Editor's note: Contrary to popular belief, speculating is different from gambling.
Yesterday, master speculator Doug Casey – founder and chairman of our Casey Research affiliate – discussed the difference between the two... and explained how to put the odds in your favor.
In today's Masters Series, we continue with the second part of this classic interview, in which Doug shares the eight-step method he uses for speculating profitably... and discusses a "very powerful" strategy that can give you huge upside in the stock market...
Doug Casey on Winning Speculations, Part II
Louis James: Let's have a quick look at the eight Ps, for those not familiar with them.
Doug Casey: The Ps are usable for all stocks, but are especially valuable for companies that don't have significant assets and have no history of earnings – probably not even any sales. Graham and Dodd's analysis simply doesn't apply to such companies. But that doesn't mean they can't be excellent speculations.
So, the first P is people. No matter how great the rest of the Ps might be, if you don't have confidence in the people, you can't have confidence in the rest of the story. There's no shortage of crooks, incompetents, and just plain stupid people in the resource sector we concentrate on, but that's equally true of real estate, tech, and any other business. Actually, it's possible to make money on crooks, incompetents, and even stupid people, but you have to get the timing right (buy in early and sell before the deal goes sour), and that's exceptionally risky – and remember, I like volatility but not risk.
In general, I stick with people that I know have the skills, determination, and track record of success it takes to beat the odds and deliver huge amounts of added value. If I don't know the people involved, I usually know someone who does. I also like to see management sharing the same risk and therefore having incentives aligned with shareholders – and I don't mean freebie stock options. I mean they put their own money into the deal and have a substantial stake in adding shareholder value.
If I'm not satisfied with the first P, it's usually not worth looking at the rest. There aren't enough hours in the day.
Louis: I've heard you say in several speeches that your biggest wins were an accident (Diamond Fields), a scam (Bre-X), and a psychotic break (Nevsun). How does that square with the above?
Doug: Well, I said you could make money on crooks, and we made something over 5,000% gains on Bre-X – but I didn't know it was a scam at the time. Nobody did. We got in early on a great story and sold when we had a huge win and it started sounding too good to be true – about when its market cap exceeded that of Freeport-McMoRan. That sell turned out to be slightly early, but that was much better than being late, because it went to zero.
Diamond Fields was a completely accidental discovery of the massive Voisey's Bay base-metal deposit in Labrador, when they were about to bail and concentrate on offshore diamonds in Namibia.
The psychotic break was on the part of a broker friend of mine in Chicago, now deceased, who personally drove the share price of Nevsun through the roof by sheer willpower.
These were all penny stocks that went well above $100 a share in the first two instances, and $20 in the third. Happy anomalies like these are part of why I have solipsistic tendencies.
But you can never know those things are coming; there's no speculation strategy for increasing your odds of having one of these in your portfolio, other than the general strategy of being in the resource sector, where it's actually possible to make 50 times your initial investment in a couple years. Resource stocks are, by far, the most volatile class of securities on the planet.
Louis: And backing the best in the business does improve your odds. Got it. What's next?
Doug: After people, the Ps don't really have a fixed order, but the next most crucial ones are property, paper, and phinancing.
Property is pretty obvious: Whether it's an oilfield, a mineral exploration project, a tech deal, or a real estate development, the project should be of genuine merit. That's why I ask you to go all around the world to check up on these things. Even with the best of people involved, we want to make our own judgments on the merits of the properties in question.
Paper refers to a company's share structure; you want to watch out, for instance, for large numbers of restricted shares that might come free trading soon; they can put a lot of selling pressure on a company if they're in the money, especially if their owners have warrants.
More on that in a minute. A relatively large number of shares selling at low prices is also usually a sign of a checkered past. But on the other hand, too tight a share structure can be problematic as well, because there's not enough trading volume to make it possible to buy or sell at good prices.
Phinancing (apologies to any language purists out there – the rest all start with P) refers to the cash on hand, compared to the cash needed to achieve the next milestones. When credit is tight and financing hard to come by, there's just no sense in buying shares in a company that's low on cash.
Even if they have great property being advanced by the best people, you know they are going to have to finance soon, which usually means you can get in at a cheaper price if you exercise a little patience (either because you can buy into the private placement or because the placement causes the share price to drop, as often happens).
And if they don't finance, they won't have the wherewithal to add value, so either way, I rarely buy companies that are low on cash, unless it's on the back of an attractive financing.
