It's OK to take a flutter sometimes
The small end of the sharemarket creates opportunities for investors and speculators alike, reports Barbara Drury.
It is the stuff of dreams. You buy shares in a tiny gem of a company that everyone else in the market has overlooked, you wait patiently for the market to recognise its true value and you sell it for 10 times the original price. You brag to your friends, book an overseas holiday and start a blog to share your investment insights.
The speculative end of the sharemarket is alive with prospectors hoping to strike it rich and occasionally they do. But more often than not the gem turns out to be a fake, or no longer fashionable, and the company disappears or goes into hibernation, along with your money.
‘‘People love penny dreadfuls but it’s a bit like going to the casino – there’s lots of glitter but they are generally loss-making,’’ says the portfolio manager at Macquarie’s Australian Microcap Fund, Neil Carter. ‘‘People focus on their winners and not their losers.’’
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Performance data to March 31, 2011. #Closed to new investment. Source: Morningstar.
But even the penny dreadfuls are not all dreadful.
Investors who want to live to invest another day need to learn how to spot the real gems and when to just cut and run. The Holy Grail of investing is to find the next 10-bagger, a stock worth 10 times its purchase price.
The term 10-bagger was popularised by Wall Street fund manager Peter Lynch in his book One Up on Wall Street. His message was that individuals can beat professional investors at their own game, provided you invest in things you understand and always quit while the going is good.
Too many speculators fall at the first hurdle, by diving in to penny dreadfuls exploring for minerals in Mongolia from the comfort of home in Sydney or Melbourne. Few have ever been near a mine, let alone Mongolia, or understand a drilling report.
Hindsight is a wonderful thing but it is difficult to pick a 10-bagger before it makes its run.
Even if you are a speculator rather than a long-term investor, you need to take a disciplined, portfolio approach to speculative stocks to improve your chances of success.
Experienced investors recommend not investing more than 5 per cent to 10 per cent of your capital in speculative stocks and you need to spread your risks across a range of companies.
‘‘Three or even 10 stocks is too small,’’ Carter says. ‘‘We have 60 or 70 stocks and our average position size [portfolio weighting] is 1.5 per cent. If you end up with more winners than losers then you will do pretty well.’’
Carter works on a batting average of six winners to every four losers.
Big fund managers, brokers and long-term investors concentrate their research efforts on the top-300 companies but with more than 2000 stocks listed on the ASX the next 10-bagger is almost certainly lurking somewhere among the 1700 dark horses where the risks, and potential rewards, are far greater.
MICROCHIP TO BLUE CHIP
Take the example of two stocks, one from the big end of town and one so small that no one has heard of it. BHP Billiton is selling for about $47, more than double its low of $20 in November 2008.
Now look at Chesser Resources, a junior exploration company drilling for gold in Turkey. It was trading at 6¢ in December 2008, reached a high of $1.28 last November and currently trades about 78¢ a share.
Depending when you bought and sold, Chesser could have been a 20-bagger or a bitter disappointment.
Chesser is just one of the many tiddlers riding the crest of the commodity price wave and a fine example of how winners can become losers in the blink of an eye.
‘‘The boom stops faster than it begins,’’ warns Grant Craighead, of independent resources newsletter Stock Resource. ‘‘You need to understand why you are investing, particularly if it is a mining exploration project with potentially high risks and rewards. You need to constantly assess the results and learn to cut and run if they are going against you.’’
AED Oil provides a cautionary tale. Carter bought shares for about 80¢ in 2006. They rose to $11.40 but started to falter after some disappointing production reports.
Carter bailed out at $7.50 – making it close to a 10-bagger – but the shares currently trade about 23¢.
The lack of scrutiny at the small end of the market means that share prices often run ahead, or behind,
true value. This creates opportunities for investors and speculators alike and it is important to understand which one you are.
Some people who call themselves investors are actually failed speculators.
Speculators are looking for a quick capital gain and are prepared to sell just as quickly if the price moves against them. Investors are on the lookout for the next JB Hi-Fi or Cochlear and are prepared to sit patiently and bank the dividends as it morphs from a microchip to a blue chip.
While junior explorers are the main topic of conversation among share traders in online chat rooms, not all 10-baggers are resource stocks. Emerging industrial stocks share some characteristics of speculative miners.
