They say the odds of winning the jackpot on a pokie machine is about one in 10 million. So low are the odds that you are nearly seven times more likely to be hit by lightening, and yet roughly a third of adult Australians have played them over the past year.
Even a cursory glance at the facts will tell you that it's a mugs game; indeed given the tax revenue generated from these machines the pokie phenomenon has been called a tax on stupidity. But what has this got to do with investing?
Well it seems to me that there is a lot of similarity between gambling on a pokie machine and trading in speculative stocks; the only difference is that the odds are less well documented. Let's see if we can address this to some extent.
Enter the penny dreadfuls
Perhaps the best area to focus on for such an analysis is the Metals & Mining sub-sector of the Australian market: firstly because the majority of companies in this area are highly speculative in nature and secondly because they tend to capture the most attention from punters.
When I say speculative, I mean that they are businesses that are yet to have any demonstrated long term viability, which is most clearly identified by looking at profitability. The majority of listed companies on the Australian market belong to this sub-sector, about 652 companies or 31% of all listed companies. Of these, less than 1 in 4 made a net profit last year, and less than 5% pay any dividend, and those that do don't offer anything too inspiring. Furthermore, over three quarters trade with a Price to Earnings ratio (PE) well outside of any respectable range (defined here as between 5 and 30); in other words, they are trading at a price that has virtually no bearing on their demonstrated earnings capacity.
Why is it then that they seem so popular with traders? Well there are some remarkable success stories, such as Fortesque Metals which has seen a 1180% gain in just 5 short years. Moreover, they tend to be remarkably volatile, giving the potential for sudden and significant short term gains. In essence, people see them as a means to generate easy money.
Knowing the odds
But is there any justification for viewing these types of stocks so favourably? If you track the performance of these stocks over the past five years the first thing you notice is that most did not exist back in 2005. This is typical of this sector which sees a high degree of turnover, with new stocks listing and replacing others that delist (most often due to running out of capital). This alone should tell you something.
But if we focus on the 55% of Metals & Mining stocks that did exist five years ago, we can see that their record, for the most part, is far from inspiring. For starters, about 58% of these stocks have declined in value over that time, and the losses are far from insignificant: the average loss was 62%. Indeed, 20% saw a loss of more than 80%! The odds are looking long indeed.
Accentuate the positive
But what about the others? Of those 359 miners that were around five years ago, only 35% of them managed to beat the market average (as represented by the ASX 200 Accumulation Index), although admittedly the gains were very impressive.
If we focus only on those that did outperform the market, we see that the average gain was in fact 456%. Although this average is significantly skewed by the top few performers; stocks like Andean resources which have grown over 4000% in that time! The median figure is more telling, yet remains very attractive at 183%. So can you argue that the gamble is worth it when you see gains of this magnitude?
Think again
Let's say you randomly purchased 10 of these stocks five years ago, with $1,000 invested into each. Based on the numbers we've seen, about 45% would cease to exist five years later. Let's be favourable and round that down and say that four of your stocks became worthless. Of the remaining six, about half of these would lose an average of 63%, leaving just three of your stocks to make any gains.
Of all the Metals & Mining stocks that did grow in value over the last five years (including those that didn't beat the index), the average gain was about 400%. As we saw, this figure is skewed by the top few performers, such as Andean. Removing the top 3 performers brings the average back to 256%, and if we just use the median figure we get 149%. Let's be fair here and assume that your three gainers achieve growth of 200%.
If we add all of this up we see that our initial $10,000 has grown to just $10,110; representing a pathetic average annual return of 0.37%, compared with 7.4% for the broader market (again represented by the ASX 200 accumulation index). And we haven't even included brokerage costs which would typically erase all of these gains and more.
Maybe you think I have been unfair assuming that my outperformers have 'only' achieved growth of 200%, and that I should have used the 400% average? Had I done so the average annual return would have grown to 10%, which is a certainly better than the 7.4% market average over this period. But is a 10% annual return sufficient to justify a strategy focused on high risk speculative stocks? Probably not when this is essentially in line with the average market performance over the past 30 years, and I would bet that most with a speculative focus would certainly hope for far more than this.
Your own worst enemy
I acknowledge that examples such as these do little to dissuade most speculators, primarily because (like most gamblers) they believe they have a system to manage their losses. Yet even if you assume that you can avoid serious losses by employing 'stop-loss' strategies, the fact is these same strategies will knock you out of those other stocks that eventually outperform.
Of all of the stocks in the Metals & Mining sector that outperformed the index over the past five years, a substantial 74% experienced a loss at some point over this period. So while we can see with hindsight that some of the gains over this period were very attractive, the reality is that most traders would have cut and run as soon as their positions went into the red. After all, that's one of the mantras of trading; 'cut your losses short and let your winners run'.
Even had you managed to hold on to your stocks while they were trading at a loss in the early stages, the data tells us that a substantial 44% were trading at a loss after three years, so we aren't just talking about a little bit of initial volatility here.
Another factor that I've previously pointed out is that traders tend to lock in profit when they can, indeed selling is the only way to make money with these stocks because until you do any gain is purely on paper. In the case of Andean resources, how many people would have resisted the urge to sell when they saw a 50% gain? What about a 100% or even 500% gain? The temptation to lock in profits is usually so great that few people get to experience the full upside due to the greed of capturing short term gains, and the fear of avoiding losing them.
