Benjamin Graham believed that an investment operation must promise safety of principal and an adequate return with the investor basing the decision on thorough analysis. If these conditions do not hold, the decision is inherently speculative. In Graham’s view, it is critical for investors to know the difference between investing and speculation and to avoid fooling themselves into thinking they are investing when they are really speculating. This advice sounds simple but is actually quite challenging to implement if the investor does not have a firm grasp of his circle of competence.
In my article last week about Berkshire Hathaway’s investment in Occidental Petroleum, I wrote that oil and gas falls outside my circle of competence. But if you had asked me about oil and gas in 2009, I would have said that it was within my circle of competence. I studied the industry, followed the market, and committed funds to the sector. My most important investment was Contango Oil and Gas. Initial success bolstered my confidence and resulted in increasing my exposure. Ultimately, things went sideways and I exited my position in 2013. When all was said and done, the loss on Contango Oil and Gas remains the largest of my investing career.
There is nothing worse than thinking that you know what you’re doing and then realizing that you lack the competence that you thought you had. Actually, there is something worse: not admitting it and doubling down. I suspect that most investors have to experience this for themselves to understand what I am referring to.
Today, I’m sharing an article that I wrote in 2016 that is related to Contango Oil and Gas and illustrates another speculative scenario. Contango Oil and Gas was involved in gold exploration in Alaska and spun off its gold operations to shareholders in 2010. While I thought that oil and gas was within my circle of competence in 2010, I knew that gold exploration was something I did not understand. Yet I held the spun off shares of Contango Ore anyway. I backed into a speculative position, but at least I knew that I was engaged in speculation.
Ultimately, my speculation in Contango Ore had a happy ending. I held the shares for eleven years, from the spin-off to late 2021, and I ended up achieving a 15.3% compound annualized return. I followed the company and its presentations during that period and I read the SEC filings but at no time did I think it was within my circle of competence. This was a company with no revenue and no proven reserves! My return had nothing whatsoever to do with skill. It was just luck. A roll of the dice.
I do not recommend any sort of speculation, but if you are going to speculate, at least know that you are speculating and not investing!
Backing into a Speculative Position
Originally published on December 13, 2016
You can choose a ready guide in some celestial voice
If you choose not to decide, you still have made a choice
You can choose from phantom fears and kindness that can kill
I will choose a path that’s clear
I will choose freewill
As Jason Zweig pointed out in last weekend’s Intelligent Investor column in the Wall Street Journal, the distinction between investing and speculation is not always completely clear. One key point is that the intention behind a purchase of a security can answer the question of whether the move is an investment or a speculation. But this presents a problem because everyone can have different intentions. Are we saying that one person’s speculation could be another person’s investment?
Investors vary widely in terms of their capabilities and aptitude for evaluating securities in different industries. For example, an investor with specific background in the defense industry might evaluate all of the available companies operating within the industry and rank them based on his assessment of intrinsic value relative to the current market price. Over time, the relative rankings will change and perhaps a market panic might punish one or more companies to the point where there is a large margin of safety. The investor purchases shares of the most attractive company for investment purposes. The investor may be correct or incorrect but the intention behind the purchase is to acquire an asset that promises safety of principal and an adequate return. This would meet Benjamin Graham’s definition of an investment operation.
In contrast, consider the intention of someone who has no particular background in the defense industry but is attracted to the possibility of making money by purchasing stocks in anticipation of a change in the political atmosphere. This individual might purchase one or more stocks, perhaps even the one that the investor purchased, in anticipation of a change in the political mood hoping that he can sell at a higher price. This individual is clearly speculating because there is an absence of fundamental analysis behind the purchase and the intent is to profit from changes in political sentiment rather than a gap between intrinsic value and market value or the accrual of earnings over a long period of time.
Let’s assume that the investor and the speculator purchased the exact same security at the same time and then subsequently sold at the same time. Obviously, the returns that both of them will experience are identical, but it is still useful to differentiate between investment and speculation. This is because, over long periods of time, process is important and will eventually dominate results. The effect of a good process on any individual investment may not be clear but, over time, a good investment process should generate good long term results.
The Default Option
There are plenty of twists and turns that will occur over an investing career. An investor can purchase a minority interest in a company with the intention of holding for a long period of time but all sorts of corporate actions can alter the timeframe. The most obvious example involves mergers and acquisitions. The company that we purchase can transform into a forced cash payout if it is acquired or we can receive shares of an acquiring company in exchange for our stake. The world is unpredictable and we cannot assume that we will be permitted to hold a security for as long as we envision. It follows that the investment thesis that underlies an investment may not be allowed to fully play out.
One special case involves spin-offs. An investor purchases a security of a company that is involved in more than one business activity. It could be a classic conglomerate or simply a business that has funded a start-up internally. The company then decides to spin off part of its operation to shareholders. In such cases, a shareholder will receive shares in a newly created independent company while retaining his or her interest in the original investment. Logically, the investor must evaluate the investment merits of both companies to ensure that they remain appropriate choices. The default choice of continuing to hold both companies is not necessarily optimal.
