Speculation Isn't Inherently Bad As Part Of An Investment Strategy

Includes: FH, MAKO, MJNA, NFLX
by: Alan Brochstein, CFA

One of the great benefits of being a Seeking Alpha contributor or member is that we can all learn from one another. I just celebrated my sixth anniversary sharing my thoughts here, and I continue to believe one of the greatest perks authors receive is feedback from readers. I shared a perspective recently regarding what I perceived as a bubble in part of the market, a group of pink-sheet stocks involved in a speculative frenzy. My article, Reefer Madness: Pot Stocks in a Bubble, caught a lot of criticism, but it reinforced my views regarding the issue. I base this not only on the insane popularity of the article (based on page-views), but also the hundreds of comments I received (and friendly private messages too!).

While I can easily dismiss one criticism (that I must be "anti-cannabis") with a disclosure I perhaps should have included on the original article (that, as a Libertarian for the past 32 years, I am anti-prohibition), I believe that I need to make an effort to address another criticism that I am "anti-speculation". While it may be true that I tend to be a lot more conservative in my views regarding investments than many, I don't really believe in absolutes such as "speculation is bad". To me, this falls into the same camp as some of the greatest ongoing debates on Seeking Alpha, like the wisdom of share repurchases. There are two sides to most things in life, and this is the case as well when it comes to speculation.

What is Speculation

This is perhaps the most controversial part of this article, and I am sure many won't agree. Unfortunately, I think it's kind of like what the Supreme Court says about pornography: "I know it when I see it." I have heard from some that ALL stocks are speculation, but this borders on absurd in my view and is usually a rationalization for not doing a proper assessment of potential risk and reward. Of course no one has a crystal ball! For the purposes of this article, I would suggest that speculation is investing where the range of outcomes can be both significantly positive or negative relative to what is typical in the equity market. More importantly, a negative outcome is likely associated with a permanent loss of capital.

One of the easiest speculative concepts to identify is the Biotech space. Here, the outcomes are highly binary. If the drug is approved, it's a huge win potentially, while failure can doom the company, especially if it is relying primarily on that single drug. I would offer from my own relatively recent experience, Savient Pharma (OTC:SVNT). The good news was that I realized it was speculative, relying upon the success of KRYSTEXXA alone (a treatment for gout). We sized it right and took a big loss on a small position that could have been a lot bigger. The bad news was that it failed miserably, and it was still a pretty big loss even if on a small position in 2011 in my Top 20 Model Portfolio.

Back to the article I shared on pot stocks, several commenters made the point that "real products" of Medical Marijuana Inc. (OTCPK:MJNA), such as Dixie Elixers sold by Red Dice Holdings (60% owned by MJNA.PK) means that the company must not be speculative. I find fault with this analysis, because products don't mean profits, and businesses succeed ultimately only when they can produce a profit. While this stock continued to fall sharply last week despite a very bullish 2014 outlook (yes, 2014), I still view it as speculative. The company is plagued with many disclosure issues and, even after the decline last week, sports a stunning market cap of $235mm (based on about 855mm shares, 47mm of which have apparently been issued in 2013).

Several commenters suggested that MJNA.PK is no more speculative than Netflix (NASDAQ:NFLX). While I don't agree with that assessment, I do think that they are correct that NFLX is highly speculative. One can arrive at this conclusion in a number of ways, including a simple look at its volatility, a consideration of the valuation (PE, P/B, etc.), a large (10mm shares) short-interest or an understanding of how rapidly the space is changing. I would suggest, though, that the business model of huge commitments to future streaming content purchases is what really makes it speculative. This massive liability doesn't show up on the balance sheet, but it has the same effect as debt. Quite simply, the company is on the hook for these future purchases even if subscribers ditch the service. The 10-K on page 31 describes it as $5.6 billion, almost all of which is due within 5 years and $5 billion of which is due within 3 years. That, in my opinion, helps to understand why the stock has rallied 94% on 4% boost to expected revenues in 2013 following the Q4 EPS release.

