Debating financial speculation with speculators

By Felix Salmon
June 23, 2011

On Tuesday I moderated a panel at the New York Forum which featured, inter alia, Duncan Niederauer, the CEO of the New York Stock Exchange, and Richard Robb, the CEO of Christofferson Robb, a money management firm which does its fair share of speculation.

My question at the beginning of this clip, for Niederauer, didn’t come entirely out of the blue. Amar Bhidé had previously talked about the casino aspect of markets, and Andrew Ross Sorkin had talked about the distinction between speculation and investment. But Niederauer was not happy when I pushed him on these concepts. Wall Street is increasingly a game of speculation rather than investment, I said, and asked how a casino operator pushing people to make bets over the course of a millisecond was not part of the problem. Rather than engaging with the question, he simply shut me down: “I thought my job description was quite different than what you just described,” he said. “So you must be talking to someone else.”

Niederauer then used all his media training to pivot and give a mini-speech instead about how self-regulation was better than Dodd-Frank. But Richard Robb, to his credit, engaged, even if what he said doesn’t stand up to scrutiny. “I don’t know what the difference between investing and speculation looks like,” he said, throwing up a straw man of everybody working at peoples’ tractor collectives. Robb’s prescription was essentially to do nothing but ban a few of his competitors: stop big banks from doing what he does, leave him alone to do anything he wants, and “let innovation find its own way, and if it’s parasitic and unproductive, it will not be rewarded by the capitalist system.”

That’s clearly false, of course: we can all think of parasitic and unproductive Wall Street innovations which have made millions of dollars for bankers and traders and money managers. Richard Robb himself gave a good example earlier on in the panel: structured investment vehicles.

And so Sorkin jumped in, making the good and obvious point that “it’s actually very easy to see what speculation is and what investing is.” Here’s one simple distinction: speculation is where you buy something in the expectation that it will rise in price, where investment is where you put money into something so that over the long term you can make a profit from the resulting cashflows, be they coupon payments or dividends. And as Sorkin said, if you make an investment for two seconds, that’s clearly speculation.

Robb’s response to Sorkin I think was one of the most telling points of the panel. “How about two days?” he asked. “Two weeks? Two months? Where would you draw the line?”

I could barely believe what I was hearing — was Robb really suggesting that holding a position for two days might be considered investment rather than speculation? Or even two months? All of them are speculation — and the fact that the likes of Niederauer and Robb can’t see that is I think a big part of the problem.

The subject of the panel was financial innovation, and Robb genuinely believes that he’s something of a centrist on the issue: he makes great play of agreeing with his friend Bhidé, for instance. But the fact is that if you’re talking to alumni of Goldman Sachs (Niederauer) or the University of Chicago (Robb), or someone who used to run the derivatives desk at a too-big-to-fail bank (Robb, again), then their idea of what’s good for the world is always going to be pretty skewed. They’ve made millions of dollars in the Wall Street casino, and they’re precisely the people being put on panels to ask whether the casino is a good thing. It’s reasonably easy to predict what they’re going to say — and to discount it heavily.

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Comments
38 comments so far

http://en.wikipedia.org/wiki/Speculation
According to Graham and Dodd, investment is where you can get a satisfactory return with little chance of a loss of principal, but speculation is when you purchase securities with little margin of safety and a higher chance of a loss of the initial investment.

What you’re really opposed to is not the relation between security purchase and margin of safety, rather you are concerned about time horizon. Hence, a better question is why is purchasing securities with a short time horizon bad? or Why is the fact that Wall Street is a “casino” bad (I could dispute that it is, but conceding that it is)?

I see almost no connection between the financial crisis and the shortening of investment time horizons. The problem was that banks held massive mortgage positions for a long time. In fact, the banks problem was their time horizon was too long!

Of course, from a Graham and Dodd perspective, they did engage in speculation and deserved to lose their principal. Perhaps G&D’s definition is more relevant here than merely time horizon.

Posted by jmh530 | Report as abusive

Uh, these guys work in the industry, so they know the tax laws.

Investments must be held for at least a year.

Long-term investments are held for at least five years.

There are supposed to be tax considerations otherwise.

I know of no firm in the industry that permits its employees (if you want to use the looser standard) to hold a position for less than 30 days in their personal account, and at least two or three require 90, with more appearing to follow.

