'Intelligent Speculation' Is a No-Brainer

 | Jun 26, 2012 | 4:00 PM EDT
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Coming from a value investor, the term "intelligent speculation" seems like a contradiction in terms. On the contrary, investors can make intelligent speculative bets provided they have a clear understanding of what they are engaging in.

Ben Graham, author of the investing classic The Intelligent Investor, said that if you are not investing, you are speculating. What's gets folks in trouble is that they think they are investing but in fact they are speculating. An investment operation is defined by three characteristics: diligent analysis, margin of safety and adequate return. Without those three conditions, you are making a speculative bet.

Given this definition, one can modify it and speculate intelligently. A speculation can still involve diligent research and analysis and what you give up in safety margin is made in return. So, instead of an "adequate" return, the potential return would be above average. Once this modified definition is understood, one can speculate intelligently. 

For example, Coca-Cola (KO) constitutes a sound investment. The company provides significant protection of principal and over the long term a very acceptable adequate return of perhaps 7% to 10% a year when you factor in the dividend. One can justify allocating a significant portion of a portfolio in KO.

On the other the hand, an investment in Polish spirits company Central European Distribution (CEDC) has a speculative component to it. But it would be an intriguing name to allocate say 1% to 2% of a portfolio. CEDC was once a market darling, trading above $30 a share. Today shares are trading for less than $3, or a market cap of $195 million for a once-billion dollar company. CEDC is highly indebted but one large shareholder continues to buy up the equity. CEDC the number one or two market share spot in most of the categories it serves. But with tons of debt and operations in Europe, it's not difficult to see why the shares are being dumped.

ATP Oil & Gas (ATPG) is another very intriguing speculative play. Shares are trading for nearly $3 after once trading as high as $60 a share. Again, the issue is debt and lots of it, but the company has some high-quality assets and reserves. It recently raised $35 million from an investor via an unsecured convertible note and warrants to buy common stock, a sign that the equity may end up doing fine.

The upside of these names is astronomical from various angles. An improvement in operations, sale of assets, or other strategic alternatives all lend themselves favorably to such speculative positions. You don't expect all of them to make money -- Sir John Templeton proved that several decades ago when he bought 100 shares of every stock on the NYSE trading for less than a dollar. He tripled his investment in four years, despite many positions going bankrupt. In this market environment, intelligent bets in speculative names could provide outsize gains.

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