The risk/reward profile is central to assessing any share
The difference between investing and gambling is that a disciplined investor focuses on shares where it is possible to estimate upside potential versus downside risk.
You can apply this approach to any size or type of company; be it growth, recovery or takeover situation. The art is to try and achieve a spread of holdings where the risk/reward profile on each, looks soundly in your favour.
At its crux is a sense for a share's intrinsic value relative to the market price which is at the mercy of swings in public sentiment. The emphasis between different measures of value can vary; for example a property or resources share tends to be more influenced by underlying asset value whereas a trading company is judged more in terms of its share's price-earnings ratio - a measure of the price paid for the share relative to the company's annual net profit. But ultimately, whether you consider assets or earnings power, investment value is defined as the total cash flow you receive from that asset: what it will ultimately fetch in the market plus dividend income along the way.
Much of the time, risk/reward profiles can appear vague, but be patient because this approach arms to take best advantage of what the market periodically offers.
Nearly a decade ago, the situation at Dana Petroleum strongly appealed, for me to go overweight in this share - most comfortably, because its risk/reward profile was so attractive. Its producing assets alone were estimated to be worth at least 200p a share, with exploration upside of at least a further 100p, and yet the market was so disillusioned over smaller oil and gas shares, Dana had drifted below 150p.
The company was generating cash enough to finance its exploration upside than engage a lot of bank debt. Such a business model has proven highly effective at delivering value over the years as oil prices have risen propelling Dana into the FTSE 250 index where, in mid-2010, it became a bid target, sold for 1,800p a share.
Likewise, Western Coal Corporation, a British Columbia-based supplier of metallurgical coal, which featured as an iBall share for 2010.
Its shares traded on a very low multiple of cash flow and earnings, the company well placed to serve Far East demand for coal in the steel-making process for urbanisation and consumer goods.
I bought around 100p; admittedly the price plunged near 10p by end-2008 with the financial crisis, but this is a very good illustration how market price can get massively out of line with long-term intrinsic value. Two years later, Walter Energy (WLT) of the US took advantage of the modest market rating to acquire Western at an equivalent of about 1,000p a share.
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