It is prudent to thoroughly understand what speculative investing involves
The basis for investing is for the company’s fundamental valuation to increase over the long-term. The stock price itself is not of primary concern since it fluctuates about widely as it goes on its roller coaster ride. This is the basic principle utilized by the famous investors like Warren Buffett and Peter lynch.
So long as the company’s fundamental valuation continues to increase, the stock price will broadly follow the valuation increase and tends to spend more time above its valuation than it does below its valuation. The stock price is mainly of interest when an investor is adding stock to their portfolio or reducing their stockholdings.
The typical stock price fluctuation with their trending nature of uptrends and downtrends following the company’s valuation is illustrated below in Figure 1.
Figure 1. Investing with an investment
grade stock
The classic definition of investing is depicted graphically in Figure 1. above. An investment grade stock will generally continue its fundamental valuation increase over time and the stock price typically goes on its roller coaster ride following the valuation upwards. Figure 1. also depicts the classic value investing entry point. Growth investors will be more inclined to buy stock when the stock price is rising in an uptrend.
Speculative investing
Speculative investing occurs when the current financial evidence which projects the fundamental valuation into the future is ignored and is instead replaced by other information which is not reflected in the company’s current financial history.
There are valid reasons why not to accept the current valuation projection into the future. One of the main reasons for this is if a company is developing a new product which has a high probability of increasing the company’s future revenue and earnings, but this is not reflected in its financial history.
An investor can speculate that the growth of a fundamentally sound company will be significantly higher in the future than what its current growth suggests. Here the investor is speculating on an investment grade stock and not a speculative stock.
All businesses face competition and the business world is fluid and not static. There are always new companies which are keen and eager to increase their market share of the revenue and will do so at the expense of its competition. An establish company can get caught out in the future by a rival company which has a superior product or a more cost effective product and takes its market share causing a declining trend in its future revenue. Even though any future decline in revenue is not currently reflected in the company’s financial history, speculative investors may factor this into its future valuation.
Thus an investor can actually speculate on the future valuation of an investment grade company. That valuation can be either an increasing trend or a declining trend.
Example: An investment grade stock may be growing its revenue and earnings at 10%, but the company has a new superior product under development which could potentially produce a 20% increase in sale and earnings. Assuming a 10% increase in near future revenue is investing and assuming the potential 20% increase is speculating.
An investment grade stock with potential to increase its current growth rate is illustrated below in Figure 2.
Figure 2. Speculative investing with an
investment grade stock
As shown in Figure 2. above, the stock price will typically follow the new valuation line. Should the speculative investor’s evaluation of the company’s increased future growth not materialize, then the valuation increase will probably just continue along its existing rate of increase.
Thus speculating on an increased valuation growth rate with an investment grade stock is fairly safe as the worst that usually happens is that the anticipated increased rate of growth does not develop.
Speculating with a Speculative stock
Speculating with a speculative stock is what many market participants consider to be speculation.
A speculative stock is simply any stock which is not considered to be of investment grade. Some speculative stocks are financially in quite good shape with good potential for growth while others are financially under considerable stress.
With the companies that are financially in poor shape there are companies with good future prospects and companies destined for bankruptcy.
Speculative investing with speculative stocks covers a broad segment of the stock market and there is never any shortage of market participants willing to speculate on the future prospects of a speculative stock that is in poor financial shape. Indeed if the speculative investor’s stock pick does turn around its financial misfortunes the increase in its fundamental valuation can be substantial and the stock price will follow its valuation upwards with its typical roller coaster nature.
Companies in poor financially shape are the long shots with speculating but they also provide the greatest rewards if the company is successful in the future.
A speculative stock which is fundamentally unsound but has good future growth potential is illustrated below Figure 3.
Figure 3. Speculative investing with a
fundamentally unsound stock
As shown in Figure 3. above, the stock price will typically follow the new valuation line. Should the speculative investor’s evaluation of the company’s increased future growth not materialize, then the valuation will probably just continue to decline at its existing rate.
Thus speculating on a turn around with a speculative stock that is financially in poor shape is high risk. If the turn around does not eventuate then the fundamental valuation will certainly continue downwards. Obviously the valuation cannot continue downwards forever and the company will sooner or later wind up in bankruptcy if is not taken over by another company.
Summary
Speculative stocks which are mostly fundamentally sound but are struggling with their revenue and earnings are less risky than those with financial problems. This is because these stocks tend to have a fairly stable fundamental valuation so if the anticipated future growth does not emerge they are more likely to at least hold their existing valuation.
The safer stocks to speculate on are smaller companies which are considered to be of investment grade. At least with these stocks if the anticipated future growth increase does not emerge they are still mostly sound investments.
Like with everything in investing, the higher the risks then the higher the potential rewards.
The risk can be managed with stop-loss techniques and series on Position Management gives the speculator numerous examples using stop-loss techniques that are suited to speculative investing.