3 warning signs with high-risk speculative investments

Here are three things you should look for with companies like Resapp Health Ltd (ASX:RAP) and Mustang Resources Ltd (ASX:MUS).

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Many investors have been stung by speculative companies like Resapp Health Ltd (ASX: RAP) and Mustang Resources Ltd (ASX: MUS) in recent times.

These companies, and many more, have experienced devastating share price falls after promised developments in their core 'opportunities' – I hesitate to use the word 'businesses' – failed to eventuate.

Here are three general-purpose warning signs that might help you steer clear of trouble in this area in the future:

  • Be aware that people have different investment goals + strategies to you

For example, short-term traders picking winning trades often use technical charts or momentum strategies, and these are among the most prolific posters on popular stock forums. If you are looking for investments that you can buy and hold for the long term, you need to know that others can have very different strategies to you, and the things that they buy may not be suited to your needs.

Tangential to this, be aware that many people post on forums anonymously, and may have a vested interest in pumping up the share price of certain companies (e.g. because they hold shares in it).

  • If they're not already doing it, don't invest in it

This is the most important rule. If a company has a wondrous product that is truly revolutionary and will change the world, it will still be changing the world in 20 years' time. Just look at Google, Amazon, Cochlear Limited (ASX: COH), CSL Limited (ASX: CSL), and more.

However, many small companies have no sales and are effectively trying to sell a dream, in the hope of raising enough cash to start building the dream. This is not a route to long-term investment success. Instead of normal business risks, investors are also taking on huge, unquantifiable, binary (i.e., only outcomes are success or failure) bets on the product development process.

Generally, the most common outcome is that shareholders overpay, the company's prospects are mediocre, and people get stuck holding shares that are down 75% while the company slowly goes broke and/or tries to start hyping interest in its shares to raise more cash.

Only buy shares in a company if it's already engaged in its activity on a reasonable scale, and has the revenues to show for it.

  • Be extraordinarily wary of hype

Many investors fail to grasp the impact of hype on share prices and their future investment returns. For example, many would balk at the idea of paying $288 per share for CSL Limited (currently $144/share) even though it is widely acknowledged as the highest quality company on the ASX.

It may stun you then to consider that some speculative companies are priced at up to 47x a rough estimate of their fair value.

For example, Getswift Ltd (ASX: GSW) has a fully diluted market capitalisation of around $470 million at today's share price.

It is priced at 470x its annualised sales, which were $0.25 million in the latest quarter. Tech companies are commonly thought expensive at around 10x sales, which is where accounting software company XERO FPO NZX (ASX: XRO) trades at present.

While Getswift is a lot smaller and expected to grow at a faster rate, on a comparable price multiple, Xero would be priced at $1,363 per share. I can tell you with absolute confidence that if you pay $1,363 per share for Xero today, you're on a railroad to nowhere.

While that is not an apples to apples comparison, it is a vivid example of the way that hype can distort reality, especially if there are no sales or profits to measure. If you keep this example in mind, you may be less likely to overpay for promising stories in the future, preserving your hard-earned cash and taking less risk in the process.

Motley Fool contributor Sean O'Neill owns shares of Xero. The Motley Fool Australia owns shares of Xero. 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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