‘‘In periods of good economic conditions, they lead the way and grow the fastest,’’ says the business manager at listed investment company Contango, Boyd Peters. ‘‘They often move early in the cycle and can grow rapidly. Moderate increases in revenue can flow straight through to profit, which can move share prices quickly.’’
Investors who bought Cochlear shares for $2.80 soon after the company listed on the ASX in December 1995 waited less than five years to make 10 times their purchase price. Cochlear is currently trading at a record price of about $81.50.
One area where the professionals do have an edge over individual investors is with IPOs (initial public offerings) such as Cochlear.
‘‘Companies planning to list or make a share placement tend to have a broker and they come to us,’’ Peters says. ‘‘We visit a lot of companies and speak to management and their suppliers. You have to do the research yourself and that’s the opportunity.’’
DIVERSIFY THE RISK
Only a handful of fund managers cover so-called microcaps but they provide a glimpse of the returns on offer from a well-diversified portfolio.
All have outperformed the overall market over the past one, three and five years. The Macquarie fund returned 21 per cent a year in the three years to March, BT’s Wholesale MicroCap Opportunities 19 per cent and Contango’s MicroCap fund 17 per cent.
Contango also has a microcap fund that returned 34 per cent in the year to March 31 and 17 per cent a year over the past three years.
Peters says microcaps are not like the ASX top 100, where you can hold eight to 15 stocks and just keep banking the dividend. Microcap prices are also more volatile than the market leaders because they have fewer shares on issue in relatively few hands and tend to be traded less frequently. This means that bad news or a few sell orders can have a big impact.
‘‘You must diversify your risk,’’ Peters says. ‘‘The recent Japanese earthquake is a case in point. Uranium stocks such as Uranium SA and Berkeley Resources fell in the order of 50 per cent the following week.’’
Most microcap funds avoid the real penny dreadfuls by weeding out stocks with a market value of less than $10 million or $20 million. That still leaves about 1000 outside the top 300.
Just because you are targeting small speculative stocks does not mean you should throw out the rule book.
‘‘We look for businesses with a strong competitive advantage in an attractive industry with good growth prospects,’’ Carter says. ‘‘We look for strong cash flow, reliable dividends, which are a sign of quality, good management and good return on equity, which is a sign of a competitive advantage.’’
While the hunt for the next 10-bagger is all about big capital gains, many microcaps do pay dividends.
For example, the Macquarie fund has a forecast dividend yield of 4.3per cent, the same as the yield on the S&P/ASX20 index of top-20 stocks.
Investors who want to tap in to this rich vein of profits but don’t have the time or expertise to research and monitor stocks might start with a microcap fund or LIC and add direct stocks as you build up your confidence and expertise.
Avoid the dogs
The resources sector has been the standout performer on the local sharemarket in recent years, thanks to booming commodity prices, and the mining and exploration minnows are hoping to hit pay dirt before the music stops.
‘‘At the moment it’s fashionable to look for coal in Mongolia and specialty metals, such as rare earth, tungsten and antimony,’’ the co-founder of independent mining research group Stock Resource, Grant Craighead, says.
Last year, the European Union identified a dozen elements at risk because of increased demand from new technologies and limited supply.
Silver is also running hot and is currently in the grip of speculators after more than doubling in price during the past 12months, outpacing the price of gold.
Yet Craighead says it is rare to find a stand-alone silver prospect — it is more often found alongside lead, zinc and other metals.
One of the most useful things speculators can do is to eliminate the duds, a skill that comes with experience.
‘‘Good speculative stocks have a long shot of finding something meaningful but you do see a lot of dogs,’’ Craighead says.
He says investors should aim to minimise unnecessary risks. He suggests looking for:
A high level of professional expertise, with experienced technical experts and proven entrepreneurs on board.
A management team with a track record of success.
Exploration permits in a region with good prospects for the minerals or metals you are targeting.
‘‘Some companies are elephant hunters — they try to reduce risk by bringing in a major joint-venture partner at the expensive stage,’’ Craighead says.
Companies exploring in Third World countries or political hot spots involve sovereign risk. For example, China recently withheld supply of rare earth metals to Japan and prices went through the roof. Australia has low sovereign risk but it has a relatively mature mining industry and prospective exploration areas have been picked over, which is why the smart money is exploring in West Africa and Mongolia.