So even by the loosest of definitions, I have no trouble saying that two days–or even two months–is speculation. And the HR policies at financial services firms and the IRS both appear to agree that even that is a very generous interpretation of where the line should be drawn.

Posted by klhoughton | Report as abusive

astute comment from jmh530!

along those lines, one thing that bothers me is the implicit assumption in the body of Felix’s post that somehow Mom&Pop’s retirement accounts are “investments” as opposed to “speculation.” Nonsense – throwing money into a handful of mutual funds / stocks / index funds and waiting 50 years until you hopefully magically get rich is not investing either.

so perhaps EVERYTHING is speculation, which has kinda been my point all along. the next questions is related to a point jmh530′s comment was hinting at:

is it any “better” or “worse” to speculate for 2 seconds or 2 hours as opposed to 2 months, 2 years or 2 decades? I don’t think it is – I think it’s an inherent hypocrisy many people have though: “Oh, what I’m doing is *good* and *noble* while those short term *speculators* are *evil*”

Posted by KidDynamite | Report as abusive

do not agree with the columnist on this one. and it’s quite simple.

>>Here’s one simple distinction: speculation is where you buy something in the expectation that it will rise in price, where investment is where you put money into something so that over the long term you can make a profit from the resulting cashflows, be they coupon payments or dividends.

Posted by goodtimesbadtim | Report as abusive

do not agree with the columnist on this one. and it’s quite simple.

“Here’s one simple distinction: speculation is where you buy something in the expectation that it will rise in price, where investment is where you put money into something so that over the long term you can make a profit from the resulting cashflows, be they coupon payments or dividends.”

imho: returns = yield return + capital appreciation/depreciation.

cashflows due to investments/speculative purchases include not only coupons or dividends but also the return of principal (most usually conceptualized as being at the end of the holding period). so in order to “profit from the resulting cashflows”, one would need to look at the composite of the coupons or dividends and the return of the “principal”. return on short-term investments (specs?) emphasize the “principal” (maybe), while returns on longer-term speculative purchases would (usually) also involve some kind of intermittent cash flows. but you need to look at both the yield and capital appreciation/depreciation components for all investments, regardless of holding periods.

no?

Posted by goodtimesbadtim | Report as abusive

Thanks KD, love your blog, BTW.

Posted by jmh530 | Report as abusive

The correct answer to any question of word meanings is “why?” If you want to say that investment has certain properties and speculation has other properties, use the definitions that give them those properties; too much attempt at intelligent discourse seems to consist in sloppiness on this front, in which a term is given a definition suitable to one purpose and is then used in a way for which its definition is entirely unsuitable. If Sorkin has a reason for using these words, and he has working definitions of them, go ahead and use those definitions, but if they have implications for whether speculation has been increasing or is bad in some sense, note that some other definition might have different implications.

klhoughton notes that the terms are used in at least one context in tax law. Economists tend to use “investment” to mean the purchase or production of goods whose primary purpose is to expand future opportunities for production, but the term “speculation” has no related meaning. Economists and tax lawyers, presumably, understand what they’re saying when they say these words, and they presumably are saying different things. I almost always mean the economists’ meaning when I use the term “investment”.

In the abstract, if I’m asked to distinguish “speculation” from “investment” as related but distinct concepts with no other context, I would lean on Buffett’s maxim that “the best time to sell is never”, by which he means you don’t buy an asset you wouldn’t be willing to buy if you knew it could never be sold. If you buy that asset and the next day the price goes up by much more than your estimate of the value does, and you sell it because you no longer believe that it’s worth more than the market price, I would call that “investment”, even though you’re selling a day or two after you bought it. The issue is not the actual time frame of the holding period; it is the intent with which you’re buying it. (If you’re looking to convince me, after the fact, that you’re an investor rather than a speculator, and you have a pattern of selling stocks five years after buying them, I’m more likely to believe you than if you have a pattern of selling two days after buying, even if five years is still well short of “forever”.)

Posted by dWj | Report as abusive

Speculation is buying an asset with the hope of selling it for a higher price. Investment is using money to create a new entity or venture (not one that buys existing assets). If you put up money to construct a building, you are investing. If you buy an existing building, you are speculating. If you fund a start-up that does not have any revenu, you are investing. If you buy shares in a company that is already in business, you are speculating.

I used to think that because I bought stocks and held them for years, I was investing. No, I’m trading, but just more slowly than others. When I start a new company, I am investing. If you just buy an existing business, you have not created anything, none of that money is going towards expanding or creating new business. You’re just hoping that you recognized value that somebody else didn’t.

