3 main risks when investing in speculative shares

Credit: Rajiv Patel

Of the 2,000 plus companies listed on the ASX, roughly 1,500 of them aren’t making a profit.

Many of them, particularly smaller resources and energy explorers, and more than a few biotechnology companies are unlikely to ever make a profit. When it comes to explorers, some wags refer to them as miners of shareholders pockets rather than resources in the ground.

Speculative shares often refer to these companies, but can also refer to those that may have only just turned a profit. It can also refer to those companies that have found success in the past but now find themselves in the dumpster. Companies such as Pacific Brands Limited (ASX: PBG), Myer Holdings Ltd (ASX: MYR), Fairfax Media Limited (ASX: FXJ) and Slater & Gordon Limited (ASX: SGH) could also be referred to as speculative.

Mostly, investors are speculating that these companies can make good in future, but they usually come with a much higher risk of failure…

  1. In some cases, particularly with newer companies, investors are banking on unproven products and services – and that there’s a market for such a product or service, whether it’s an existing market, or the company has spotted a gap in existing products and services. 1-Page Ltd (ASX: 1PG), Reffind Ltd (ASX: RFN), Mobile Embrace Ltd (ASX: MBE) or Ziptel Ltd (ASX: ZIP) are all examples of speculative companies offering products in niche spaces. Those niche markets may go onto become much larger markets themselves, or existing peripheral players could expand their offerings, essentially merging markets and keeping out the disruptors.
  2. Investors expect the company to become profitable or, at least, cash flow positive at some stage – you want a return on your investment – either from dividends or capital gains in the share price. In many cases, investors are jumping in at an early stage because a large portion of the capital gains can come in the early life of a company. As shares go from 10 cents to $1.00, investors make 10x their initial capital, but the company may find it much harder and take longer to get from $1.00 to $10.00.
    Part of that growing share price is the understanding that the company is or will become profitable. For many speculative shares, reaching $1.00 from 10 cents is a pipe dream, never mind $10.00. Biotech company Pharmaxis Ltd (ASX: PXS) shares have traded as high as $4.31 and as low as 4 cents in the past decade as exhilaration has been replaced by failure in its clinical trials.
  3. Trusting management have the skills to make the company profitable, which can be a problem, even if the company has the most wonderful product. Now defunct satellite group Newsat Limited promised to be Australia’s first satellite company and aimed to launch at least two satellites into space. Unfortunately, management appear to have been the major contributors to the failure of the company’s strategy.

Foolish takeaway

Speculative companies might have products and services wanted by customers, but that doesn’t necessarily mean they will generate strong returns for investors. More than a few factors need to align for that to occur – and that’s why speculative companies are much higher risk than companies already profitable with a proven track record.

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Motley Fool writer/analyst Mike King doesn't own shares in any companies mentioned. You can follow Mike on Twitter @TMFKinga

Unless otherwise noted, the author does not have a position in any stocks mentioned by the author in the comments below. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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