What is a Speculative Company?
- A speculative company dedicates a significant percentage of its assets to high-risk investments in the hopes of reaping extraordinary returns.
- Investing in a speculative company, on the other hand, need not be viewed as a high-risk investment, especially if that company has established a credible, and successful, business model.
- Energy companies are prime examples of a speculative company, since they are continuously committing a significant percentage of their assets to exploration projects that, more often than not, end in failure.
Understanding Speculative Companies
A speculative company has a significant percentage of its assets tied up in projects with uncertain returns. A speculative company participates in projects with a high probability of failure. However, should a project succeed, the returns can be quite substantial.
Investing in a speculative company, on the other hand, need not be viewed as a high-risk investment, especially if that company has established a credible, and successful, business model. As such, the stock of certain speculative companies (Exxon Mobil Corp or Shell Canada) is not classified as speculative stock since the expected return of these established speculative company's stock can be estimated with a reasonable degree of confidence.
Energy companies are prime examples of a speculative company, since they are continuously committing a significant percentage of their assets to exploration projects that, more often than not, end in failure. However, should one of these ventures succeed, and they find a new source of oil or natural gas, the potential returns can be immense.
While there is significant risk involved in investing in early-stage speculative companies, the possibility that a small company may find a giant mineral deposit, invent the next big app, or discover a cure for a disease offers enough incentive for speculators to take that risk.
Although most speculative stocks tend to be early-stage companies, a blue chip can occasionally become a speculative stock if it falls upon hard times and has rapidly deteriorating prospects for the future. Such a stock is known as a “fallen angel” and may offer an attractive risk-reward payoff if it can manage to turn its business around and avoid bankruptcy. General Electric (GE), currently trading around $9.38 per share, might qualify as an example of a fallen angel. GE's stock fell so far off its all-time high and its core businesses changed so much that it was replaced on the Dow Jones Industrial Average (DJIA), an unfathomable fall for the only remaining original member of the index.
Investing in Speculative Companies
It can be difficult to rationalize the decision to invest in a speculative company because the traditional valuations metrics like the price-earnings (P/E) and price-sales (P/S) ratios cannot be used, since they are often early-stage and unprofitable. For such companies, alternative techniques like discounted cash flow (DCF) valuation or peer valuation might be needed to project future potential.
Speculative companies often account for a small portion of an experienced investor's portfolio. Such stocks may improve the return prospects for the overall portfolio without adding much risk, thanks to the beneficial effects of diversification. Experienced investors who dabble in speculative stocks typically look for companies that have experienced management, strong balance sheets, and excellent long-term business prospects.
Most investors should avoid speculative stocks unless they have the time to dedicate to research, while traders should be sure to use risk management techniques when trading speculative companies to avoid sharp losses.