The other risk is commodity risk, or the risk that the price of the commodity you have targeted will turn against you.
It is the stuff of dreams. You buy shares in a tiny gem of a company that everyone else in the market has overlooked, you wait patiently for the market to recognise its true value and you sell it for 10 times the original price. You brag to your friends, book an overseas holiday and start a blog to share your investment insights.
The speculative end of the sharemarket is alive with prospectors hoping to strike it rich and occasionally they do. But more often than not the gem turns out to be a fake, or no longer fashionable, and the company disappears or goes into hibernation, along with your money.
‘‘People love penny dreadfuls but it’s a bit like going to the casino – there’s lots of glitter but they are generally loss-making,’’ says the portfolio manager at Macquarie’s Australian Microcap Fund, Neil Carter. ‘‘People focus on their winners and not their losers.’’
Advertisement: Story continues below
Performance data to March 31, 2011. #Closed to new investment. Source: Morningstar.
But even the penny dreadfuls are not all dreadful.
Investors who want to live to invest another day need to learn how to spot the real gems and when to just cut and run. The Holy Grail of investing is to find the next 10-bagger, a stock worth 10 times its purchase price.
The term 10-bagger was popularised by Wall Street fund manager Peter Lynch in his book One Up on Wall Street. His message was that individuals can beat professional investors at their own game, provided you invest in things you understand and always quit while the going is good.
Too many speculators fall at the first hurdle, by diving in to penny dreadfuls exploring for minerals in Mongolia from the comfort of home in Sydney or Melbourne. Few have ever been near a mine, let alone Mongolia, or understand a drilling report.
Hindsight is a wonderful thing but it is difficult to pick a 10-bagger before it makes its run.
Even if you are a speculator rather than a long-term investor, you need to take a disciplined, portfolio approach to speculative stocks to improve your chances of success.
Experienced investors recommend not investing more than 5 per cent to 10 per cent of your capital in speculative stocks and you need to spread your risks across a range of companies.
‘‘Three or even 10 stocks is too small,’’ Carter says. ‘‘We have 60 or 70 stocks and our average position size [portfolio weighting] is 1.5 per cent. If you end up with more winners than losers then you will do pretty well.’’
Carter works on a batting average of six winners to every four losers.
Big fund managers, brokers and long-term investors concentrate their research efforts on the top-300 companies but with more than 2000 stocks listed on the ASX the next 10-bagger is almost certainly lurking somewhere among the 1700 dark horses where the risks, and potential rewards, are far greater.
MICROCHIP TO BLUE CHIP
Take the example of two stocks, one from the big end of town and one so small that no one has heard of it. BHP Billiton is selling for about $47, more than double its low of $20 in November 2008.
Now look at Chesser Resources, a junior exploration company drilling for gold in Turkey. It was trading at 6¢ in December 2008, reached a high of $1.28 last November and currently trades about 78¢ a share.
Depending when you bought and sold, Chesser could have been a 20-bagger or a bitter disappointment.
Chesser is just one of the many tiddlers riding the crest of the commodity price wave and a fine example of how winners can become losers in the blink of an eye.
‘‘The boom stops faster than it begins,’’ warns Grant Craighead, of independent resources newsletter Stock Resource. ‘‘You need to understand why you are investing, particularly if it is a mining exploration project with potentially high risks and rewards. You need to constantly assess the results and learn to cut and run if they are going against you.’’
AED Oil provides a cautionary tale. Carter bought shares for about 80¢ in 2006. They rose to $11.40 but started to falter after some disappointing production reports.
Carter bailed out at $7.50 – making it close to a 10-bagger – but the shares currently trade about 23¢.
The lack of scrutiny at the small end of the market means that share prices often run ahead, or behind,
true value. This creates opportunities for investors and speculators alike and it is important to understand which one you are.
Some people who call themselves investors are actually failed speculators.
Speculators are looking for a quick capital gain and are prepared to sell just as quickly if the price moves against them. Investors are on the lookout for the next JB Hi-Fi or Cochlear and are prepared to sit patiently and bank the dividends as it morphs from a microchip to a blue chip.
While junior explorers are the main topic of conversation among share traders in online chat rooms, not all 10-baggers are resource stocks. Emerging industrial stocks share some characteristics of speculative miners.