Posted by KenG_CA | Report as abusive

Felix – I’ve been reading you’re great blog for some time, but this post was so stupid I had to log in and correct you. To be fair, this is a point that most everyone gets wrong, and that finance guys have done a horrible job explaining.

You are absolutely 100% wrong that holding a security for share price appreciation (as opposed to dividends / coupon) is always speculation. Just simply dead wrong. As an extreme example, take Berkshire Hathaway. They have never issued a dividend and may never do so, ever. Would you say that someone who has been holding Berkshire stock for 20 years is a speculator? No, of course not. Neither is someone holding Berkshire for two months necessarily a speculator.

The biggest source of financing for practically any large corporation isn’t debt issuance or equity issuance – it’s retained earnings. Companies generate free cash flow, some of which they reinvest in the business, the rest of which they return to investors. Management gets paid based on stock price, and (with board approval) makes the decision on how much cash to reinvest based entirely on what decision will optimize the stock price. If investors in the market believe in the company, its strategy, and its management, then management maximizes the stock price by reinvesting a lot of that cash. If investors don’t believe in the company, management maximizes the share price by returning as much cash as possible to investors. You can see this happen in rapid motion during big capital allocation decisions like M&A. Berkshire is an extreme case in that investors want to give as much cash as possible to Buffet as possible, so he retains 100% of earnings. Activist investors seeking to increase cash payouts at failing companies are extreme cases in the opposite direction. But this same general dynamic plays out in slow motion every single day on the stock market.

When you buy a stock for two days, or two months, or two decades, you are expressing a vote of confidence in management that will enable it to reinvest more cash into its strategy. Far from a casino in the sky with no impact on the real economy, this is the most important capital allocation mechanism in the world. And the “speculators” you deride who invest in shares for two months are helping to shift capital – in the form of retained earnings – to winning firms who will make good use of it. Whether or not the resulting cash flows are returned through dividends or buybacks (which operate via stock price) or, like Berkshire, through ever-increasing share price, is immaterial to the investment vs speculation categorization.

I think you owe your panelists an apology.

Posted by finstrat | Report as abusive

finstrat, Berkshire Hathaway is basically a hedge fund, and sometimes a PE fund, but they are speculators, and anyone who buys their shares is speculating that they will increase in value because they are smart managers of money.

Management doesn’t always get paid based on stock price, as there are lots of examples of execs getting compensation that is not in line with the performance of the company’s stock. And they don’t always make their decisions based on optimizing the stock price (two of the more successful companies, Apple and google, don’t seem to pay much attention to stock price). The main reason publicly traded companies retain (hoard is a better word) most of their earnings is because the tax laws penalized the distribution of profits through the double tax that’s levied on them. The accumulation of profits does not reward shareholders, and does not qualify as re-investment.

When you buy a stock for two days or two months, you are not expressing a vote of confidence in management, as they can’t possibly do anything that will impact the price that quickly. And for most companies, the price of the stock that might be affected by how much people are willing to pay for the stock has no bearing on how much the company actually re-invests. If a company’s stock price declines in spite of record earnings (like Apple, for example), they don’t decide to re-invest less of their earnings. It has no impact on that decision.

Felix doesn’t owe anybody on that panel an apology. While I have drawn a sharp distinction between speculation and investment, I am not implying that the former is negative. I don’t have a problem with people speculating, I just don’t believe they should receive preferential tax treatment, as they have added no value to the economy.

Posted by KenG_CA | Report as abusive

C’mon, Felix. I wasn’t suggesting that a 2-day holding period should be called “investing.” That was an obvious bit of rhetoric–no one knows where to draw the line and defining speculation is a hopeless exercise.

I don’t want to spoil all the fun, but it’s simply not true that Christofferson Robb “does its fair share of speculation.” We are a buy-and-hold investor and still have deals we bought in 2003.

Richard Robb

Posted by RichardRobb | Report as abusive

KenG_CA – Have to say I don’t buy any of your points.

“Berkshire Hathaway is basically a hedge fund.” Not really. Yes, lots of Buffet’s positions are speculation, most obviously the derivatives plays. But most of the value of the firm is in consolidated subsidiaries like geico, and most of the rest is in buy-and-hold positions like coke. It may be an unusual conglomerate, but it’s clearly a real, brick-and-mortar company, much more so than it’s a hedge fund or pe shop.

