Hyperdynamics Takes a Hyperdive; A Lesson in Intelligent Speculation

On Jan. 14 I published my cautionary article on Hyperdynamics (AMEX: HDY). The comments I received over the next few days were generally nasty, condescending, or both. I was secretly short the stock or in league with short-sellers, said the critics. I was a clueless ass. I hadn't done any research. That kind of thing.

Well the stock tumbled as low as $3.75 on 25 January, and closed at $4.21on January 26th. I published my article on the day the stock hit its all-time high of $7.78. I must be very well-connected with nefarious market manipulators!

How we got here
To refresh everyone's memory, Hyperdynamics' stock price doubled from mid-December to mid-January. My contention was that this move was primarily driven by the announcement of a letter of intent with an unnamed independent E&P that would foot part of the bill for Hyperdynamics' proposed three-well drilling campaign offshore Guinea in late 2011.

My non-research told me that Hyperdynamics had seen a previous agreement with Repsol (NYSE: REP) fall apart. I floated the possibility of a repeat, stating that "if the current negotiations fall through, I expect the shares to take a dive."

That's exactly what has happened.

Did I call this one or what?
No, not really. I hashed out a valuation, assuming the letter of intent would be signed, and still found the shares to be on the fully valued side, given the frontier nature of the drilling program. But I at least considered the possibility of the letter not getting signed, and its implications for the share price. I have to assume most shareholders did not, given the sell-off.

This is why we invest -- or speculate -- with a margin of safety. Speculators (and I don't mean that in a pejorative sense) may not feel like the concepts developed by luminaries including Benjamin Graham and Warren Buffett apply to them, but they do.

There's a right way and a wrong way to do this
Intelligent speculation, just as with intelligent investing, means buying at a discount to your probability-weighted expected value. In other words, buying a stock or other security only when the odds of making money are tilted in your favor. The problem, of course, is that predicting the future is tricky. Speculative odds are therefore incredibly difficult, if not impossible, to handicap with any precision. That leads many speculators to throw probabilistic thinking out the window, shrug, and say things like "Downside is only 100%." That is a mistake.

Here's a quick example. If you figure you have 1-in-10 odds of making eight times your money (+700%), otherwise you lose it all (-100%), your expected return is -20%. That's a bad bet. You'd require the prospect of making more than 10 times your money to expect a positive result, given the same estimated odds. Only the latter situation would qualify under Graham's definition of intelligent speculation, assuming the estimated odds were arrived at through well-reasoned analysis. (I recommend his lecture on the subject, which you can read at this link.)

The upside in a speculative investment like Hyperdynamics, or Rare Element Resources (AMEX: REE) -- all of whose rare-earth element resources are classified as inferred, and therefore geologically speculative by definition -- or Oilsands Quest (AMEX: BQI) -- an emerging oil sands outfit that's been emerging, rather than producing oil, for longer than I can remember -- is tremendously appealing to our sense of greed. Greed is good, but only when others are fearful.

There is a time and a place for speculation, but it's typically not when everyone's jumping on the bandwagon. In the case of Hyperdynamics, a subset of shareholders has a cost basis of under a dollar a share. Those folks arguably speculated intelligently, assuming they did their research, and can afford to ride out this setback for the company. Those waiting until the shares had tripled following BlackRock's investment at $2 per share, on the other hand, did not leave themselves an adequate margin of safety.

I'm all for sprinkling one's portfolio with a little speculation, but I encourage my fellow investors to be smart about it.

Disclosure: Author has no positions in companies mentioned.