The example with Andean is again telling. Purchasing in September 2005 you would have paid about 17c per share. By April the following year, your shares would have grown to about 44c; a massive 158% gain in just 6 months. However, over the following 4 months shares dropped all the way back to 23c. How many traders would have resisted the urge to sell and lock in profits over this period? Certainly any stop loss order would have been well and truly triggered. I seriously doubt that anyone outside of the company would have experienced the full 4000% appreciation over the past five years.
The skills to pay the bills
There is of course the belief of some that they can reliably and consistently pick the winners in advance. My previous example was based on a random section of stocks, but surely if you were 'in the know' you could have tilted the odds in your favour, right? I doubt it.
For starters, it seems strange to me that none of the major financial institutions have any significant market exposure to these types of stocks. If picking winners in advance was so straightforward, wouldn't the financial giants have big teams of high paid analysts with sophisticated models dedicated to identifying these mega-gainers? They don't, because they know it's a mugs game and are more concerned with investing in quality businesses.
Of course the very nature of the market itself reveals a major difficulty. In essence shares are valued according to supply and demand, which are in turn determined by the consensus outlook for a given stock. The fact that Andean was trading at less than 20c per share back in 2005 should tell you a lot about what the consensus view was at the time. For the view to change, new information was needed (in this case the discovery of high quality mineral deposits), and as such in order to take full advantage of the price appreciation with any certainty, you are left having to accurately predict the future. Good luck with that.
There are countless examples of miners that have all the potential in the world and have every reason to think they are sitting on a gold mine (sometimes literally), but in most cases the belief turns out to be unjustified and expectations left unfulfilled. The trader of these stocks is essentially making a bet that expectations will be fulfilled, and indeed surpassed if truly spectacular gains are desired.
How are 'Blue-Chips' different?
By now we can see that, as with pokie machines, the odds are against you when it comes to investing in speculative mining stocks. But are things any different when it comes to the so called 'blue-ship' stocks; that is, large, established and proven enterprises with a good track record of profitability and dividend payments? And maybe if the odds are better, are the likely returns so poor as to hardly make them worth the effort?
It is tempting here to look at the ASX 20 (the 20 largest stocks) and look at the historical performance, but there is a problem with this. Due to the rise of new players and the decline of others, the 20 largest stocks change, so to retrospectively look at the top 20 today will be to unfairly bias the results in a very positive way. Indeed a quarter of the largest 20 in 2005 no longer make the list today (although admittedly two of these, Coles and St George, didn't drop out but were merged with Wesfarmers and Westpac respectively). Nevertheless, if we look only at the largest stocks of 2005 and track their subsequent performance the results are very impressive.
For starters the average total return for these stocks is 32%, above the market average, and truly amazing given this period encompasses the worst financial disaster since the Great Depression! Three of these stocks actually doubled in value (see below). Out of all these stocks, only three have declined in value over this period, the average loss being 32%. Contrast this with the average loss of the miners (those that were still in existence) which was 62%.
*Return values for CGJ and SGB are based on the issue of new shares (WES and WBC respectively) plus any cash payments received as part of the takeover deal. Performance was tracked between September 2005 and September 2010.
What is also very interesting is that these stocks, every one of them, pay a dividend. Indeed over just five years there has been an average total yield of almost 25%. That is, shareholders have received a quarter of their investment back in cash in just five years! Most also offered franking credits and as such allowed for very favourable tax treatment. Moreover, shareholders didn't have to do anything to get these cash returns and didn't incur any transactional costs. Money for jam.
Don't get me wrong, I'm not saying you should just invest in the top 20 stocks. Rather, your focus should be established businesses with proven and reliable cash flow and a policy of regular and rising dividends. They probably won't grow by 4000% in five years, but they will most likely provide you with an attractive return on your investment capital, without all this risk that is associated with their speculative cousins.
Not worth the gamble
Now that we have looked at the numbers we can make a number of conclusions:
- While speculative mining stocks offer the potential for great returns, chances are you will underperform the market.
- Those that don't underperform, usually experience a period of loss before they eventually come good.
- These stocks usually don't pay a dividend, so you get no benefit from holding these shares until you sell. And then only if you can sell for a higher price (which as we have seen is unlikely)
- 'Boring' blue chip stocks do far better on average, are far less likely to result in a loss over the long term, and offer reliable and attractive income returns. They are also considerably less volatile.
As with playing the pokies, there is absolutely nothing wrong with having some fun with money you are prepared to lose. You just don't want to fool yourself into thinking that buying unproven, volatile, high risk stocks is anything except pure speculation, or more plainly; gambling.
Besides, the fact is that large established, dividend paying stocks will nevertheless provide you with excellent long term returns and let you sleep much easier at night. Even the occasional underperformer such as Telstra will do little to dent the average overall performance of a well diversified portfolio.
Remember, it's not about always finding the best stocks (that's impossible in my view), it is about owning a variety of quality businesses that are likely to provide you with a very attractive average performance overall.
