"Successful investing is anticipating the anticipations of others." — John Maynard Keynes
The concept of intelligent speculation strikes most value investors as a bit of an oxymoron. After all, Benjamin Graham went to great lengths to define the difference between investment and speculation; he did not choose "The Intelligent Speculator" as the title for his masterpiece.
The late George Carlin had a comedy routine where he associated certain words with either negative or positive connotations. When one mentions the term investing to a group of Grahamites it brings about feelings of peace, tranquility and security, sort of a value nirvana. If you mention the term speculation to the same group they are likely to scowl at you and then spit.
The intent of this article is to bridge the gap between successful investing and speculating. More specifically, how one can employ logically-based speculation which is a function of empirical observation, to increase portfolio returns or dampen the risk of dramatic short-term losses. It is not an attempt to discredit nor discount the concept of margin of safety. Margin of safety is instrumental in achieving long term gains while reducing long term risk without regard to one's specific investing practices. Margin of safety remains as Warren Buffett points out, "the three most important words in all of investing."
Utilizing Speculation in Purchasing Microcap Stocks
When I employ intelligent speculation in the purchase of tiny companies, I borrow the horse racing concept of an overlay. An overlay occurs when the actual odds of a horse winning a race are much greater than the price which is reflected in the parimutual odds (price listed on the odds board). Suppose the actual odds of "The Factor" winning this year's Kentucky Derby are 5/1, (one chance out of six) and he goes off at 10/1; wagering on "The Factor" is a very good statistical play whether he wins or loses. The risk/reward is highly favorable toward the bettor even though he will lose the wager much more often than he will win. Bear in mind that this example is not an endorsement of the horse nor Bill O'Reilly, for that matter.
Unlike paramutual wagering, speculating on a "stock overlay" rarely results in a loss of the entire principle invested, if ones thesis fails to materialize. While intelligent speculation should be viewed in terms of a favorable risk/reward scenario, it is important to note that not all logically-based speculations turn out as intended. One should never overload their portfolio with low-quality stocks merely because they visualize a favorable set of circumstances unfolding.
The Case of Forward Industries
Intelligent speculation can occasionally be employed in anticipation of the occurrence of an upward earnings surge.
As I pointed out in my first edition of this series of articles, tiny companies with low average volume and low stock floats can experience extreme volatility to the upside when a positive catalyst presents itself. http://www.gurufocus.com/news/129055/introduction-to-microcap-investing--the-explosive-power-of-a-catalyst These features add considerable leverage to the effect of an earnings surprise or any other catalyst for that matter, which an astute investor may be able to surmise in advance.
Let's take the example of tiny Forward Industries, ticker symbol FORD, a company that I purchased in the Fall of 2004, buying at average price of about $2.50 per share. Here is the chart of the company: http://moneycentral.msn.com/investor/charts/chartdl.aspx?symbol=FORD&&CP=0&PT=10
The chart sort of resembles the flight pattern of a bottle rocket.
Forward Industries made its money by supplying soft carrying cases for such things as portable electronics, diabetic testing kits and cell phones. Most of their profits were made by supplying the cases for cell phones, principally to Motorola and Nokia, largely in the form of OEM cases provided in the box of a new cell phone. The company held absolutely no moat, outsourcing rather than manufacturing all their products, and only required 45 employees to run the business. I would not ordinarily invest in such a low-quality company, but the set of circumstances which I could see unfolding led me to speculate on the likely upsurge in price per share. The speculation I am about to describe was a perfect example of a "stock overlay" with an extremely favorable risk/reward scenario.
How could one have predicted the temporary earnings spike in Forward Industries which lead to the parabolic move? Part of the answer was recognizing the surge in cell phone sales of Motorola and Nokia which began in 2004, the second part was identifying some of their obscure suppliers which were flying under the radar.
Forward Industries was about to encounter a huge one-time earnings windfall as Nokia and Motorola sales increased in 2004. It turns out that the two cell phone giants had signed deals with Forward Industries to provide cell phone cases as part of a free in-the-box promotion. In other words, every person who purchased a new Nokia or Motorola cell phone automatically received a free carrying case provided by Forward Industries. This information was freely available by reading the filings of the company; additionally, stock promoter Ceocast was making sure that all their readers were aware of the information.