“Management doesn’t always get paid based on stock price.” I’m not going to pretend that executive compensation is perfect, but are you honestly trying to argue that management isn’t obsessed with share price? Seriously? Have you read a newspaper in the last 20 years? If anything, the average management team is OVER fixated on stock price.

“The accumulation of profits does not reward shareholders, and does not qualify as re-investment.” It’s pretty obvious you’ve never taken an accounting 101 course. If you had, you would know that retained earnings is all earnings not returned to shareholders, and is NOT the same thing as balance sheet cash. The vast majority of retained earnings in almost any company are reinvested in the business, not held as cash. Even a cursory glance at any company’s balance sheet will tell you that.

I could go on…. but I won’t.

Posted by finstrat | Report as abusive

“The vast majority of retained earnings in almost any company are reinvested in the business, not held as cash.”

Reinvested? Maybe, but not necessarily profitably. Some companies are in the habit of making overpriced acquisitions which will eventually be written off.

My speculation/investments are largely cash-flow based. I want the future cash flow to justify the price that I pay. Of course I’m happy to sell in a few months if the price has risen to the point that the cash flow no longer justifies the price.

Posted by TFF | Report as abusive

“Reinvested? Maybe, but not necessarily profitably. Some companies are in the habit of making overpriced acquisitions which will eventually be written off.” Yeah, and their stock price almost always takes a hit, in both the short and long terms. There are plenty of reasons that management pursues lousy M&A deals (and lousy investments more generally), but shareholder capitalism isn’t one of them.

Posted by finstrat | Report as abusive

finstrat, so BH holds on to their investments for a long time. so what? Do they usually invest more money into them, other than the purchase price? I know they do sometimes, but not always. They are a holding company, and their name creates a premium over the value of the companies they own. There’s nothing wrong with what they do, but they are long term speculators.

Some managers are obsessed with stock price, but not all. However, that obsession doesn’t always correlate with individual compensation. And obsession with stock price != re-investment of profits.

As far as accumulated earnings go, look at the record amounts of cash being held by corporations these days. Beyond that, look at all those execs who have decided to use those earnings to buy back shares, the only goal of which is to drive the stock price up (just like you say), but rarely achieves that, and is certainly not an investment. As TFF mentioned, a lot of those “investments” don’t pay off.

In any case, when you buy shares in a publicly traded company, you are not directly or indirectly investing in any new venture. You’re trading dollars for shares. Not a cent of what you just expended on those shares will create a job, or result in a building being constructed, or a person trained, or a new piece of capital equipment being purchased.

Posted by KenG_CA | Report as abusive

check out Princeton history professor Jonathan Levy’s research on the history of speculation, a sample of which is here:

http://www.historycooperative.org/journa ls/ahr/111.2/levy.html

In the above paper Levy writes:

“Justice Oliver Wendell Holmes, Jr., … decided the legitimacy of futures trading. In 1905, Holmes delivered the majority opinion in the U.S. Supreme Court case Board of Trade v. Christie, elaborating his own version of ‘contemplating delivery,’ which declared futures trading not only legal but also desirable. … Through ‘hedging,’ dealers reiterated, speculation ultimately insured against giant fluctuations in the market. … Of futures [trading], Holmes wrote simply, ‘Speculation of this kind by competent men is the self-adjustment of society to the probable.’ ”

Somewhat similarly, Robert Shiller’s thesis in his book “The New Financial Order: Risk in the 21st Century” (2003) is that society would benefit from MORE tradeable markets & speculation, not less.

For Holmes & Shiller (and pragmatists generally), speculation by competent, capable entities is to be encouraged; its a ‘good’ thing.

Posted by dedalus | Report as abusive

“Do they usually invest more money into them, other than the purchase price?” Yes!!! That is practically their entire business model. Their portfolio is half companies that throw off a lot of cash (eg all the insurance companies and their free float) and half companies that need lots of capital (eg the utilities, railroad, netjets, etc). Retained earnings is practically what makes Berkshire, Berkshire.

If you’re honestly going to argue with a straight face that most management teams aren’t obsessed with stock price… well, then you’re blind to all empirical evidence and there’s nothing I can say to persuade you.

