This may be the single greatest piece of investing advice I’ve ever received.

The author of this quote is Benjamin Graham, mentor to Warren Buffett, and undeniably one of the greatest investors who ever lived. Graham emphasized the importance of understanding the underlying value supporting a company’s stock.

He recognized the fundamental mischaracterization of the term investor. For Graham, many so-called “investors” were truly nothing more than speculators; individuals looking for a “shortcut” to superior returns. Graham understood that the majority of individuals lacked the patience and discipline required to succeed in the world of investing.

Investing is much more than an end in itself; it’s the means to an end that make all the difference.

As an investor, you need to recognize that emotion should yield to reason. But more often than not, we confuse emotion (i.e. greed) for logic; we act like sheep anxious for the slaughter. We repeatedly choose the path too often taken.

The Dutch tulip bulb mania of the 17th century offers us the perfect example. Tulip bulbs imported to Europe from Turkey became overwhelmingly popular among citizens of all classes. Demand quickly outpaced supply, and the price for a single bulb quickly began to rise. People mortgaged their homes and their businesses to buy the bulbs. At its peak, the market bubble drove the price for a single Dutch tulip bulb to an astounding $76,000.

Before long, people began to see the error of their ways. They began to exercise reason in place of greed. They realized the price for tulips centered on speculation and nothing more. In the end, a bulb produced nothing more than a single flower. Well you know the story: Markets adjusted and speculators lost everything.

But speculation can come in many different forms. Irrational decision-making does not require extreme illustrations like tulip bulbs or even cash-burning dot-coms for that matter. Investor traps can lie in some of the greatest growth stories of all time.

And that’s the point of the opening quote.

A great growth story does not necessarily equate to a great business.

Graham calls attention to the fervent demand for air transport stocks in the 1940s and ’50s. Everyone knew (and rightly so) that air transportation was here to stay. It didn’t take an expert to forecast the enormous long-term growth rates for air travel in the second half of the 20th century. Consequently, air transport stocks were the hot investment.

But as you know, passenger growth certainly isn’t the only denominator driving an airline’s profit.

The airline business has horrible margins. Fuel costs, fierce competition and labor disputes have hindered the industry since its very inception. Even though predictions on passenger growth rates proved true, the business itself never offered significant returns. As Graham wrote in The Intelligent Investor, “In 1970, for example, despite a new high in traffic figures, the airlines sustained a loss of some $200 million for their shareholders.”

What was it that English entrepreneur Sir David Branson said? “If I was a businessman, or saw myself as a businessman, I would have never gone into the airline business.”

Airlines certainly aren’t the only great growth stories that proved to be entirely unprofitable. They’re not even the most recent example, less we forget the 1990s.

So before you sink Junior’s 529 into the greatest hyped small-cap since Microsoft went public on March 13, 1986, make sure there’s more to the story than 1.3 billion depraved consumers eager to spend that 40-plus% annual savings rate they’ve parked away in low-yielding Chinese savings accounts over the years.

Until Next Time,
Christopher Hancock
April 24, 2007

Emotion vs. Reason in Investing was originally featured in the Penny Sleuth.