These capture the attention of investors due to their large gains, but invest carefully
Companies can be broadly classified into two groups, investment grade stock and speculative grade stock. Benjamin Graham was largely responsible of the development of modern day fundamental analysis. He considered a company which is fundamentally sound with realistic and proving growth to be of investment grade. Any company not considered to be of investment grade is considered to be a speculative stock.
Investment grade stock
The reason the growth is important for an investment grade stock is that the primary purpose of investing is that the fundamental valuation increases over time and the only way this can occur is if the company is growing.
Growth is the important factor but the company needs to be able to sustain that growth well into the future which it cannot do if it has financial problems, thus the requirement for the company to be fundamentally sound.
Also the growth is based on the proven growth rate and not based on estimates which can be overly optimistic. In addition the historical growth rate needs to be a realistic determination. If the five year trend in revenue and earnings is generally increasing, then an average growth rate is appropriate. Simply using the growth rates from last years financial statements can mask the true trending nature of the growth rates.
The future growth of an investment grade company will likely continue on at the same rate as its historical growth rate. While competition and consumer habits can change in the future, business largely adapt in an attempt to maintain their growth rates. The growth in the future valuation of a company will likely continue at its present rate. This is the basis for intelligent investment which utilizes current historical financial information to determine the company’s future valuation.
The historical financial information is the definite evidence. When information is used that is based estimates to determine a company’s future financial position, this information is not definite evidence which makes any decision based on it as speculative. Estimates are merely someone’s opinion as to what might happen.
With an investment grade stock, if the future valuation is based on the current historical definite evidence it is considered investing and if the future valuation is based on estimates it is considered speculative investing. This is illustrated below in Figure 1.
Figure 1. Speculating with an investment
grade company
From Figure 1. above, investing is a continuation of the current growth in valuation which is based on current definite evidence. Any other assumption to its future valuation growth is speculating.
Speculative grade stock
A speculative stock is simply any stock that is not considered to be investment grade.
Note that there is no reference to the stock price whether a stock is speculative. There are companies with stock prices above $1 or even above $5 which are not of investment grade and they are therefore still speculative stocks. While it is true that a lot of stocks under $5 and especially $1 are not of investment grade, there are some low priced stocks that are of investment grade. Stocks under $5 are however commonly referred to as Penny Stocks even though this is not justified if the stock in question is of investment grade.
Company size is not a factor in determining its investment grade. It’s just that a lot of small stocks tend to be fundamentally unsound. The market participant needs to be cautious when using stock price to determine the investment quality of stocks.
While it is true that the risk with a small company in not meeting its future valuation growth is higher than that for a large company, if the small company was determined to be of investment grade then it is not a speculative stock.
Having determined that a stock is of speculative grade, there are however different degrees of speculative stocks. Some are very close to investment grade with lots of future potential while others are nothing more than companies heading straight for bankruptcy. Thus a distinction needs to be made between speculative stocks
The Fundamentally Sound Speculative stock
There are companies which are financially stable but their revenue and earnings are not increasing and thus are not considered investment grade. These companies may simply be facing a lot of competition but they are still well managed financially. This is especially the case with small companies which have a limited product line or service.
These companies are essentially fundamentally sound and any company which is in the process of developing a new product or service may well turn its lagging revenue around. These companies can be considered to be fundamentally sound speculative stocks. This is illustrated below in Figure 2.
Figure 2. Speculating with a fundamentally
sound speculative stock
From Figure 2. above, it is debatable whether an investment in such a stock based on its current definite evidence should be called investing. This is because investing is based on the idea of the company valuation increasing. Strictly speaking it is not speculating since the decision is based on definite evidence.
The other two future valuations are based on estimates which by definition are not definite evidence and as such are considered speculating.
The Fundamentally Unsound Speculative stock
Any speculative stock that is not considered to be fundamentally sound is considered to be a fundamentally unsound speculative stock.
These companies are not financially stable and/or are losing profits year after year. A competitor might be growing its revenue at the expense of these companies. Other companies might be in financial trouble for one reason or another and cash flow is usually an issue.
Typically their valuations are in a downtrend and usually their stock prices are beaten down. Many investors will consider these companies to be the true speculative stocks. Certainly any such stock which turns around its financial misfortunes has the potential to significantly and rapidly increase its fundamental valuation. This is no doubt why investors speculate on these companies.
The typically speculative stock which is fundamentally unsound is illustrated below in Figure 3.
Figure 3. Speculating with a fundamentally
unsound speculative stock
From Figure 3. above, the current valuation is in a downtrend which is typical. Even if the future valuation is based on the current definite evidence, the valuation trend is still down and as such cannot be considered to be investing. By definition investing is the process of a company increasing its valuation. After all, nobody invests with the intention of their investment declining in value. Granted an investor can short sell to profit from the decline, but strictly speaking short selling is trading and not investing.
So for lack of a better term to describe negative investing, it will be referred to as speculating even though the valuation is based on current definite evidence.
The other two scenarios are simply speculating.
Summary
The stock investor has two options with an investment grade stock.
An investor can invest with an investment grade stock based on its current financial history, or the investor can speculate with an investment grade stock based on information which is not currently reflected in the financial history.
Any investing conducted with a speculative grade stock is speculating.
Not all speculative stocks are the same. Some are quite financially sound but are not considered investment grade and others are basically financially distressed stocks.