What Is a Speculative Company?
A speculative company invests an outsize proportion of its earnings and assets to high-risk investments in the hopes of generating extraordinary returns. Biotech, energy, startup firms and others that pour resources into product development and R&D would be classified as speculative companies.
Note that a speculative company need not, in and of itself, constitute a speculative investment for investors—although their stock prices may be volatile.
- A speculative company invests a bulk of its resources into higher-risk growth projects.
- 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
Speculative companies take on risk by putting a large portion of its assets into projects with uncertain returns and a probability of failure. However, should a project succeed, the returns can be substantial.
Investing in a speculative company, on the other hand, isn't necessarily high-risk, especially if that company has established a credible, successful, business model. As such, the stock of speculative companies like Exxon Mobil or Royal Dutch Shell aren't classified as speculative since their expected return can be estimated with a reasonable degree of confidence.
Energy exploration companies are prime examples of a speculative company, since they are continuously committing a big chunks of their assets to exploration projects that more often than not end in failure. However, should one of these ventures succeed in the form of discovering a new source of oil or natural gas, the investment has paid off.
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. The stock of General Electric (GE) has plummeted due to a fraud settlement and changes in its business so that today it may be considered a fallen angel.
Investing in Speculative Companies
Deciding to invest in a speculative company is difficult because the traditional valuations metrics like the price-earnings (P/E) and price-sales (P/S) ratios can't 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.