In the 18th century, pioneering economist Adam Smith said that the public tends to overvalue when he called “speculative ventures”. That still makes excellent investing advice today. When a company is losing money, it has a great deal of freedom to speculate on its future. With a little imagination, it can always show that anything’s possible, based on a logical series of events that it says will take place as it advances inevitably toward profitability. Meanwhile, it doesn’t need to worry that its price-to-earnings or p/e ratio is too high, since it doesn’t have one—it has no “e”. When a former money-loser finally starts making money, however, the handcuffs go on. Suddenly it has a p/e, probably one that is sky-high. Inevitably the killjoys (like us) then start calculating how fast it needs to grow to justify its current stock price, let alone go higher. Meanwhile, the company’s management has to look at dull, non-uplifting matters like production, costs and deliveries, rather than ramble on about how wonderful things will be in a few years. Then too, once a company becomes profitable, it faces a new risk: the unexpected earnings downturn. Of course, we do sometimes recommend stocks that have not yet begun making money, mainly in our advisory for more aggressive investing, Stock Pickers Digest. As long-time readers know, we have had some standout successes, including stocks taken over at a rich premium.
Trying to sell before the death spiral goes too far
Looking at things more generally, however, you need to recognize that the odds are against you when you invest in companies that are not yet making money. Some if not many of these companies will never make any money. When investors come to realize that a money-loser they own is unlikely to advance into the ranks of the profitable, they generally sell in a hurry. When that happens, the price of the abandoned stock can drop way faster than that of a money-maker that is simply having a bad quarter or two. The drop in the money-losing stock is also much more likely to be permanent. This drop in speculative stocks is always a bigger risk when the markets are volatile and investors are skittish. Their readiness to sell can set off a death spiral in speculative stocks that have been around for a few years but have failed to achieve profitability. Under those circumstances, it is probably best to sell disappointing speculative stocks before the spiral has gone too far. COMMENTS PLEASE—Share your investment experience and opinions with fellow TSINetwork.ca members Have you ever based any of your investment decisions on the opinions of an economist? Did that work out in your favour? What is the worst advice or prediction you have ever heard from an economist? This article was initially published on September 26, 2012
