An Introduction to Speculation
Speculation is a term that is commonly used throughout the stock market, but just exactly what is speculation. The financial press frequently makes reference to speculative stocks as being any stock that is priced under $1 and at other times price under $5. The general implication is that the financial press considers a stock to be speculative when it's priced under a certain limit.
At other times the financial press uses the term speculation to describe investors picking the market direction. Speculation is also sometimes used when referring to stocks outside of the S&P 500 and yet at other times speculation is simply used to describe a small company.
It's no wonder why investors are totally confused with what speculation even really means.
To clear up the confusion, a distinction is first made between speculation and a speculative stock.
The term speculation is defined in the dictionary as "to form an opinion without having any definite evidence".
With reference to the stock market, the term speculation refers to the decision made by a market participant. That decision was however based on information that is not guaranteed to be 100% accurate or complete. Thus the information was rationalized as to its reliability.
Speculation thus refers to an individual's rationalized decision. Such a market participant is referred to as a speculator and is often called a speculative investor or a speculative trader.
Speculation refers to an investor’s decision that is based
on information that is not accurate or complete
A speculative stock on the other hand simply refers to a company whose future financial growth prospects are considered less likely to emerge based on its current financial history.
A Speculative stock is a company whose proposed
future growth is not supported by its historical growth
Companies can be broadly classified into two groups. The famous investor - Benjamin Graham considered a company which is fundamentally sound with realistic and proven growth to be of investment grade. Any company not considered to be of investment grade is considered to be a speculative stock.
Thus, speculation refers to an individual's rationalized decision and a speculative stock refers to a company which is not of investment grade.
A distinction needs to be made between speculating on an increase in a company's future valuation and speculating on the stock price movement.
There are two prices for any company. One is the stock price and the other is the fundamental valuation of the company. A market participant can speculate on either of these two prices.
Stock Price vs. Fundamental Valuation:
- When a market participant speculates on the price movement of a stock, they are referred to as speculative traders. Strictly speaking all trading is speculation since the trading decision is based on stock price history which by its very nature is extremely volatile and does not provide any definite evidence.
- When a market participant speculates on an increase in a company's future valuation, they are referred to as being a speculative investor. This is the case whether the company is of investment grade or a speculative stock. In either case speculative investing is speculating on the future valuation of companies since there is no definite evidence. Investing (as opposed to speculation) is accepting the current proven growth which is the definite evidence.
Thus a speculative investor speculates on the future valuation of the company while a speculative trader speculates on the future stock price movement of the company.
An investor (as opposed to a speculative investor) simply accepts the current growth as being indicative of future growth.
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
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.
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.
It is prudent to thoroughly understand what speculative investing involves
The basis for investing is for the company's fundamental valuation to increase over the long-term. The stock price itself is not of primary concern since it fluctuates about widely as it goes on its roller coaster ride. This is the basic principle utilized by the famous investors like Warren Buffett and Peter lynch.
So long as the company's fundamental valuation continues to increase, the stock price will broadly follow the valuation increase and tends to spend more time above its valuation than it does below its valuation. The stock price is mainly of interest when an investor is adding stock to their portfolio or reducing their stockholdings.
The typical stock price fluctuation with their trending nature of uptrends and downtrends following the company's valuation is illustrated below in Figure 1.
Figure 1. Investing with an investment
The classic definition of investing is depicted graphically in Figure 1. above. An investment grade stock will generally continue its fundamental valuation increase over time and the stock price typically goes on its roller coaster ride following the valuation upwards. Figure 1. also depicts the classic value investing entry point. Growth investors will be more inclined to buy stock when the stock price is rising in an uptrend.
Speculative investing occurs when the current financial evidence which projects the fundamental valuation into the future is ignored and is instead replaced by other information which is not reflected in the company's current financial history.
There are valid reasons why not to accept the current valuation projection into the future. One of the main reasons for this is if a company is developing a new product which has a high probability of increasing the company's future revenue and earnings, but this is not reflected in its financial history.
An investor can speculate that the growth of a fundamentally sound company will be significantly higher in the future than what its current growth suggests. Here the investor is speculating on an investment grade stock and not a speculative stock.