“use those earnings to buy back shares, the only goal of which is to drive the stock price up (just like you say), but rarely achieves that, and is certainly not an investment” Have we repealed the law of supply and demand? When does buying not drive up the price? Ever? Name me one share buyback program that hasn’t – on the margins – increased share price. (Of course buybacks can happen at cross currents to a secular share price decline, but they still serve to blunt the fall; indeed that’s often the goal.) And yes, buybacks are not an investment – that’s the whole point of my argument. Low share price reduces investment and returns capital to owners, high share price increases investment levels.

“In any case, when you buy shares in a publicly traded company, you are not directly or indirectly investing in any new venture.” The key word is “indirectly.” If my argument is correct, then secondary trading of equities IS an indirect investment in real investments of the underlying company, by shifting more free cash flow to reinvestment. And I honestly haven’t heard anything that invalidates my argument.

Posted by finstrat | Report as abusive

KenG, isn’t the purpose of share buy-backs to decrease the float and thus increase per-share earnings? For a company with a low P/E, this is probably a more effective way of increasing earnings than acquisitions.

Posted by TFF | Report as abusive

One last note and then I’m signing off and going back to… actual work.

I’m not saying that all capital market participants are “investors” and there are no “speculators” out there. Clearly HFTers are speculators, and what they do is not going to directly impact real investments. (But they do lead to more liquid markets, lower bid-ask spreads, and help “real” investors… but that’s a topic for another day.)

I’m just making two points. My narrow point is that you can “invest” in a security (as opposed to “speculate” on it) without having to collect dividends/coupons. My broad point is that we need to ditch this simplistic, ignorant, stupid assumption that the secondary equity markets “don’t matter.” Most bloggers, journalists, and semi-informed citizen observers think that unless you buy in at the IPO, your investment is just high class gambling. That is absolutely wrong. If we want to fix our financial system, we should start by accurately understanding the role it is actually supposed to play in the economy.

Posted by finstrat | Report as abusive

TFF, that’s the premise, but I’m unconvinced it works, and have not seen any evidence that it does. A buyback may have a transient effect on the share price, as it temporarily increases the demand for shares, but once the buyback has been completed, there are only a marginal number of shares less available for sale. I’d rather have a dividend, unless a company is buying back 10-20% of their shares. Since shares don’t trade at a specific multiple of earnings, the impact of buying back a per cent or two of outstanding shares is nebulous.

finstrat, you can call buying shares in an existing company an investment, but it should not be awarded the same tax treatment, as the benefit to society is negligent. You will also need to arbitrarily establish the point at which holding an asset transitions from speculation to investment. I wouldn’t call buy and hold “high class gambling”, but that would be a good description of short term trading, especially given how much people don’t know about any given stock (i.e, there are always some people with inside information).

I think the equity markets do play a valuable role in the economy, but not one that deserves special treatment.

Posted by KenG_CA | Report as abusive

@ KenG_CA

Look at the shares outstanding for IBM they have been dropping by very roughly 5% per year. After the Dot.Com bubble burst the shares went from $60 to $80 and bounced around $80 for a year. From 2002 to today, still a bad period for the market IBM is up 100%. That’s a pretty good example of buybacks working. Buybacks do deserve the bad rap though as many executives buy back stock at cyclical peaks rather than troughs.

The one time buybacks should be mandatory vs dividnds is in the rare cases that the stock is trading below book value. Bank of America has a market cap of 108B and a book value of twice that… and they are begging to reinstate their dividend… foolish… should be illegal… every dollar they spend buying back shares is worth $2 to shareholders.

Lastly from much further up the thread… if Berkshire isn’t an investment than absolutely nothing is. There is no better example of building longterm value in all the world.

Posted by y2kurtus | Report as abusive

Interesting debate. Speculation Vs. Investment is a tough nut to crack, because, despite being setup as a binary (x is speculation, y is investment), they are very much inter-related.

Additionally, there is likely a subjective definition for each person. So, I’ll provide mine (that I just formulated, so it’s rusty)

Speculation is only concerned with price appreciation. I speculate in stocks by purchasing stocks with the goal of selling them later and earning money. I have no idea how that money helps the company I just bought, I just want to sell at a certain time (10 days, 20 years) with more money (hopefully adjusted for inflation). Ditto to my 401k. The time factor doesn’t really matter in this instance.

Investment IS speculation, although the outcome is increased productivity (I suppose if it was intended or not). VC invests in facebook because facebook needs some more server space to better store and deliver its data. This leads to a more productive facebook, but VC does this because it thinks it will eventually make money. And to counter that all VC is investment, I have a feeling the latest round of Groupon fundraising was NOT investment. It seems like most of that money went to paying out previous investors.