Louis: Roger that. And the rest of the Ps?
Doug: They are politics, promotion, push, and price.
Politics refers to the risk of political intervention (or "social" problems, which amount to the same thing) that can ruin a perfectly good project. Anything from trouble with indigenous populations, to local bans on your company's proposed activity, to raised taxes and royalties, to new regulations that ruin a project's economics – there's so much economically suicidal politics that can kill a deal, it could take years to list all the specific risks. But these things really have killed, are killing, and will kill projects, so you have to research local, regional, and national politics carefully and avoid speculations with clear political red flags. Or use them to your advantage when you think others are reading things wrong.
Promotion refers to a company's ability to get its story out to the market. I've lost money on good people working on great projects because they simply could not promote their work to a market that would have cared had it known about it. "Promotional" has negative connotations, but that's only justified when a company has nothing but promotion going for it. All sizzle and no bacon. If your pick really does have the bacon, it's essential that it be effective at getting the market to hear the sizzle.
Push is related to promotion, but is not the same thing. It's the specific set of milestones that you can reasonably expect to push share prices higher. This could be a value-accretive acquisition, important drill results from a mineral or oil/gas play, a feasibility study – basically any good news you have reason to believe lies ahead and should be good for the share price. A catalyzing event that makes the deal a "buy" right now, as opposed to at some unknown time in the future.
Price is not simply the share price, nor just a company's market capitalization (share price times number of shares issued and outstanding), but those things in relation to the price of the underlying commodity or asset a company was working on. In other words: Is the price of gold, oil, uranium, copper, nickel, lithium, or whatever – a hundred other commodities – going up or down? You've got to have a grip on the big picture of the world economy, as well as the technologies that are using, will be using, or may stop using these things.
Louis: These eight Ps have become my Eight Commandments, and they sure have worked for me. So, I think our astute readers can see how private placements fit into this, but can you spell that out for us in brief as well?
Doug: Sure. When a company needs cash, it usually either borrows it (bonds, debentures, and lines of credit) or issues more stock. There are other options, like selling royalties or doing JVs, of course. For going concerns, it's usually debt, but if a bank won't lend the company money, it's usually forced to dilute existing shareholders by issuing new paper. That's generally a bad sign in a company that has cash flow.
But in the junior exploration companies, both in oil and gas and in metals, there is almost never any significant revenue, so they are constantly back at the trough, raising more money – and that's a good thing, if they add value burning that cash.
Louis: As when a company spends $50 million exploring and developing a gold project that ends up with a $500 million NPV.
Doug: Speak to me. If it's a good company, meaning, solid on the eight Ps except for needing more cash, a financing via a private placement of new shares to existing and new shareholders can be a great opportunity.
Louis: A lot of people seem reluctant to go there. There are trading holds placed on the new shares, hassles getting brokers to cooperate, and qualification requirements. Can you tell us why all of this is worth the effort?
Doug: Leverage. Think about it, why would anyone buy new shares in a public company when they can just buy shares on the open market?
Because the company offers them incentives, usually in the form of selling the new shares at a significant discount to market, and/or offering a warrant – a kind of free option to buy more shares in the future at a set price.
The warrants, in particular, are very powerful. Listen, if you like a company enough to buy the shares anyway and you can do so at or under market and get a free warrant as well, it's a no-brainer. When the shares come free trading, which is only after four months in Canada, where most of our stocks trade, you can sell them and retain upside free of risk through the warrants, or you can hold them, in which case the warrants multiply your potential upside.
If a warrant is good, say, for two years, that gives the company a long time to add value, and you only exercise the warrant if you can sell the shares you'd get for more than what you'd pay for them. You either know you're going to win, or you don't spend another dime.
Louis: OK, but what about the hassles?
Doug: They exist, and they can be quite onerous. Many private placements offered by Canadian companies are not available to U.S. persons, and even when they are, you generally need to be a qualified investor, which, among other things, usually means having a net worth in excess of a million dollars.
But if you qualify, you're walking away from free money if you don't participate in private placements, and a good broker can help you handle the hassles.
Editor's note: Doug recently hosted a special training workshop in which he revealed the secrets behind his incredibly lucrative trading strategies. Best of all, it doesn't involve anything risky... you can do it from the comfort of your own home... and the training is 100% free. Learn more here.