All businesses face competition and the business world is fluid and not static. There are always new companies which are keen and eager to increase their market share of the revenue and will do so at the expense of its competition. An establish company can get caught out in the future by a rival company which has a superior product or a more cost effective product and takes its market share causing a declining trend in its future revenue. Even though any future decline in revenue is not currently reflected in the company's financial history, speculative investors may factor this into its future valuation.
Thus an investor can actually speculate on the future valuation of an investment grade company. That valuation can be either an increasing trend or a declining trend.
Example: An investment grade stock may be growing its revenue and earnings at 10%, but the company has a new superior product under development which could potentially produce a 20% increase in sale and earnings. Assuming a 10% increase in near future revenue is investing and assuming the potential 20% increase is speculating.
An investment grade stock with potential to increase its current growth rate is illustrated below in Figure 2.
Figure 2. Speculative investing with an
investment grade stock
As shown in Figure 2. above, the stock price will typically follow the new valuation line. Should the speculative investor's evaluation of the company's increased future growth not materialize, then the valuation increase will probably just continue along its existing rate of increase.
Thus speculating on an increased valuation growth rate with an investment grade stock is fairly safe as the worst that usually happens is that the anticipated increased rate of growth does not develop.
Speculating with a Speculative stock
Speculating with a speculative stock is what many market participants consider to be speculation.
A speculative stock is simply any stock which is not considered to be of investment grade. Some speculative stocks are financially in quite good shape with good potential for growth while others are financially under considerable stress.
With the companies that are financially in poor shape there are companies with good future prospects and companies destined for bankruptcy.
Speculative investing with speculative stocks covers a broad segment of the stock market and there is never any shortage of market participants willing to speculate on the future prospects of a speculative stock that is in poor financial shape. Indeed if the speculative investor's stock pick does turn around its financial misfortunes the increase in its fundamental valuation can be substantial and the stock price will follow its valuation upwards with its typical roller coaster nature.
Companies in poor financially shape are the long shots with speculating but they also provide the greatest rewards if the company is successful in the future.
A speculative stock which is fundamentally unsound but has good future growth potential is illustrated below Figure 3.
Figure 3. Speculative investing with a
fundamentally unsound stock
As shown in Figure 3. above, the stock price will typically follow the new valuation line. Should the speculative investor's evaluation of the company's increased future growth not materialize, then the valuation will probably just continue to decline at its existing rate.
Thus speculating on a turn around with a speculative stock that is financially in poor shape is high risk. If the turn around does not eventuate then the fundamental valuation will certainly continue downwards. Obviously the valuation cannot continue downwards forever and the company will sooner or later wind up in bankruptcy if is not taken over by another company.
Speculative stocks which are mostly fundamentally sound but are struggling with their revenue and earnings are less risky than those with financial problems. This is because these stocks tend to have a fairly stable fundamental valuation so if the anticipated future growth does not emerge they are more likely to at least hold their existing valuation.
The safer stocks to speculate on are smaller companies which are considered to be of investment grade. At least with these stocks if the anticipated future growth increase does not emerge they are still mostly sound investments.
Like with everything in investing, the higher the risks then the higher the potential rewards.
The risk can be managed with stop-loss techniques and series on Position Management gives the speculator numerous examples using stop-loss techniques that are suited to speculative investing.
Trading with the aid of fundamental information
The difference between speculative investing and speculative trading is simply the difference between investing and trading.
Difference between investing and trading:
- Investing is the process of following the increase in the fundamental valuation of the company irrespective of the stock price.
- Trading is the process of following the stock price movement irrespective of the fundamental valuation of the company.
By the very nature of businesses which take considerable time for changes to be reflected in their fundamental valuations, this makes investing a long-term proposition. On the other hand stock prices are highly volatile and move extremely quickly which makes trading attractive as a short-term proposition.
When a market participant speculates on the price movement of a stock, they are referred to as speculative traders. This leads to the issue with stock trading which is sometimes cited by the financial press as speculation.
While stock trading strictly speaking is speculating, a distinction is made between the stock trading and speculative trading to distinguish between the different approaches used.
The term stock trading is usually used in reference to traders who exclusively utilize technical analysis for their decision making process. They are often referred to as technical traders and can also be referred to as either technicians or as chart pattern traders. Technical traders include day traders, swing traders and position traders.