My definition then can keep the ultimate result out of the original “investor’s” hands. You can have the intention of investing, but the end result can be speculation.

Advertising may fall under speculation – there is certainly no increase in productivity by getting the word out to you customers, although, indirectly, more customers means more money to increase productivity in the future.

I think speculation naturally gets a bad rap, but it is an inherent feature of capitalism (in my definition at least).

Posted by djiddish98 | Report as abusive

@y2K, IBM’s net income in 2002 were $5.3 billion, and it was $14.8 billion in 2010. So while their earnings increased about 180% over that period, their stock price went up only about 100%. How did the share buyback help?

BofA is trading below book value because a lot of people think it is a horribly managed bank with more skeletons in the closet.

If you buy Berkshire stock, you may be personally investing, but somebody else is liquidating their stake. The net investment in the economy is zero. From a personal perspective, you are risking money, but it is not the same as creating a new venture, for as far as the economy is concerned, there is no new investment, just a transfer of title.

Posted by KenG_CA | Report as abusive

while i think felix is generally a good blogger, and sorkin is a decent writer, sometimes when i read these posts/articles i wonder if these guys actually understand any of the math behind finance.

as several other posters have said, contra salmon/sorkin, it is *not* obvious what is the distinction between investment and speculation. can we all agree that a guy who buys a stock for two seconds is a speculator and not an investor? yeah, probably. but is someone who buys a bond and holds it for two years so obviously an investor and not speculator? of course not. i might buy a government bond and hold it because i think the forwards priced into the bond when i bought it will not be realized over time. that has nothing to do with my interest in investing in america; it is a strictly financial consideration about whether the price is right or wrong. and in that sense, i fail to see an obvious distinction between the guy who does that and a guy who holds a bond for only a day or two.

probably most of us have some sense that there is a difference between investing and speculation, and probably most of us feel that holding period has a bearing on the issue. but this post doesn’t do anything to shed light on the distinction, other than making declarative statements about things that are “obvious.” don’t tell us that something is obvious: make the case.

Posted by alphabet | Report as abusive

KenG, it is interesting that you cite IBM as an example. I’ve been a shareholder in IBM since mid-October 2008 and positively LOVE their strategy.

They have a cash-cow business, throws off a ton of free cash flow. Yet it isn’t growing much. They had $86B of revenue in 2001 and will have roughly $105B of revenue this year. Just 2% annual revenue growth over a decade, LESS than inflation.

Of course, their net income has increased much more rapidly, up 92% from 2001 to 2010. Instead of “reinvesting” in businesses with mediocre returns, they’ve been investing more selectively on higher-margin businesses — and using the money for buybacks instead. As a result, that 92% growth in net income has produced a 165% growth in per-share earnings. That’s an additional 4% annual growth in EPS as a result of buybacks!

Contrast IBM with MSFT. Their revenue has increased 147% from 2001-2010, with net income increasing 143%. Net earnings have increased 216%.

Which of the two has fared better over the last decade? Which of the two has convinced investors that it knows how to operate a cash cow profitably? Microsoft has done a better job of driving revenue, a better job of driving earnings, but investors have NO CONFIDENCE in its ability to continue doing so. They point towards failed venture after failed venture, businesses that lose more money the larger they grow.

Perhaps instead of reinvesting in growth, Microsoft would have done better to buy back a few of its shares over the last decade?

Posted by TFF | Report as abusive

TFF, I didn’t choose IBM as an example, y2kurtus did. And he chose the time period. I don’t feel it’s safe to assume that their growth in earnings was a result of added investment, but rather a change in strategy. And that change in strategy had them transition from a cash cow in dying businesses to one that is heavily dependent on high margin services and software. (and don’t buy into all that 100 year anniversary PR they are spewing out. I think they are a good company, but they have made their share of bad investments) Microsoft didn’t have the luxury of already selling million dollar solutions, as they sold things that cost in the tens and hundreds of dollars, and that’s not as easy to transition out of (not that I’m defending Microsoft, I could spend a few hours filling this page with criticism of their mistakes).

I also don’t believe that you can say that a change in per-share earnings over a specific period is definitively related to buybacks. Market moods have impacted overall prices as the market was depressed in 2001, so some of the share price gains are due to overall market rebounds.

