Question: My friend recently tipped me to buy a rarely traded stock on rumors that it is entering into a big project soon. I hesitated to buy at first, but the stock jumped so fast that the share price increased sixfold from 5 cents to 28 cents in a few days. My broker told me that it may go up further next week. I feel tempted to buy some shares since the share price does not cost too much. Should I invest?—Rachel Jinayon by e-mail
A: While it is true that the stock may look cheap and affordable, it doesn’t mean that it is undervalued. You may be overpaying for the share price if you find out that the stock has hardly any business operation at all.
The reason why the stock is going up is that the expectation of new earnings stream that will result from the rumored project that the company is currently negotiating. When there is earnings flow, there is basis for valuation. The higher the earnings outlook, the higher the share price should be.
But since this is purely rumor for now, it is difficult to justify the value of the stock at the current share price. People buy the story hoping that other people will pay a higher price. The more people follow, the higher the demand for shares, hence the higher share price.
It may not be a good idea to invest on speculation unless you have other sources of information that will give you valid reason to believe that the stock has a sustainable potential upside.
While it is possible that you can still make money by chasing up the stock at this stage for trading purposes, there is a larger risk that you may lose big time once you make the wrong move of entering at a time when market traders who have pumped up the stock start to take profits.
Stocks like these are examples of small cap stocks. Small cap stocks are normally speculative in nature with low market capitalization of about P2 billion and below. Small caps create a lot of excitement because the lack of available shares in the market can cause wild price swings in a day that provides a great deal of trading opportunities.
Investing in small cap stocks is not the same as investing in large cap stocks. When you invest in large cap stocks, such as the blue chips, you can afford to be passive by simply keeping it for long-term capital appreciation and collecting dividends along the way. Unless the stock market takes a deep plunge, there is no need to worry too much on large price sell down because the blue chips are more stable and predictable as the economy grows.
On the other hand, when you invest in small caps, you will need to be more actively involved in trading. You need extra discipline and time to monitor the share price daily because you need to be on guard for any possibilities that may need your quick decision, whether to take profits or cut your losses anytime.
The challenge in small cap investing is to find stocks that can become the next blue chip. Small cap stocks that offer huge value potential by way of merger or acquisition by an established company are promising targets for investment. The stock market gets thrilled by this kind of stories every day, especially when a buying activity is happening. The valuation of the target price, while this is in process, largely depends on market perception rather than fundamentals.
Unlike large cap stocks which are mostly followed by institutional investors here and abroad, small cap stocks are followed by market traders and retail investors who are out to make quick profits. Small cap stocks can double or triple its share price in a matter of a few days. Trading small cap stocks definitely offer higher returns than large cap stocks, but not without higher risk.
While this can indeed be riskier, it doesn’t mean that you should never invest in small caps. If you have the appetite for higher risk and know how to manage it, you can try investing in small caps, particularly the low-priced stocks and take advantage of their volatility. Low-priced stocks exhibit higher volatility than high-priced stocks. The lower the price, the higher the potential returns.
One way to measure an expected return is through the use of the square root method. For example, a stock has a share price of P4.00. To project the expected return based on its volatility, simply get the square root, which is P2.00, and add a constant P1.00 to arrive at P3.00. From this price, square it back and you get an initial target price of P9.00. The return is a huge 125 percent.
You can apply this to manage your selling targets especially if there is no historical reference, such as technical resistance. Note that if you apply this method to higher priced shares such as the blue chips, you will get lower returns because volatility lessens as a share price increases.
The key to successful small cap investing is knowing how to manage your risks. Lower your risk by validating the story you hear from your broker or online forums through research. How likely is the deal going to push through? How will the new deal going to impact the current earnings of the company? How much investment is going into the company? Can you understand the new business model that the company is entering into? What is the track record of the current management in handling deals like this?
Always limit your exposure to this kind of stocks. Maybe you can start with a small allocation in your portfolio and try to balance this with blue chips as your core holdings.
Henry Ong is a registered financial planner of RFP Philippines. To learn more about financial planning, attend our FREE personal talk on Sept 18, 7 p.m. at PSE Ortigas. To register, e-mail info@rfp.ph or text <name><e-mail><RFPinfo> at 09173464126.