Risks And Returns – Getting An Optimum Match
PEG Corporate Finance and Research View:
In the first part of this article – you can read Part 1 here, we mention how most traders lose big money as they chase blindly on “aggressive” stocks without having an edge over others or an effective trading system to do it. In other words, instead of buying low and selling high, they frequently buy high and sell low and repeat the cycle again and again.
This is especially true in the case of penny stocks where fundamentals are usually over-exaggerated and valuations over-priced.
Yet, a simple look at analysts consensus calls (stocks which are tracked by financial analysts and where these analysts give recommendations and fair value targets the stocks they cover) show that there are at least 70 penny stocks which may have some fundamental backings and are tracked by financial analysts.
In fact, we found over 30 stocks priced below 30 sen that are covered by analysts and could present as candidates for selection in a reasonably safe penny stock holdings by conservative to moderate investors without resorting to blindly chasing speculative stocks.
And out of these 30 stocks (or 70 stocks as one wish to be), there are at least 30-over stocks which are favored by analysts with buy calls and substantial upside to their target price recommendation (see table below).
For conservative or moderate traders or investors, these stocks would probably give them a safer risk-reward profile for the construction of a penny stocks portfolio rather that relying on second or third-graded stocks in the market.
Granted these stocks may potentially move slower than “speculative” penny stocks, they still likely will offer reasonable very attractive upside (even just basing on their fundamental valuation by analysts) with some rated as having upsides of more than 50%.
In any case, conservative or moderate investors can still rely on the fact that a rising tide will all boats. This is akin to market players eventually gravitate back to stocks that have not moved in a rising market at some point in the bull market.
With the right tool and knowledge above, we can already create a portfolio of penny stocks that are sound in fundamentals yet offer us substantial upside in the long run which could outperform most mutual fund holdings.
Most retail or even accredited high net worth investors tend to be overly narrow in their portfolio construction as they are not able to find the right universe of stocks to choose from for an “efficient” portfolio. As such, they tend to forsake the benefits of diversification and chase only one or two penny stocks with their funds.
As we all know, the common wisdom is ‘don’t put all your eggs in one basket’. The logic is that an investor who puts all of their funds into one investment risks everything on the performance of that individual investment. Which is akin to chasing a penny stock with all your funds.
A wiser policy would be to spread the funds over several investments (establish a peny stocks portfolio) so that the unexpected losses from one investment may be offset to some extent by the unexpected gains from another.
Thus the key motivation in establishing a portfolio is the reduction of risk. In Modern Portfolio Theory, the principle is that it possible to maintain returns (the good) while reducing risk (the bad).
A portfolio’s total risk consists of unsystematic and systematic risk. However, a well-diversified portfolio only suffers from systematic risk, as the unsystematic risk has been diversified away.
An investor who holds a well-diversified portfolio will only require a return for systematic risk. Thus their required return consists of the risk-free rate plus a systematic risk premium.
In the case of a penny stock portfolio, a well-constructed portfolio will give a better risk-return profile than just chasing one or two speculative penny stocks. Even if you tend to believe in the rumours or tips contributing to their risk, the nature is such that their market risk cannot be eliminated in such that a market (weakness) reversal may still prevent these stocks from being played up.
– Unsystematic/Specific risk: refers to the impact on a company’s cash flows of largely random events like industrial relations problems, equipment failure, R&D achievements, changes in the senior management team etc. In a portfolio, such random factors tend to cancel as the number of investments in the portfolio increase.
– Systematic/Market risk: general economic factors are those macroeconomic factors that affect the cash flows of all companies in the stock market in a consistent manner, e.g. a country’s rate of economic growth, corporate tax rates, unemployment levels, and interest rates. Since these factors cause returns to move in the same direction they cannot cancel out. Therefore, systematic/market risk remains present in all portfolios.
In conclusion, we believe that elite investors and traders will benefit better in the long run by having a sound penny stock portfolio which will give them a more balanced risk-reward return.
Such a simple construction of just using analysts’ calls and ratings would easily give a more fundamental approach to benefiting from a penny stock portfolio in the market.
But like in any portfolio construction of stocks in the market, such a strategic approach could be accentuated multi-folds in its benefits by marrying in the tactical approach of timing the entry and exit of penny stocks in the portfolio to give a better optimum return.
Such a tactical approach requires more works in tracking and monitoring but this work could be done easily through automation using algorithms. If you can benefit from both selection and timing, why tie up your hands and returns by just using one approach?
Obviously, the market consists of all types of risk profile investors and a conservative/moderate approach above may not be the “cup of tea” for more aggressive investors.
How can one be aggressive for returns and yet still limit their trading risk as much as possible? For aggressive investors who tend to be more interested in volatile and speculative stocks, selection and timing is thus more critical than normal.
Obviously, the key is manageable risks as higher returns beget higher risks.
In Part 3 and Part 4, we look at how algorithms could help to select a penny stock portfolio where the “action” and “speculation” are and yet be able to keep the portfolio to a manageable risk for aggressive investors and elite traders.
In fact, depending on the risk and reward ratio, an elite trader should not just anticipate the action but always go where the action is.
This is the most rewarding part of being an elite trader but you must have your own trading edge and knowledge to do it to manage the risk-reward outcome effectively.
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