While most of your investment decisions should be based on the principle that you should invest in companies that are generating consistent cash flow at reasonable valuations, this can become boring. For some people that’s fine, but for others there needs to be another element of excitement to the investment process. It follows that if you want to — and if you can afford to — you can speculate with some of your money.
Speculation, as opposed to investing, is betting on a company that doesn’t have a cash flow stream that is looking for one. It could be a small mining company exploring for gold or a drug company looking for the next weight-loss pill or a cure for cancer. These companies don’t have a clearly visible cash flow stream in the future, and so there is a risk that they will go bankrupt or dilute shareholders to the point that each share is worth just a small portion of the company.
The good news is that such companies are often inexpensive relative to their cash flow potential. That is, if these companies find the cash flow streams that we are hoping for, then their valuations can skyrocket to many multiples of their current market capitalizations.
Speculation is just that — you’re betting on something that isn’t there, and therefore you are gambling. But just like card counting, you can do things to skew the odds into your favor, and in effect, you can speculate intelligently. Here are some tips for doing so.
1. Bet on people, not on stories
When you are speculating, you are betting that a company’s management will find a new cash flow stream that will profit shareholders. Any company can tell you a great story about how it is going to find the next cure for cancer or create some amazing new technology that is going to change some industry forever. But you need to differentiate fantasy from reality.
One way of doing so is to look at the company’s management. This is crucial. For instance, if you are betting on a drug company looking for a cure for cancer, you need to make sure that the top executives can actually find one. The CEO should be an oncologist with an MD or PhD, not to mention years of research existence. Maybe that person has worked for a company that has done extensive cancer research. But unless he or she has credentials, that person isn’t going to find a cure for cancer. Checking up on management’s credentials is easy: the company should have short biographies of the top executives on its website.
You can also look elsewhere on the Web. If you can’t find this information right away, move on. Remember, there are thousands of speculative companies out there, and you shouldn’t be wasting your time on one that isn’t easy to understand.
2. Search under the radar
Part of speculation is unearthing companies before the market has discovered them. For instance, if you think you have a great speculative idea that you came up with reading The New York Times, think again. Chances are the company has been discovered and scrutinized, and it follows that you probably don’t have an advantage. Look for small companies that aren’t traded very frequently. Look through newsletters and websites that specialize in the sort of company you wish to speculate in. If you take the time, you will be able to find the gems that can make you fortunes, but if you don’t, then chances are you are following the crowd, and this strategy never works in investing of any kind.
3. Become an expert yourself
When you speculate, don’t do so lightly. If you want to speculate in a small mineral exploration company, then read up on mineral exploration. If you do, you will be better equipped to find subtle differences between companies that amateurs would miss, and this is how you are going to find the winners before the market does.
Becoming an expert also means restricting your speculation to one, maybe two sectors. Don’t speculate across industries — you will spread yourself thin, and you will lose your edge.