If you want to talk about wasteful “investment” of retained earnings, let’s talk about Intel. Unlike a lot of tech companies that have lost market value over the last decade, Intel has lost real capital, squandering tens of billions of dollars on foolish acquisitions and aborted ventures. And they buy back shares, too. So if I buy shares in Intel from someone who wants to sell theirs, am I really investing in the economy? (this last question is not for you, as I think you are only challenging my position on buybacks).

Posted by KenG_CA | Report as abusive

KenG_CA, as a matter of curiosity who invests in a new venture with no hope of making a return?

Posted by Danny_Black | Report as abusive

Danny, who said anything about that? I’m not qualifying the distinction between investment and speculation with expected results. I’m just saying that for the sake of defining the difference between investment and speculation as it relates to society and tax policy, an investment should only be considered when capital is deployed in a new venture.

I get the feeling that people who buy stocks and bonds and real estate don’t like the connotation that comes with the term “speculator”, and want to be viewed as a responsible “investor”. They’re not buying an asset with the goal of flipping it as soon as it reaches a specific price. “Speculator” is not always a derisive term, so people shouldn’t get so defensive about being called one. I don’t believe there is anything wrong with speculating, it’s just not the same thing as investing.

Posted by KenG_CA | Report as abusive

“I also don’t believe that you can say that a change in per-share earnings over a specific period is definitively related to buybacks.”

Come again? Aren’t per-share earnings equal to net income divided by shares outstanding? What does this have to do with market moods? I don’t think I cited share price once.

Plenty of companies “buy back shares”. In some cases the shares bought back don’t even offset the options issued. I don’t pay that much attention to Intel (bad business, poorly operated), but I would be surprised if their float has decreased by as large a % as IBM’s.

Intel offers a higher dividend, though.

Posted by TFF | Report as abusive

Agree with the author and attended the same event. Kept asking myself who was that casino operator enforcing all of the speculative trading / gambling. http://tiny.cc/itmca

Posted by GT_Global | Report as abusive

TFF, you said

“As a result, that 92% growth in net income has produced a 165% growth in per-share earnings. That’s an additional 4% annual growth in EPS as a result of buybacks!”

and then I said:

“I also don’t believe that you can say that a change in per-share earnings over a specific period is definitively related to buybacks.”

I’m saying you can’t assume that any stock will maintain a specific P/E – which is assumed when you claim growth in share price due to stock buybacks. For a specific amount of earnings for any company, their share price will only rise after a buyback if the market maintains the P/E. Over a ten year period, you can’t assume a stock will be priced according to a static P/E.

Posted by KenG_CA | Report as abusive

KenG, I didn’t say anything about P/E ratio. I didn’t say anything about “growth in share price”. In fact I didn’t mention share price even once. I talked about earnings-per-share growth. You seem to be assuming something that I absolutely did not say.

I’m frankly not all that interested in “share price” (other than preferring that it be low when I buy). Please explain your obsession with share price? Are you confusing share price with what a company is worth?

If I buy a company with $9/share of earnings, and it increases those earnings by 11% annually (helped by the continuing repurchase of 4% of the outstanding shares each year), then in a decade I’ll be looking at $25/share of earnings. At the present payout ratio, that is $5/share of dividends. Nice coupon on a $100 initial investment, no?

I agree that you can’t assume that a stock will be priced according to a static P/E. Happily I don’t make stupid assumptions like that. I invest for the cash flow, as long as I trust management to use it wisely. That can be a dividend, or fairly-priced acquisitions, or (in the case of a lower P/E company) share buy-backs.

As for the share price? Your guess is as good as mine, but if IBM hits $25/share earnings in 2018, then I would expect a share price between $250 and $400. I would prefer the lower end of that range, as buy-backs are far more powerful drivers of per-share earnings growth when P/E valuations are LOW than when they are HIGH. If the P/E passes 15, I’ll need to reconsider my rationale.

Posted by TFF | Report as abusive

Ideal holding period: forever.

Annuities are dead. Fixed income is dead. (The yields are so low on each that they are worse than useless.) You can fund a retirement on 3% dividends AND get built-in inflation protection AND never touch the principal.

Doesn’t that make much more sense than buying bonds with a 3% coupon and no inflation protection whatsoever? Or an annuity that offers a fixed 6% yield and no residual principal?