The temporary sustainability of the large earnings spike that began unfolding in Forward Industries's last calender quarter of 2004 was confirmed when they released their quarterly report. From the 10Q released on Jan. 21, 2005: "Net sales increased $4,423,000 or 98% to $8,916,000 in the 2004 Quarter compared to $4,493,000 in the 2003 Quarter, primarily as a result of a significant increase in sales of cell phone carrying cases to our two largest cell phone customers during the 2004 Quarter, during which both these customers initiated new product launches. We expect this spike in sales to persist into the three months ending March 31, 2005, with difficulty in assessing periods beyond that time."
The above paragraph virtually insured that Forward Industries was going to have at least one more banner quarter and now the day traders and momentum players had entered the stock. Meanwhile, the insiders were exercising options and selling shares at huge profits. They were taking advantage of the enormous volume to sell shares and pocket millions as a result of the temporary earnings bonanza. I took their cue and sold all my shares before the stock reached double digits, recording a large short-term capital gain. I sold way too soon as usual; the stock never quit ascending until it reached well over $20 per share by the summer of 2005. A look at the 10-year summary of the company reveals the temporary nature of the earnings windfall. http://moneycentral.msn.com/investor/invsub/results/statemnt.aspx?lstStatement=10YearSummary&symbol=FORD
Two distinct lessons can be learned from the tale of tiny Forward Industries. First, that astute investors can sometimes anticipate an earnings surprise in a microcap and take advantage of a parabolic move. Secondly, the earnings windfall is almost certain to be temporary in nature when it involves a low-quality company absent of any competitive advantage; therefore timely selling becomes as important as buying.
Utilizing Intelligent Speculation to Avoid losses
I was among the throng of investors who paid no heed to the flashing warning signals that existed long before the financial meltdown of 2008. I remained fully invested into and throughout the crisis, ensuring that I had no additional money to invest when stock prices represented compelling values in late 2008 and early 2009. If I had employed the use of intelligent speculation in regard to the potential catastrophic effects of the U.S. housing bubble, I would have been wise to raise some cash and hold it for a rainy day.
Investors need to constantly pay heed to the effect of changing macro and microeconomic conditions which may effect their companies. Additionally, they need to continually speculate about the potential dangers of such things as unlikely accidents or a changes in public policy which could effect the earnings power of their companies. Investors who own uranium mining stocks now or held offshore energy companies last Spring know all about the potential danger of not speculating about unforeseen circumstances. This type of speculation amounts to risk assessment, and it involves thinking well beyond the parameters of the company's balance sheet or ten-year cyclical adjusted earnings. Fortunately for long-term investors, such events generally do not permanently destroy the long term earnings power of a company.
Investors and traders are quite familiar with the positive effects of Fed policy in regard to equity prices when they are engaging in monetary stimulus. They also need to speculate about the potential consequences should the Fed decide to withdraw such monetary stimulus. These considerations become magnified when investors employ margin in an attempt to amplify their gains or invest in heavily indebted companies. Rising interest rates effect virtually all companies; however, the magnitude of the effect can vary greatly. Investors would be wise to consider the potential consequences of a change in Fed policy as we approach the end of the second quarter.
Conclusion
1) The use of intelligent, logically-based speculation can enhance an investor's returns when purchasing microcap stocks.
2) Intelligent speculation usually involves low-quality companies and should only represent a small portion of one's portfolio.
3) Margin of Safety remains the fundamental rule in value investing and should never be totally forsaken in favor of intelligent speculation.
4) Intelligent speculation should only be undertaken if one visualizes an extremely high risk/reward scenario.
5) Temporary earnings windfalls can result in huge moves in tiny stocks and can sometimes be predicted in advance.
6) Intelligent speculation is a trade; therefore selling is just as important as buying.
7) Intelligent speculation concerning economic factors which influence markets as well as individual stocks can be important in avoiding large losses.