So, all stocks, to at least some degree, are risky because no one knows the future, but there is a wide range of uncertainty with some stocks that one can characterize as speculative because the range of expected outcomes is so broad in its distribution. Binary events, immature companies, unprofitable companies, highly valued companies, companies with lots of debt - these are all factors that contribute to the degree of speculation in my view. Speculative stocks aren't inherently "bad", but they are risky. While it's not my topic today, I would expect that a portfolio of speculative stocks does tend to be expensive on an "expected value" basis, kind of like the lottery, but I would also expect that speculation runs in cycles such that speculating is better at some times than others (like the beginning of a bull market rather than the end).

How Poor Speculation Can Make You Poor

Babe Ruth hit lots of home-runs, but he struck out a lot. He still is considered one of the greatest baseball players of all-time. If you use a "Babe Ruth" philosophy with stocks, and are willing to take a bunch of huge losses in pursuit of even huger gains, you better get several of those winners, or you won't be remembered as kindly.

Let's walk through the math of poor speculation. In our example, let's assume that the speculation is binary and pays off at 3:1 if the speculator is correct but entails a 2/3 loss if not. A $1000 investment then will be worth $3000 with success or $333.33 with failure. In our example, let's assume it's a "fair bet" too, meaning that over time the expected value is $1000. In this example, that probability of winning is 1 out of 4 times (if you make four $1000 bets for a total of $4000, you will end up with $4000, consisting of a single $3000 pay-off and three $333.33 pay-offs).

If you aren't a good speculator in "round 1" and miss all four, your $4000 is suddenly worth $1333.33. Now, you try it again, making four bets with your diminished capital ($333.33 each). This time, you beat the odds and score two "home-runs" and "strike out" twice. Not bad! Where does that leave you? You make 3X on two, which gives you $1000 each ($2000 total). You get back 1/3 on the other two, or $111.11 each ($222.22). Adding it all up, you now have $2222.22. Ouch!

In case it's not clear, you started with $4000 and you lost almost half your capital in a fair game where over the two rounds you experienced the proper odds, on average. Wait, you say, what if you won twice in the first round and then lost all four times in the second round? After round 1, you would be up big, with a total of $6666.66 on your $4000 investment, but then after the four losses you would be at the same $2222.22.

Smarter Speculation

If you want to be a smarter speculator, the answer is easy: Don't take big losses! The reality, though, is that when you are swinging for the fences, you often strike out. I am probably not the best person to advise on becoming a better speculator, as it's not an area where I really focus. Still, as I think about the whole topic, I think I have some ideas that might help mitigate disasters:

  • Restrict speculation to a limited amount of available capital
  • Restrict position sizes within speculative part of portfolio
  • Make sure risk/reward is understood in some sort of analytical frame-work
  • Remember stocks aren't pieces of paper
  • Make sure that the company is capitalized adequately
  • Look for insider ownership
  • Look for signs of smart management
  • Try to avoid "all-or-nothing"
  • Look for signs of excessive investor interest (bubble)
  • Avoid speculating on margin

The first two points are simple and are about risk management. A strategy based solely on aggressive speculation is a risky process. Additionally, while I tend to think 20 stocks in an equity portfolio provide proper diversification in most cases, if one is using highly speculative stocks, I suggest smaller positions. A 1% position on a stock that is going to return market plus or minus 15% is silly in the context of an entire portfolio, but a speculative stock that could triple or lose 2/3 of its value makes sense in this proportion.

An analytical framework to me is simply some sort of quantification of the downside and the upside with some sort of attached probabilities. In other words: What's the game? In my example earlier, it was a simple end up with 3X or 1/3X, and I said that the odds were such that one would win 1/4 of the time but lose 3/4. In this case, it was a "fair" bet. What about the lottery? Is that a fair bet? Not mathematically - your "expected return" is negative. This could degenerate into a very complex conversation about "utility preferences", but let's keep it simple. As I say, stocks aren't just pieces of paper - they represent ownership in a company. Instead of thinking about a stock, like MJNA.PK, trading at .27 "could go to $1", calculate the enterprise value (market cap less cash plus debt) and do the scenarios on that basis. Think about a company worth $235mm: What are the odds it's worth less than $50mm or worth more than $500mm? If you can't do this basic level of analysis, you are merely gambling without knowing the odds.

The next three concepts are related. If a company needs financing in the future, it makes any sort of investment more speculative by nature. Lots of debt and/or negative operating cash flow are signs of potential dilution. The more shares, the less they are worth (all things equal), by definition. Often if there is large insider ownership, especially of shares or in-the-money options, there is a better chance, in my view, that management will do the right thing and not take a "heads I win, tails you lose" mentality. Similarly, if the people on the Board or the management team have succeeded in the past, they deserve some benefit of the doubt.

