Punting on Penny Dreadfuls

A lot of us seem to love a punt; after all why would we invest in stocks that have never made a profit if this wasn’t the case? Sure, there are always lots of feel good stories that can help us justify such investments, and there are certainly many examples of ‘penny dreadful’ stocks that have gone on to become real success stories. The thing we must acknowledge though is that such investments are very high risk, and we are essentially buying in hope that the future will be very attractive.

The trouble is that we often forget two very important facts. Firstly, that future expectations are often already priced in by the market, and that these expectations are far from guaranteed.

Consider a stock which has yet to turn a net profit, but is expected to do very well in the next few years (essentially, most of the penny dreadful miners out there). Let’s say XYZ Ltd is trading at $3 and has forecast earnings as follows:

Currently, investors are paying $3 for an asset that has so far only ever lost money each year. The investment is based entirely on optimism for the future, but the fact that the market is prepared to pay good money for exposure to this says that there may well be a sound justification for doing so. After all, as you can see earnings are expected to double every year from between 2011 and 2013.

Let’s assume that forecasts do indeed turn out to be correct, and XYZ does generate an EPS of 20c in 2013. Based on the current market average PE of 15 (which is essentially the long term average), shares in XYZ could reasonably be justified in trading at $3. For it to trade any higher than that in 2012, the rate of expected earnings growth would need to remain high. And with a company expanding at such a high rate, a PE of 30 could well be justified, and there is real potential you could double your money in a few years. However if it doesn’t you will likely see little price appreciation over the next few years.

Therefore these types of stocks need to not only meet expectations, but their future prospects must remain very attractive. That is, they must be expected to continue to grow earnings at above average rates. Maybe they will, but then again maybe they won’t.

If earnings fall short of expectations, the situation becomes even worse of course, and the historical record here should, at the very least, force us to be cautious. Consider the case with Fortesque Metals. In 2007 it fell short of earnings guidance by almost 200%. The following year saw a 343% shortfall, and last year it was (only) 18% shy of expectations. Of course since 2007 the share price has increased on balance, although it’s been a very volatile ride. The only reason why it continues to attract demand is that the future has remained attractive, at least as far as the market is concerned.

But the record also shows that earnings can and often do fall well short of expectations. Other stocks such as Astron (ATR), Bougainville Copper (BOC), Iluka Resources (ILU), Perilya Ltd (PEM), plus dozens more show just how difficult fulfilling growth forecasts can be. I’m not saying that you should avoid investing in such companies. But you should be very aware of the risks.

For you to do well in such instances the company in question needs to either:

1. Exceed expectations
2. Match expectations AND continue to convince the market that future growth will remain attractive

If this isn’t the case, you are not likely to get a good return. And because you don't typically receive a dividend along the way, there is absolutely no reward for holding such stocks in the interim. Of course, these stocks tend to be very volatile, so there are opportunities for savvy traders, but for investors they represent high risk.

The market may not be perfectly efficient, but it is very, very good at pricing assets. To assume that you can identify value better than the collective wisdom of the market, and that your value judgement will soon be recognised and reflected in the share price, is not a safe assumption.

Investing in blue chip, dividend paying stocks may not be as sexy, and certainly doesn’t allow for the same degree of potential return, but it is nevertheless a much safe proposition. And besides, even average levels of growth can be very rewarding over time. 12% annual growth will see you double your money in around 6 years, and you may well decide that a likely return of 12% pa is far better alternative than a potential, yet far less likely return of 50%pa.

So the question is: are you feeling lucky?

Make the markets work for you

Andrew Page