8) Certain types of intelligent speculation are tantamount to risk assessment.
The concept of intelligent speculation strikes most value investors as a bit of an oxymoron. After all, Benjamin Graham went to great lengths to define the difference between investment and speculation; he did not choose "The Intelligent Speculator" as the title for his masterpiece.
The late George Carlin had a comedy routine where he associated certain words with either negative or positive connotations. When one mentions the term investing to a group of Grahamites it brings about feelings of peace, tranquility and security, sort of a value nirvana. If you mention the term speculation to the same group they are likely to scowl at you and then spit.
The intent of this article is to bridge the gap between successful investing and speculating. More specifically, how one can employ logically-based speculation which is a function of empirical observation, to increase portfolio returns or dampen the risk of dramatic short-term losses. It is not an attempt to discredit nor discount the concept of margin of safety. Margin of safety is instrumental in achieving long term gains while reducing long term risk without regard to one's specific investing practices. Margin of safety remains as Warren Buffett points out, "the three most important words in all of investing."
Utilizing Speculation in Purchasing Microcap Stocks
When I employ intelligent speculation in the purchase of tiny companies, I borrow the horse racing concept of an overlay. An overlay occurs when the actual odds of a horse winning a race are much greater than the price which is reflected in the parimutual odds (price listed on the odds board). Suppose the actual odds of "The Factor" winning this year's Kentucky Derby are 5/1, (one chance out of six) and he goes off at 10/1; wagering on "The Factor" is a very good statistical play whether he wins or loses. The risk/reward is highly favorable toward the bettor even though he will lose the wager much more often than he will win. Bear in mind that this example is not an endorsement of the horse nor Bill O'Reilly, for that matter.
Unlike paramutual wagering, speculating on a "stock overlay" rarely results in a loss of the entire principle invested, if ones thesis fails to materialize. While intelligent speculation should be viewed in terms of a favorable risk/reward scenario, it is important to note that not all logically-based speculations turn out as intended. One should never overload their portfolio with low-quality stocks merely because they visualize a favorable set of circumstances unfolding.
The Case of Forward Industries
Intelligent speculation can occasionally be employed in anticipation of the occurrence of an upward earnings surge.
As I pointed out in my first edition of this series of articles, tiny companies with low average volume and low stock floats can experience extreme volatility to the upside when a positive catalyst presents itself. http://www.gurufocus.com/news/129055/introduction-to-microcap-investing--the-explosive-power-of-a-catalyst These features add considerable leverage to the effect of an earnings surprise or any other catalyst for that matter, which an astute investor may be able to surmise in advance.
Let's take the example of tiny Forward Industries, ticker symbol FORD, a company that I purchased in the Fall of 2004, buying at average price of about $2.50 per share. Here is the chart of the company: http://moneycentral.msn.com/investor/charts/chartdl.aspx?symbol=FORD&&CP=0&PT=10
The chart sort of resembles the flight pattern of a bottle rocket.
Forward Industries made its money by supplying soft carrying cases for such things as portable electronics, diabetic testing kits and cell phones. Most of their profits were made by supplying the cases for cell phones, principally to Motorola and Nokia, largely in the form of OEM cases provided in the box of a new cell phone. The company held absolutely no moat, outsourcing rather than manufacturing all their products, and only required 45 employees to run the business. I would not ordinarily invest in such a low-quality company, but the set of circumstances which I could see unfolding led me to speculate on the likely upsurge in price per share. The speculation I am about to describe was a perfect example of a "stock overlay" with an extremely favorable risk/reward scenario.
How could one have predicted the temporary earnings spike in Forward Industries which lead to the parabolic move? Part of the answer was recognizing the surge in cell phone sales of Motorola and Nokia which began in 2004, the second part was identifying some of their obscure suppliers which were flying under the radar.
Forward Industries was about to encounter a huge one-time earnings windfall as Nokia and Motorola sales increased in 2004. It turns out that the two cell phone giants had signed deals with Forward Industries to provide cell phone cases as part of a free in-the-box promotion. In other words, every person who purchased a new Nokia or Motorola cell phone automatically received a free carrying case provided by Forward Industries. This information was freely available by reading the filings of the company; additionally, stock promoter Ceocast was making sure that all their readers were aware of the information.
