Speculative Trading: How to Avoid Big Losses

What is Speculation?

Stock speculation is an unfortunately common phenomenon in periods like today, i.e clean tech shares. Financial historians have suggested that societies stumble into periods where people simply suffer a case of collective financial amnesia. Humanity reliably forgoes the readily available and time-tested lessons of history. Due to a combination of greed and “FOMO”, many people suddenly begin chasing baubles of little to no financial merit.

To simplify: in our view, stock speculation is the act of buying an asset you do not fully understand based almost entirely on price performance.

Types of Speculative Investors:

As explained in our Market Cap vs. Revenue post, history indicates that paying over 20x price to sales is little more than the tacit admission that you are effectively putting on a speculative trade. Any premise of buying and holding has been tossed aside and the typical speculator expects a greater fool to take them out of the position at a higher price.

The human tendency to believe we can predict the future is an unfortunate one. We encourage readers to revisit what we learned from Chapter 7 of Seth Klarman’s Margin of Safety book, quickly revisit the pain of investing in bear markets, or read a quick summary of the Enron disaster. Keep history close!

Speculative Investments Come with DIRE Risks:

The chart below shows the return on stocks at 20x price to sales as the market crashed from the dot.com peak. You did not lose “some” money. You lost nearly 90% of your money. Price movements in stocks at these valuations can be violent and swift. . KCR would like to make the following observation about a 90% drawdown:

• One dollar turns into ten cents ($0.10)
• It is easy to forget that if your investment falls to 10 cents you now need a 900% return just to get to the break even point
• Short term trading in high volume stocks at high valuations = high risk and often disaster

The internet bubble took the United States past the historic valuation highs of 1929 that preceded the Great Depression. This newsletter has been tireless in advocating investors avoid mutual funds and other financial instruments whose share prices seem to rely entirely on technical analysis rather than fundamental merits.

The class of stock promoters endorsing “HODLers” and other acronym rich terms sweeping speculators today might be careful. As our QTFC on Galbraith’s book about market euphoria reminds us: stock promoters who held themselves out as geniuses became the target of great acrimony after each crash.

The table below compares the companies trading at 20x price to sales today with the crop of companies that were at 20x price to sales at the peak of the Dot.com bubble. Notice how similar the two groups are.

Today as in 2000 both groups traded at huge multiples of sales, had negative PE ratios, margins and ROAs. Investors are suffering from a -10% total yield and being diluted by share issuance.

Stock Market Speculation: The Ruinous Rhyme of History

Ask yourself the following: why is today any different this time than 2000?

In 1994 C-Span recorded a presentation by Fidelity legend Peter Lynch. He emphasized the need to understand the companies you own. He talks about how he has made lots of money in firms like Dunkin Donuts and Coca Cola.

A fierce advocate for common sense, Mr. Lynch’s point is to buy what you understand and not treat stocks like “lottery tickets” because you must understand the actual business behind the shares you buy. If you do not you are engaged in rank stock speculation of the worst kind.

Mr. Lynch contrasts the simplicity and common sense required to make money in the stock market with the type of companies a typical retail investor engaged in stock speculation tends to pursue:

The single most important thing to me in the stock market is to know what you own. I’m amazed at how many people own stocks they wouldn’t be able to tell you why they own it. … If you can’t explain to a 10 year old in two minutes or less why you own a stock you shouldn’t own it. ….

And this is the type of stock people like to own. This is the kind of company people adore owning. This is a relatively simple company. They make a very narrow, easy to understand product:

They make a 1 MB SRAM CMOS bipolar risk floating point data I/O array processor with an optimizing compiler a 16 dual port memory a double diffused metal oxide semiconductor monolithic logic chip with a plasma matrix vacuum fluorescent display that has a 16 bit dual memory that has a Unix operating system four whetstone megaflops polysilicone emitter a high bandwidth, that’s very important[LAUGHTER], six gigahertz double metallization communication protocol an asynchronous backward compatibility peripheral BUS architecture four way interleaf memory a token ring interchanging backplane and it does it in 15 nanoseconds of capability.

If you own a piece of crap like that you will never make money. Somebody will come along with more whetstones or less whetstones, a bigger megaflop or a smaller megaflop.

…

I made money in Dunkin Donuts. I could understand it. When there was recessions I didn’t have to worry about what was happening, I could go there and people were still there. I didn’t have to worry about Korean imports.

Mr. Lynch continues:

If you don’t understand it, it doesn’t work. This is the single biggest thing. It bothers me that people are very careful with their money.

The public when they buy a refrigerator they go to Consumer Reports, they buy a microwave oven they do that. … They do research. They go on a trip to Wyoming they get a Mobil travel guide. … People hear a tip on a bus on some stock and they’ll put half their life savings in it before sunset and they wonder why they lose money in the stock market. …

I’ll switch my thoughts to my long-shots. Avoid long-shots. I bought about 30 long shots in my life. I’ve never broken even on one of them.

History is clear: Buying stocks at 20x sales is the act of buying long-shots. Below is the compound return of investing in stocks over 20x price to sales vs. the broad market.

To the degree you believe the financial history that goes back many centuries will somehow be revoked this time we wish you luck.

Speculative Investments in a Single Table: Ben Graham Would Not Believe These Stock Existed

In the panel below we compare fundamentals of the stocks trading at 20x sales today to the top 25 ranked stocks in our Large Cap and Small & Midcap Model today. KCR’s research team is convinced that fundamentals will matter again as they always have.

How Stock Speculators are Different from Stock Investors In Two Simple Lists

Hopefully this post has helped some readers avoid the temptation of engaging in day trading by offering a very specific variant of the dire risks that arise when market sentiment rapidly shifts to bear trading as we believe it is about to. Investors engage in a process of rigorous research, preferably employing a margin of safety and purchase high quality assets at a discount to intrinsic value. Stock speculation involves the purchase of companies because they are going up agnostic of their fundamental merit.

We believe the lists provided below offer a lesson in high-contrast between speculative investments that we believe are ripe for disaster and actual stocks that are candidates for further investment research.

The list of stocks over 20x sales today runs into the hundreds. For the sake of simplicity we only list the firms that are burning cash and issuing stock to fund operations. Can you explain what these firms do to a 10 year old in two minutes?

Below that list of “value offenders” we published our top 25 ranked stocks in our Large Cap and Small & Mid Cap models. Aside from having features associated with quality these companies trade at reasonable valuations. In today’s environment these groups appear to be a lesson in contrast. Stock speculation vs. margin of safety long term investing.

Login or subscribe below to see the list of “value offenders” and top ranked Kailash stocks. If you are interested in learning how others explain and view stock speculation vs. investing globally, we suggest a review of Investopedia’s post, this work from the Journal of Finance or these articles from Business Insider, Morningstar, and Forbes to be excellent resources.