My next point is to avoid completely binary situations if you can. If a company is a one-trick pony and the horse gets sick, game over. A large cash balance, other products or opportunities, etc. can prevent a complete zero.

This point ties into the analytical frame-work discussion to some degree, but one needs to be careful timing a speculative buy. When lots of other investors have a much lower cost than you, you are at a disadvantage. Check for short interest, message board popularity, SA followers or anything you can that will help you know if there is a bubble brewing. I am not saying to necessarily avoid chasing bubbles, if that's what you do, but I am saying that you need to know it's a bubble.

The last point is a simple one. I already showed how speculative errors can lead to large loss of capital. Imagine if this is on borrowed money! Margin is already speculative enough - don't compound it.

Some Examples

While 98% of my focus is on stocks I would consider not too speculative, I occasionally find a risky stock that I think could be a chance worth taking. I want to share a couple and show how they fit into my advice I just shared.

First is Mako Surgical (NASDAQ:MAKO), which I disclosed earlier this year is in my Top 20 Model Portfolio. If you are interested in the company, I did write about it last July when it was near 15 in the after-hours, calling it a compelling entry but needing more study on my part. We ended up adding it later, selling it, and then purchasing it again.

Make no mistake, this is speculative. Why? It's a new product (minimally invasive knee and hip surgeries) by a company competing against much larger organizations. Plus, the company isn't profitable on a cash flow basis. The company issued equity in Q4, so it doesn't have a funding overhang any longer, but, until it becomes profitable, this will remain an issue. Plus, the stock is very expensive on a P/B or P/S basis. My view is that the stock could double if the company is able to meet current sales expectations (i.e. trade at 7.5X 2013 sales of 132mm). Management has good insider ownership, and the CEO has successfully sold companies he started in the past. Another issue that reduces the risk at least modestly is that the company has a recurring revenue model based on procedures. The installed base could jump ship if there is a better mousetrap down the road, but it's unlikely that it would happen overnight.

The next idea fascinates me, but I am merely a spectator: Vringo (VRNG). This is a real soap opera in the IP space, which is a rapidly evolving speculative arena in itself. In this case, VRNG has won a jury verdict against Google (NASDAQ:GOOG), but the stock is trading at the same price as before it went to trial. There are a lot of moving parts, and there are lawyers who think that they know about trading/investing and traders/investors who think that they know about the law going back in forth on this one.

When I first came upon it, it had all the marks of a speculative frenzy. I was somewhat negative on the over-hyped name, and was blasted in the comment sections of articles and on the StockTalks for sharing my view. As I got to know the story better and as it scored a victory, albeit less than many had hoped, my framework changed and I became positive below $3. I won't share my full analysis, but based on my assumptions of a running royalty, the cash coming into the company over the next few years could be over $600mm. There is a lot of optionality as well, with some potential outcomes that I think are no longer expected (specifically, a correction to the damages award, which seems to be a mistake, or perhaps even a successful appeal of the "laches" decision that restricted the period of infringement) possible as well as some other shots on goal (ZTE lawsuits, MSFT lawsuit and more). When I apply probabilities and potential outcomes, I come up with an expected value in excess of $4. In my base scenario, I can see the stock climbing towards 5 on a 3.5% running royalty decision by Judge Jackson, but there are outcomes that push the stock as low as 1 or perhaps much higher than 5 as well. I think that Adam Gill has done a great job of explaining some of the issues from a legal point-of-view, most recently addressing the original jury award but also a more negative view on the laches ruling. There are some other strong contributions as well, though one slight negative is that there are so many! This one is definitely in the limelight, but the large short-interest along with my own understanding of the sentiment suggests there's no longer the excessive hype I detected back in early October. Insider selling back then was an issue in my view, and the fact that management has selling plans still is certainly a negative to the story.


Speculation can be dangerous, as my mathematical examples (and experience!) have shown, but that doesn't mean it's inherently bad or irresponsible to engage in it. I have shared some ideas that I think can help improve the outcomes, or, more importantly, avoid the kind of catastrophe that can occur to an undisciplined speculator.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: MAKO is held in one or more model portfolios managed by the author at InvestByModel.com

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