‘‘In periods of good economic conditions, they lead the way and grow the fastest,’’ says the business manager at listed investment company Contango, Boyd Peters. ‘‘They often move early in the cycle and can grow rapidly. Moderate increases in revenue can flow straight through to profit, which can move share prices quickly.’’
Investors who bought Cochlear shares for $2.80 soon after the company listed on the ASX in December 1995 waited less than five years to make 10 times their purchase price. Cochlear is currently trading at a record price of about $81.50.
One area where the professionals do have an edge over individual investors is with IPOs (initial public offerings) such as Cochlear.
‘‘Companies planning to list or make a share placement tend to have a broker and they come to us,’’ Peters says. ‘‘We visit a lot of companies and speak to management and their suppliers. You have to do the research yourself and that’s the opportunity.’’
DIVERSIFY THE RISK
Only a handful of fund managers cover so-called microcaps but they provide a glimpse of the returns on offer from a well-diversified portfolio.
All have outperformed the overall market over the past one, three and five years. The Macquarie fund returned 21 per cent a year in the three years to March, BT’s Wholesale MicroCap Opportunities 19 per cent and Contango’s MicroCap fund 17 per cent.
Contango also has a microcap fund that returned 34 per cent in the year to March 31 and 17 per cent a year over the past three years.
Peters says microcaps are not like the ASX top 100, where you can hold eight to 15 stocks and just keep banking the dividend. Microcap prices are also more volatile than the market leaders because they have fewer shares on issue in relatively few hands and tend to be traded less frequently. This means that bad news or a few sell orders can have a big impact.
‘‘You must diversify your risk,’’ Peters says. ‘‘The recent Japanese earthquake is a case in point. Uranium stocks such as Uranium SA and Berkeley Resources fell in the order of 50 per cent the following week.’’
Most microcap funds avoid the real penny dreadfuls by weeding out stocks with a market value of less than $10 million or $20 million. That still leaves about 1000 outside the top 300.
Just because you are targeting small speculative stocks does not mean you should throw out the rule book.
‘‘We look for businesses with a strong competitive advantage in an attractive industry with good growth prospects,’’ Carter says. ‘‘We look for strong cash flow, reliable dividends, which are a sign of quality, good management and good return on equity, which is a sign of a competitive advantage.’’
While the hunt for the next 10-bagger is all about big capital gains, many microcaps do pay dividends.
For example, the Macquarie fund has a forecast dividend yield of 4.3per cent, the same as the yield on the S&P/ASX20 index of top-20 stocks.
Investors who want to tap in to this rich vein of profits but don’t have the time or expertise to research and monitor stocks might start with a microcap fund or LIC and add direct stocks as you build up your confidence and expertise.
Avoid the dogs
The resources sector has been the standout performer on the local sharemarket in recent years, thanks to booming commodity prices, and the mining and exploration minnows are hoping to hit pay dirt before the music stops.
‘‘At the moment it’s fashionable to look for coal in Mongolia and specialty metals, such as rare earth, tungsten and antimony,’’ the co-founder of independent mining research group Stock Resource, Grant Craighead, says.
Last year, the European Union identified a dozen elements at risk because of increased demand from new technologies and limited supply.
Silver is also running hot and is currently in the grip of speculators after more than doubling in price during the past 12months, outpacing the price of gold.
Yet Craighead says it is rare to find a stand-alone silver prospect — it is more often found alongside lead, zinc and other metals.
One of the most useful things speculators can do is to eliminate the duds, a skill that comes with experience.
‘‘Good speculative stocks have a long shot of finding something meaningful but you do see a lot of dogs,’’ Craighead says.
He says investors should aim to minimise unnecessary risks. He suggests looking for:
A high level of professional expertise, with experienced technical experts and proven entrepreneurs on board.
A management team with a track record of success.
Exploration permits in a region with good prospects for the minerals or metals you are targeting.
‘‘Some companies are elephant hunters — they try to reduce risk by bringing in a major joint-venture partner at the expensive stage,’’ Craighead says.
Companies exploring in Third World countries or political hot spots involve sovereign risk. For example, China recently withheld supply of rare earth metals to Japan and prices went through the roof. Australia has low sovereign risk but it has a relatively mature mining industry and prospective exploration areas have been picked over, which is why the smart money is exploring in West Africa and Mongolia.
The other risk is commodity risk, or the risk that the price of the commodity you have targeted will turn against you.
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