Speculation: a mug's game?

To some, the share market by its very nature is an exercise in speculation. But this is not true.

At one end of the scale are the followers of fundamentals and value investing, for whom Government bond-type yields are about as risky as they like to get.

At the other end of the scale are pure speculators, who invest where earnings are virtually non-existent and the speculative premium (measured in the price/earnings ratio) massive.

Most speculators are involved in momentum investing, where they buy a share because it is going up, and that drives it still higher. Momentum investing works until it no longer works. Momentum was one of the major fads of the past decade, fuelled by the hot performance of technology and dot-com shares.

The prices of these shares seemed to rise for no good reason, despite lack of earnings, or sometimes even the prospect of earnings. No historical valuation models could justify the prices achieved by many of these stocks. Very often, the booming momentum investment is in the throes of developing a high-tech product that few understand but which we are assured will change the world.

A feature of the dot-com boom was that analysts began to believe the traditional earnings/book value/cash flow method of valuing companies no longer applied. Internet companies could be valued on "eyeballs", because if you had the traffic, the profit would follow.

That was a disaster and simply reaffirmed that every time investors seek to move beyond traditional valuation techniques, they get burned.

As momentum investors see a rising trend, they all join in, driving prices even higher. It may seem like a winning strategy. But the risk of this strategy is that, while momentum investors can all pile in together, they cannot all escape (sell) at the same time unless markets are both highly liquid (large blocks can be sold quickly and at the same price) and continuous (prices do not gap sharply downward with no opportunity to sell).

Unfortunately, the typical momentum share is usually neither liquid nor stable, and because the share price is typically very low (10c to, say, 80c) the leverage that worked so well to make money also helps the gains disappear.

One of the most extraordinary momentum shares of recent years is Plus SMS.

The company joined the stock exchange in August 2000, raising $600,000. In May 2001 it acquired Retail Services Ltd, for $1.15 million. This didn't work out too well and, in March 2005, the company reported it had acquired all of the shares in Plus SMS, for a price of $12 million, satisfied by the issue of 240 million RetailX shares at 5c a share, and the name was changed to Plus SMS. Further shares were issued at 10c each.

Plus SMS describes its activities as "involved with routing SMS and MMS messages over existing telecommunications infrastructure, using the settlement processes that are in place for payment". There is no proven revenue from this company, no profit and certainly no cash flow.

To create Plus SMS, shares were issued at between 5c and 10c. But "investors" have subsequently decided that they know its true value, chasing the share price to 75c. Because there are so many shares in issue, the cheap sounding 75c actually values the company at over $200 million.

For that money, you could acquire the entire Provenco Group, (Eftpos provider with sales of $115 million) plus the whole of Renaissance Corporation ( Apple Computer distributor, with sales of $155 million) and have change over for a $40 million portfolio of coastal property.

The speculative premium on Plus SMS is virtually the entire $200 million value placed on the company. From what I can see, that value was established on the back of some press releases about securing the numbers used in text messages.

The speculator might argue that it is before a product or innovation is properly established that you should climb into the shares, reaping all the rewards of a fantastic growth rate thereafter.

The problem with this thinking is that you are taking on the role of venture capitalist, and the success rate among start-ups is very low. For start-ups based on innovation, the historic success rate is even lower.

I believe that the time to invest in a new business is when it has moved beyond venture capital, has established a clear market niche with competitive power in that niche, and with revenues and cash flow to prove it.

It is then becoming a growth stock.

Those who think it is too late to buy into a company that is already a recognised leader should consider the case of Microsoft. Sure you could have bought into Microsoft for $1 in 1987. But nobody could be sure it would emerge as the winner in a sector that was evolving in many directions, with several players emerging.

By the time Microsoft released Windows 95 in the middle of the 1990s, however, it became clear the software giant was unassailable. But had you waited for Windows 95, you could have bought Microsoft shares for around $6. Today they trade at $26, and that's after a sharp correction.

Those who were prepared to carry the start-up risk between $1 and $6 are welcome to their profit. But if they had 10 technology start-ups in their portfolio, they would have lost money on most of them.

If your personality veers towards speculation, at least do it in a disciplined way. This involves looking for signals beyond mere price momentum.

A combination of the following signals present your best bet at speculation gains: price momentum (the share is going up); plus profit momentum (the company has just reported a rise in its fortunes); plus insider buying (directors and staff are suddenly buying into their own company).