As an investor that is highly focused on fundamental research, I crunch through a lot of companies. The majority of companies that I analyze are rejected relatively quickly. The combination of a strong balance sheet, good financial returns, history of profitability and good long term growth prospects is difficult to find. The interesting thing about all this sifting is that you end up being exposed to lots of different companies and many different types of potential investments. When you look at the attributes previously listed (and more!), what you see is that I have a tendency to look for investments with limited downside. And by downside I don’t mean the likelihood that the stock price will drop, that happens to most companies eventually, but the likelihood that the company risks permanent impairment that will dramatically change its future earnings abilities. I like to think of it in terms of probabilities. I’m looking for companies that have a high probability of a high return. Mathematically you might say I’m looking for investments that have an 80% probability of 50-100% return. In this post, I’d like to explore something that I often find instead: low probability, high(er) return investments. Let’s call them LPHR’s.
How to get speculative or high returns from Stock Market
The theory here is a lot like venture capital investment. Not that I’ve actually ever made a venture capital investment, but bear with me. Venture capital firms expect to make many reasonably small investments in promising companies. Many of these, perhaps most of these, will prove to be big money losers. But the small minority of investments that do perform will earn many times the original investment. Consider the following case. A series of four equal investments which all have the same stats: an 80% chance of losing 30-100% of your original investment and a 20% chance of 500% return. The potential returns over time might look like this:
LPHR Potential Returns
| Investment 1 | Investment 2 | Investment 3 | Investment 4 | |
| Return –> | -100% | -70% | -30% | 500% |
In this case the total return is 50% despite the very poor performance of the majority of the investments. In theory, this should provide good investment results. I’ve been investing with this methodology for the past several years with a very small portion of my portfolio. Let me repeat, with a very small portion of my portfolio. You might want to consider using a normal portfolio position of say 3-5%, but spread it across 5 to 10 low probability bets (0.3 – 1% positions). Or alternatively, you could consider a totally separate account. However you do it, you should really be limiting your exposure to these types of investments because the odds are high that any individual investment will implode. For those considering investing with the LPHR method, here are some of the lessons from my own experience:
Probability Problems: Theory is a lot simpler than practice. Plopping some probabilities down on paper is really easy. Hey, the example above took me about one minute to make up. That doesn’t make them right. I may asses the investment as having a 20% probability of a successful outcome, but what happens when it’s actually a 5% probability? That can change the dynamics quite significantly. With LPHR there is just less room for error. By nature a lot of these investments have significant uncertainty about them so the margin of error is just higher. Hence there is a need for very small investments.
Long Periods of Boredom, Followed by Intense Terror: Most of my LPHR investments were event driven – this means that there is some type of catalyst that is driving the change. This could be a change in management, a restructuring, merger or general business turnaround. As a result, I spent most of the time waiting around for the event that would propel the investment higher.
Extreme Volatility: All of the investments that I made in the LPHR category ended up being some type of turnaround situation. These situations lead to extreme volatility as they are influenced significantly by short term events like earnings announcements. The higher the uncertainty in a given investment situation, the more the stock price will be pushed around by short term results. You must have the stomach for price swings to engage in this type of investing.
Focus on the Story: Partly as a result of the volatility, it is sometimes difficult to focus on the underlying story of the investment. You should always focus on the underlying investment story when you are tracking any kind of investment and not let short term market swings scare you out of your company. This is doubly true for LPHR investments because given their nature they are often even more uncertain than normal investments and you may have long periods of time where there are no significant changes in the story – but the stock price moves substantially. The stock price is usually only rises strongly only after the uncertainty has cleared up.
It Always Takes Too Long: This is really true for any investment. But I always find the investment takes longer to work through to the expected (or unexpected) outcome. It is important to allow enough time for your investment to play out. That said, if the story changes for the worse or new negative developments arise, don’t hesitate to get out.
How did it all work out? Well, so far, not that bad. Over the last several years, I have made 4-5 LPHR investments. The results turned out not too different from the normal trading that I am doing (except I have yet to get my 500% return!). Two of the positions I sold for significantly losses. Two I still hold; one has had ~150% return and the other a ~60% loss (but I’m still very optimistic that they will both be big winners). One pleasant surprise – these investments have not been correlated to the overall market. Which is good since the current market direction has been down…?
Feel free to tell me if you have had similar experience with this type of investment approach!
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