Know These Boom or Bust Scenarios
Depending on risk tolerance, it could make sense for an investor to own some speculative stocks, which are high-risk stocks that have a wide range of potential outcomes.
As a reminder, “risk” does not mean “loss.” The term simply means high variability. For example, this means that the stock could realistically give you, say, anywhere from a 50-fold gain or close to a 100% loss.
This week we take a look at events that can cause those big swings. This is not meant to be an exhaustive list, but they are common catalysts that can make a huge difference in a small company’s fortunes.
First, let’s discuss a few factors that could make the good kind of risk pay off.
R&D Breakthrough: This is particularly applicable to companies whose potential lie in the product(s) that it’s researching and developing. It could be a new life-changing drug, a new type of cheaper and more efficient battery technology, or anything that makes a significant improvement to the status quo. The market opportunity of a significant new product, specifically, potential sales and profits, is what attracts investors.
Here’s where the size of a small company sets it up for bigger potential gains (in percentage terms). When an already huge company with $10 billion annual revenue brings a $1 billion new product to market, it’s only a 10% revenue increase, but if a company with $10 million annual revenue brings a $50 million product to market, that’s a five-fold increase! You can see why risk-tolerant investors seeking big gains would invest in small companies.
Positive Legislative Change: Regardless of what industry a company occupies, it has to follow local laws. One recent example of a favorable law passing was the Inflation Reduction Act of 2022, which earmarked hundreds of billions of dollars to encourage clean-energy spending. This lit a fire under the stocks of many companies engaged in green energy.
Here’s another example that’s more forward looking: If momentum gathers in Congress to finally push through a bill to legalize marijuana federally, it would spark a big pot stock rally.
Partnership or Acquisition: For a young company, the end game doesn’t have to be bringing a breakthrough product to market. In fact, it’s typically very expensive to develop a new product or new drug from start to finish. Small companies often have to seek partnerships with bigger companies to exchange future stakes in return for cash funding.
Sometimes, if the product in development is impressive enough, a larger company can swoop in and sweep the small company off its feet with a huge offer to buy it out entirely. Often, just the knowledge that the small company is discussing a partnership or buyout with another company is enough to get the stock to rally.
Make or Break: When a company is small and doesn’t have a diversified portfolio of products or potential products, one failure could destroy the value of the company. That’s the downside to having just one or two eggs in the basket. How one outcome can drastically change a company’s trajectory explains why speculative stocks can have such wild swings in short amounts of time.
Running Out of Cash: When investing in small companies, it’s important to closely track the company’s cash position because typically it won’t have much cash on hand, particularly those companies that aren’t generating sales yet. Nevertheless, companies need to spend cash to conduct R&D and keep the lights on.
When a company runs low on cash, it has to raise capital somehow. If a company can’t find a deep-pocketed company to partner with, it will have to issue debt or equity. Additional shares dilute the value of existing shares.
High-interest debt places a heavy financial burden and debt covenants can limit what the company can do in the future. And if it’s desperate enough, it might have to enter into an unfavorable deal with another company, giving up lots of future value for some cash. These factors can drastically affect the estimated value of the company and thus its stock.
For better or worse, any of the above events can change the value of a speculative stock, likely drastically. The key is not to avoid them entirely, but to understand how much risk you can tolerate, and then invest accordingly.
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