As Joel Greenblatt pointed out in You Can Be a Stock Market Genius, spin-offs are often fertile grounds for investors. Many investors who receive shares of a spin-off will immediately sell those shares regardless of the underlying merits of the newly created independent company. There are many reasons behind this but the most important might be that the value of the spin-off is usually very small relative to the original investment. As a result of this type of selling, spin-offs can become undervalued.
You Still Have Made a Choice
Rather than examine the investment merits of picking up newly independent companies created via spin-offs, let’s consider the case where someone has purchased a company on its investment merits and receives shares in a spin-off.
If the shareholder is an investor rather than a speculator, retaining the shares of the newly independent company requires analysis of the economics of the business. Basically, the investor has to ensure that the spin-off qualifies as an investment rather than a speculation.
Retaining the shares of the spin-off without going through this process is speculative even though the shareholder has not taken any proactive steps to acquire that investment. He has simply received the shares. But it is still speculative to hold.
One recent example that comes to mind is the spin-off of Contango Ore from Contango Oil & Gas which took place in November 2010. Contango Oil & Gas shareholders received one share of Contango Ore for each ten shares of Contango Oil & Gas that they owned. At the time of the spin-off, we wrote about the situation in some detail and concluded that Contango Ore had to be classified as a speculation. The company was set up to explore for gold and rare earth elements in Alaska and had no proven reserves or any prospect of generating revenue for many years. We concluded as follows:
As we stated at the outset, CORE is a speculative company and it is obvious that the shares could end up being worthless. In fact, it is probably more likely than not that the shares will have little value in the long run. Nevertheless, Ken Peak [Contango’s Chairman and CEO] has a history of success in extraction of resources from the earth’s crust and he could very well surprise us with a major discovery. In addition, speculators may build “castles in the air” and bid up CORE shares in an irrational way due to the fact that it has gold and rare earths exposure. We are inclined to retain the spun off shares as a “lottery ticket”, although we are under absolutely no illusions that it represents an “investment operation” as defined by Benjamin Graham.
Contango Oil & Gas itself was not a speculative position for someone who understood the industry and owned shares based on an assessment of the company’s intrinsic value and long term prospects. At the time, many value investors owned shares of Contango Oil & Gas partially due to the fact that the company’s CEO had an unusually value-oriented approach to oil and gas exploration. We presented the investment case for Contango Oil & Gas a couple of years later and although the investment ended up not working out as expected, the intent behind it was not speculative in nature.
The same cannot be true for continuing to hold Contango Ore. It was speculative at the outset and remained entirely speculative for a long period of time. Over a period of many years, Contango Ore drilled test holes in Alaska and recently reported very promising results for the 2016 exploration program. When the shares were initially distributed to Contango Oil & Gas shareholders in late 2010, the valuation of Contango Ore was $4.60 per share. In response to recent development, shares are now quoted at $21.20. This represents a compound annual return of ~29 percent since the spin-off. Ironically, shares of Contango Oil & Gas have collapsed over the past six years and are down over 80 percent since the spin-off.
Winning the Lottery
Receiving shares of Contango Ore in the spin-off was similar to receiving a lottery ticket representing shares in a speculative company with no proven reserves or prospect of receiving any revenue. Could these shares have been considered an investment for anyone? Perhaps for an individual who had some special insight into the location where Contango Ore had drilling rights or deep knowledge of gold exploration in general, but even then there would have been no way to assess the intrinsic value of the company.
Is holding Contango Ore today an investment or a speculation? It is possible for someone with a special competence in gold exploration to estimate the intrinsic value of Contango Ore today now that extensive drilling results are available but there is obviously still great uncertainty since the company has yet to produce any gold. Justifying the $92 million market capitalization could be difficult.
It is important to make a clear distinction between investing and speculating and to classify one’s activities appropriately. The possibility of major losses exists when someone who believes that he is investing is actually speculating instead. There is nothing illegal or immoral about speculating but such activities really do need to be segregated from investing in our minds to avoid trouble.
The other key point is that one cannot judge whether something is an investment or a speculation simply based on the outcome. It is possible to have a solid investment framework and still end up with specific investments that did not work out. It is also very possible to speculate and end up with situations that worked out very well. The end result alone obviously matters. But from a process standpoint, we need to care equally about the rationale that led us into specific situations. We should not fool ourselves into believing that a speculation was really an investment just because it turned out well.
Finally, it is important to understand that we are really making a choice even when we do not act. If an investor receives shares in a spin-off that he cannot readily evaluate as an investment, he should have the intellectual honesty to either sell or continue holding but with the understanding that doing so is speculative. Anything else risks polluting the investor’s understanding of his own process and potentially impacting good decision making in other contexts.
Copyright, Disclosures, and Privacy Information
Nothing in this article constitutes investment advice and all content is subject to the copyright and disclaimer policy of The Rational Walk LLC. The Rational Walk is a participant in the Amazon Services LLC Associates Program, an affiliate advertising program designed to provide a means for sites to earn advertising fees by advertising and linking to Amazon.com.
Individuals associated with The Rational Walk LLC owned Contango Ore shares from the spin off in 2010 until 2021 and owned Contango Oil & Gas shares from 2009 to 2013.