.
Criteria 2: Safety of Principal
For Graham, safety in an equity investment came primarily from paying a price significantly below appraised business value. Graham referred to this discrepancy as the investment’s “margin of safety,” noting that the margin of safety is dependent on the price paid.²
This concept is central to value investing. A margin of safety does not eliminate risk, but it helps reduce the likelihood that analytical mistakes, unfavorable business developments, or changing market conditions will lead to a permanent loss of capital.
At Tortuga Capital, we believe that a focus on safety of principal begins with the recognition that price and value are not the same thing. Market prices can fluctuate for many reasons, including investor sentiment, short-term disappointment, institutional selling, or changing perceptions about a company or industry. Business value, by contrast, is rooted in the underlying economics of the enterprise.
For this reason, we seek to invest only when the gap between market price and appraised business value appears meaningful. This emphasis on margin of safety is one of the primary distinctions between investment and speculation. Speculation is often concerned with what the market may do next. Investing, properly understood, is concerned with what an asset is worth and whether the price offers adequate protection against uncertainty.
Conclusion
The terms “investor” and “speculator” are often used interchangeably, but the distinction is important. In our view, a true investor conducts thorough analysis, seeks safety of principal, and requires the prospect of a satisfactory long-term return.
Speculation is primarily concerned with short-term price movement and the behavior of other market participants. Investing is concerned with business value, disciplined analysis, and the relationship between price and value.
At Tortuga Capital, our approach is grounded in this distinction. We believe that long-term investment success requires independent analysis, patience, and a persistent focus on margin of safety.
¹ Benjamin Graham and David Dodd, Security Analysis (New York: McGraw-Hill, 1934), 54.
² Benjamin Graham, The Intelligent Investor (New York: HarperCollins, 1973, 2003), 517.