While technical traders are speculating on the future price movement of a stock, their decision making process is based solely on the stock's price history. In contrast, speculative traders base their decisions largely on fundamental considerations while incorporating technical charting analysis. Also technical traders usually have a fairly short time frame while speculative traders usually have longer time frames which can extend beyond one year.
The Speculative Trader
Speculative traders can be thought of as fundamental traders who speculate on the future price movement. Probably the most famous speculative trader of all time is the famous investor - Jesse Livermore who amassed a fortune speculating on the markets.
A speculative trader has the same options as a speculative investor but also has some additional options.
- Trade an investment grade stock based on its future valuation continuing as its present rate.
- Trade an investment grade stock based on a change in its future valuation.
- Trade a speculative stock which is basically fundamentally sound based on its future valuation continuing as its present rate.
- Trade a speculative stock which is basically fundamentally sound based on a change in its future valuation.
- Trade a speculative stock which is financially distressed based on its future valuation continuing as its present rate.
- Trade a speculative stock which is financially distressed based on a change in its future valuation.
The speculative trader can speculate on the price movement of either an investment grade stock or a speculative grade stock.
Speculating on the price movement of an investment grade stock is illustrated below in Figure 1.
Figure 1. Speculative trading with an
investment grade stock
From Figure 1. above, the speculative trader has identified a small company which is determined to be of investment grade. The speculative trader takes an entry as the stock price is well below its fundamental valuation and also below its book value. While the stock is in a downtrend, the speculative trader enters on a bounce in stock price and places a stop-loss below the Relative Low.
A technical trader may see the same stock and come to the conclusion that since the stock is in a well defined downtrend that a short position would be appropriate.
Thus the speculative trader and the technical trader can come to the exact opposite conclusion regarding which direction to trade the stock.
Speculative traders can also speculate with stocks on the short-side by speculating that the stock price will decline.
Speculating on the price decline of a speculative stock which is financially stable is illustrated below in Figure 2.
Figure 2. Speculative trading with a
fundamentally sound speculative stock
From Figure 2. above, has identified a speculative stock which is financially stable but has been struggling with its revenue and earnings. The earnings forecasts are for an increase in earnings; however the stock's rally has significantly outpaced any realistic increase in valuation. The market has priced in an earnings figure that is probably based on a whisper number.
After the earnings are released, even if they match the forecast estimates, the stock will likely sell-off due to profit taking. For the stock rally to continue, the earnings results would have to exceed what the market has priced into the stock.
The speculative trader decides to short sell the day before the earnings release. If the earnings release does not reach the forecast estimate and the earnings is merely much the same as previous releases, then this stock will likely be sold back down to its valuation line.
A technical trader may see the same stock and come to the conclusion that since the stock is in a well defined uptrend that a long position would be appropriate.
Thus the speculative trader and the technical trader can come to the exact opposite conclusion regarding which direction to trade the stock.
Beginner traders whether they are speculative traders or technical traders or investors typically trade on the long-side and are often caught out when they trade speculative stocks.
A common pitfall for beginners is that they are keen enough to exit their trades at a profit, but when they endure a string of losing trades they become reluctant to sell at their stop-loss levels. They begin to notice that the stocks subsequently traded back to breakeven after being stopped out at a loss. This is the roller coaster nature of stocks.
The problem for the beginner trader is that they start to hold onto their losing trades after they trigger their stops by justifying that they will return back to their entry price. While this is an issue with an investment grade stock, it is disastrous with speculative stocks especially if they are financially distressed as the valuation has a high probability of continuing downward and the stock price may never return to their entry price.
Beginner traders who also incorporate short selling have the problem that some speculative stocks can significantly increase in valuation which can send the stock price soaring. Any beginner who did not exit their short position will endure a substantial loss.
Any stock trading requires a sound risk management strategy to be implemented otherwise trading will lead to nothing but losing.
Technical trading is appealing to beginners as they require no fundamental knowledge in order to participate. However incorporating fundamental considerations is the essence of speculative trading.
The series on Chart Investing gives the speculator numerous examples using charts as the primary means of tracking the stock price.
The series on Position Management gives the speculator numerous examples using stop-loss techniques that are suited to longer term trading and speculative investing.
If selling at a stop-loss causes the technical trader anguish, there are speculative strategies which are based on speculative short-term investing which do not even incorporate stop-loss tactics and are instead based on probability.