The temporary sustainability of the large earnings spike that began unfolding in Forward Industries's last calender quarter of 2004 was confirmed when they released their quarterly report. From the 10Q released on Jan. 21, 2005: "Net sales increased $4,423,000 or 98% to $8,916,000 in the 2004 Quarter compared to $4,493,000 in the 2003 Quarter, primarily as a result of a significant increase in sales of cell phone carrying cases to our two largest cell phone customers during the 2004 Quarter, during which both these customers initiated new product launches. We expect this spike in sales to persist into the three months ending March 31, 2005, with difficulty in assessing periods beyond that time."
The above paragraph virtually insured that Forward Industries was going to have at least one more banner quarter and now the day traders and momentum players had entered the stock. Meanwhile, the insiders were exercising options and selling shares at huge profits. They were taking advantage of the enormous volume to sell shares and pocket millions as a result of the temporary earnings bonanza. I took their cue and sold all my shares before the stock reached double digits, recording a large short-term capital gain. I sold way too soon as usual; the stock never quit ascending until it reached well over $20 per share by the summer of 2005. A look at the 10-year summary of the company reveals the temporary nature of the earnings windfall. http://moneycentral.msn.com/investor/invsub/results/statemnt.aspx?lstStatement=10YearSummary&symbol=FORD
Two distinct lessons can be learned from the tale of tiny Forward Industries. First, that astute investors can sometimes anticipate an earnings surprise in a microcap and take advantage of a parabolic move. Secondly, the earnings windfall is almost certain to be temporary in nature when it involves a low-quality company absent of any competitive advantage; therefore timely selling becomes as important as buying.
Utilizing Intelligent Speculation to Avoid losses
I was among the throng of investors who paid no heed to the flashing warning signals that existed long before the financial meltdown of 2008. I remained fully invested into and throughout the crisis, ensuring that I had no additional money to invest when stock prices represented compelling values in late 2008 and early 2009. If I had employed the use of intelligent speculation in regard to the potential catastrophic effects of the U.S. housing bubble, I would have been wise to raise some cash and hold it for a rainy day.
Investors need to constantly pay heed to the effect of changing macro and microeconomic conditions which may effect their companies. Additionally, they need to continually speculate about the potential dangers of such things as unlikely accidents or a changes in public policy which could effect the earnings power of their companies. Investors who own uranium mining stocks now or held offshore energy companies last Spring know all about the potential danger of not speculating about unforeseen circumstances. This type of speculation amounts to risk assessment, and it involves thinking well beyond the parameters of the company's balance sheet or ten-year cyclical adjusted earnings. Fortunately for long-term investors, such events generally do not permanently destroy the long term earnings power of a company.
Investors and traders are quite familiar with the positive effects of Fed policy in regard to equity prices when they are engaging in monetary stimulus. They also need to speculate about the potential consequences should the Fed decide to withdraw such monetary stimulus. These considerations become magnified when investors employ margin in an attempt to amplify their gains or invest in heavily indebted companies. Rising interest rates effect virtually all companies; however, the magnitude of the effect can vary greatly. Investors would be wise to consider the potential consequences of a change in Fed policy as we approach the end of the second quarter.
Conclusion
1) The use of intelligent, logically-based speculation can enhance an investor's returns when purchasing microcap stocks.
2) Intelligent speculation usually involves low-quality companies and should only represent a small portion of one's portfolio.
3) Margin of Safety remains the fundamental rule in value investing and should never be totally forsaken in favor of intelligent speculation.
4) Intelligent speculation should only be undertaken if one visualizes an extremely high risk/reward scenario.
5) Temporary earnings windfalls can result in huge moves in tiny stocks and can sometimes be predicted in advance.
6) Intelligent speculation is a trade; therefore selling is just as important as buying.
7) Intelligent speculation concerning economic factors which influence markets as well as individual stocks can be important in avoiding large losses.
8) Certain types of intelligent speculation are tantamount to risk assessment.
