Why are speculative stocks risky? Should you invest in one?

Summary

• A new entrant, or a company with incapable management or a rough patch ahead etc. is considered to be a speculative stock.
• The major difference between a speculative stock and not-so speculative stocks lies in the “predictability of their future earnings”.
• Due to the higher risk of owing these speculative stocks, big funds such as pension funds, hedge funds, or mutual funds try to steer clear from these stocks.

When it comes to investing in the stock market, there are various types of stocks investments that serve various purposes. Some companies have a very strong underlying business and have a predictable (to some extent) future visibility of their earnings. These types of stocks are generally preferred by astute investors, HNIs, or institutional investors.

On the other hand, there is a group of stocks which does not have strong fundamentals such as a robust balance sheet or consistent cashflows. Generally, these stocks are not recommended by popular business media channels or market experts, due to their questionable sustainability of the underlying business. 

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Investing in the stock market is speculative in itself, be it in a well-established company or a company with poor business. However, taking an extreme example, there is a difference between investing in a blue-chip company such as Google and Microsoft, and investing in a newly listed business or a penny stock. The major difference lies in the “predictability of their future earnings”. The companies with long history of surviving numerous business cycles, high-quality management, strong fundamentals, etc., are considered to be less speculative. On the other hand, investment in a new entrant, or a company with incapable management or a rough patch ahead are considered to be more speculative bets.  

Read More: What is a risk free investment?

Are speculative stocks risky and how to spot them?

More often than not, a speculative stock is easy to find as companies which are not doing well would disclose that in their regular result updates. Also, there are numerous other factors that could be looked upon to spot a speculative stock. Some of the factors are listed below.

1. Generally, a new company

Very often, a company that has just begun its operation and has been in the business for 3-4 years could be considered a speculative bet. The primary reason is there is not much of a history to analyse the potential of the company’s business model, capability of its management, its competitiveness, etc. Lack of historical performance data makes it harder to estimate the future earnings of a business.

Also, a new business hasn’t gone through all the business cycles, such as boon and recession in the economy (which takes at least a decade) to understand the true potential of it.

2. High volatility in the share price

Speculative shares generally tend to show a higher level of volatility and a relatively unstable than their larger peers. Volatility, simply, is the magnitude of price movement in a specified time in either direction.

This is due to the fact that every stock reflects the mass psychology of investors investing in it. Generally, small retail investors or short-term swing/intraday traders trade in these stocks, entering and exiting swiftly with the sole aim of booking quick gains, which makes these stocks move a lot. On the contrary, a large fund in a blue-chip can’t do this, hence the respective stocks are relatively less volatile.

3. Generally priced at a discount

Due to the higher risk of owing these speculative stocks, big funds such as pension funds, hedge funds, or mutual funds try to steer clear from these stocks. This affects the demand for these stocks, making them trade at a discount to the intrinsic value of the business. As a rule of thumb, lesser the optimism among investors regarding a business, higher would be the discount available in its share price.

To put growth stocks in perspective, almost always they trade at a premium because of the very high predictability of their increasing earnings in the future. The most recent example is the “work-from-home” stocks during the COVID-19 pandemic.

4. Poor financial performance

One of the best ways to quantitively measure a company’s performance is to look at its result updates. How the company is currently performing gives a lot of insights into what it might be capable of doing in the future. If the earnings trend downward, or if the revenue is going to the dogs, then the investment becomes risky.

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While analysing a result, an investor should also do a comparative analysis with respect to its peers to see if it’s only the company that is showing lackluster performance or is it a sectoral trend. In the latter case, the speculative or risky view could be broadened to the entire sector as well.  

5. Prone to market scams and frauds

Speculative stocks are also used to lure retail investors having greed to make a quick buck. The popular “pump and dump” frauds use these speculative stocks to rip investors off their money. This artificially inflate the prices of these stocks, which is relatively easy to do due to a less volume in these stocks.

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After seeing price surge for a few days, investors get in to join the rally and this is where these fraudsters dump their holdings for a profit, leaving investors with a messed-up position with falling share prices.

One thing is to be noted that all the factors mentioned above only serves as a guide in helping investors spot speculative stocks. These are not hard-and-fast rules. Also, any other factor that poses a threat or a risk for the company makes it more speculative. In a nutshell, higher the risk for a company or more questionable the sustainability of the business, more speculative it would be, and vice versa. 

Should you invest in speculative stocks?

Investing in speculative stocks is highly risky, which is compensated by the high reward as well (if the company takes off). In case the company makes a turnaround, maybe due to a changed management or infusion of more capital, etc., these stocks can skyrocket in a jiffy.

However, it’s not easy to separate the wheat from the chaff and rarely a company makes this shift and turns around. Most of the companies would not make a shift and also poses the risk of losing entire capital in cases such as bankruptcy.

So, investors have to ask themselves, are they willing to take the risk of losing multiple bets in order to make a potential windfall profit on a few. It’s very similar to a venture capitalist who invests in multiple start-ups and rarely a business becomes a unicorn, compensating for all the losses incurred with other start-ups.     

To sum it up, speculative stock space is the playing field for aggressive traders or high-risk appetite investors who are swift and nimble to go in and out of a position and have sufficient capital to keep them afloat in case of a losing streak. It is not recommended for conservative investors with small capital.  

Read More: Five penny stocks that turned multibaggers this year