The key is to free yourself from the dangerous presumption that the value of a stock is in its share price. The value of a stock is in the future cash flow that it represents. That has (almost) nothing to do with the share price.

Posted by TFF | Report as abusive

TFF, if you are talking about “per share earnings” in the context of whether buybacks are good for shareholders, then you are implying that the price is directly related to the per share earnings. Not all companies distribute earnings to shareholders.

I bring up share price because many speculators/investors/traders depend on share prices rising to make money, as not all companies pay dividends. If you are buying solely for dividend income, then the price will still probably matter to you, for if it rises tremendously you might want to sell the stock and buy one with a higher yield.

Posted by KenG_CA | Report as abusive

KenG, I think I explained myself quite clearly. You may disagree, but don’t put words into my mouth. Share buybacks are good for shareholders to the extent that they drive per-share earnings higher. Whether or not the share price increases, I win. Either the per-share earnings shoot through the roof, escalating ever more rapidly, or the share price gets dragged along behind the per-share earnings. EITHER WAY I WIN!

IBM does pay a dividend, targeting roughly a 20% payout ratio. Their share buy-backs are on top of this. Easier if we stick to real examples. I’m typically not invested in any companies that don’t pay a dividend, as I believe that practices helps to encourage a financially disciplined mindset for management.

You own companies for their future cash flow. Unless a company is growing VERY rapidly, it probably tosses off more cash than it can productively use internally. The remaining cash goes towards acquisitions (sometimes make sense but are usually dilutive), share buy-backs (which make terrific sense when your P/E ratio is low), or dividends (which are tax-inefficient but otherwise nice). The nice thing about share buy-backs is that the money can easily be diverted to acquisitions if something genuinely profitable turns up. The market tends to react negatively when you cut the dividend.

And yes, I’m quite ready to sell a company when the mood changes. Nothing sweeter than buying a company at a 12 P/E, enjoying 10% to 15% earnings growth for a couple years, and selling at a 16 P/E. But your rationale for buying/owning a company should NEVER depend on presumptions of a rising share price, certainly not over anything less than a decade.

Posted by TFF | Report as abusive

TFF, I wasn’t putting words into your mouth, as my comments were not so much specifically directed at you, but rather at the concept of buybacks in general. However, judging from your comments, you have a much different philosophy on managing your wealth than most people who use public equity markets for that purpose. Since there are so many stocks that pay little or no dividend, I think it’s safe to assume that most people who buy stocks are doing so with the hope they will appreciate and be able to realize long term capital gains. It is those people who are counting on buybacks to drive share prices up.

Since the post started this thread with a question about financial innovation, I would like to suggest that the double tax on dividends be eliminated, so that more companies would be willing to distribute more of their profits. That would be a far more efficient way to deliver value to shareholders than buybacks.

Posted by KenG_CA | Report as abusive

“I would like to suggest that the double tax on dividends be eliminated, so that more companies would be willing to distribute more of their profits.”

Sure, I like that proposal fine! Especially if we can convince the Lords of American Industry that a variable dividend is not the end of the world. (I believe European companies already follow this practice?)

The key to investing — as opposed to speculating on market sentiment — is putting capital in places where it can be used efficiently. If a company doesn’t have promising internal growth prospects, and can’t find a fairly-priced acquisition with good synergies, then management needs to find the discipline to return that cash to shareholders. Let them figure out how to allocate it next.

Posted by TFF | Report as abusive

Without reading all the comments, I will say the “investment is good and speculation is bad” construct is fatally flawed. I’m a big supporter of more regulation of the finance industry, but I think pure, greedy speculation can have a lot of upside, particularly through increasing liquidity in certain instruments.

In the commodity markets, for example, it would be tough to see a market for hedges for airlines, farmers or food producers without traders constantly trying to make a buck. The old-fashioned market-makers on the NYSE floor also do the same thing, doing nothing except trying to buy low and sell high. I read once that most guys still on the floor read the New York Post rather than the WSJ. They couldn’t really care less about the long-term fundamentals of a company, but they still help grease the wheels for investment.

The real issue is how speculators could take systematically dangerous risks. Do you remember all the CME traders threatening the downfall of the international markets? Neither do I. On the shadow market, on the other hand, counterparty risk can be extremely unpredictable and subject markets to bank runs. The real way to help make financial markets robust is not to demonize “speculation,” but the system robust to too much speculation.

Posted by mwwaters | Report as abusive
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