Rational Speculation Model: an Introduction

A Rational Speculation Model

What represents good speculative value? Is there such a thing? Is rational speculation possible? It certainly is, but not in the sense most people would expect.

Rational speculation involves the assessment of the probability of an imagined outcome based on available information, comparing that fundamental probability to the payout implied by the market's current valuation of that play should that imagined outcome become reality, and making a speculative investment if the payout would match or exceed the fundamental probability that the imagined outcome would become reality.

Rational Gambling: no such thing

Whether a play represents good, fair or poor speculative value depends on how the payout leverage based on a play's current market pricing compares to the fundamental odds that the expected payout will be achieved. That also happens to be the primary principle of gambling, which, because it is a zero sum game, is at best a wash in the long run unless the payout consistently exceeds the fundamental probability of delivering that payout. In gambling this condition exists only if the game is rigged, in other words, the player cheats, or the other players are consistently mistaken about the probability of outcomes, in other words, they are fools. All gambling forums defend themselves against cheating, and stupid participants get financially eliminated before their stupidity becomes a recognizable pattern open to systematic exploitation. A winning streak attributable to "luck" is not a factor because it is never sustainable in the long run. Because gambling systems are zero sum processes involving random outcome generators, "rational gambling" can never qualify as an investment strategy. In fact, because of the percentage collected by the operators of gambling systems, even a gambler with perfect knowledge of outcome probabilities cannot break even in the long run. Victimizing fools and cheating excluded, gambling cannot qualify as rational unless the entertainment value of the gambling activity exceeds the value of the lost capital.


Rational Speculation: it works because venture capital markets create new wealth

Speculative venture capital markets, however, where the potential outcome consists of the creation of new wealth, where human ingenuity and effort are key inputs in determining the outcome, and where by definition all bets are fluid in the sense that they can be made and taken back at any time, are not the same thing as gambling. Gambling is a process that rearranges ownership of existing wealth. Venture capital speculation also rearranges ownership of existing wealth, but it is also capable of creating new wealth through its role as a mechanism for matching risk capital with venture projects that have the greatest likelihood of creating new wealth. Provided the venture capital market is not undermined by fraud, corruption, and disclosure suppression policies, the pool of wealth whose ownership is under constant rearrangement also undergoes long run growth. There will always be winners and losers, but unlike gambling where the payout to the winners is completely at the expense of the losers, the payout to the winners in an efficient speculative venture capital market is on an aggregate basis greater than the losses suffered by the losers. (The winners include the recipients of the capital spent by the ventures.) For any capital deployment to qualify as an investment, there must be a reasonable probability that the value of the output will be greater than the value of the input. Because this is the case for legitimate venture capital, the rational speculation model, which is built on the similarities and differences between gambling "projects" and venture capital projects, qualifies as an investment strategy.

Economic value versus market value

Speculative value is very different from the traditional concepts of economic and market value. "Economic value" refers to the intrinsic worth of an asset. An asset is something tangible or intangible which has the ability to generate cash flow in exchange for delivering a good or service without transferring ownership of the asset in whole or in part. Economic value is thus a measure of the asset's ability to generate cash flow, not the "market value", which is what somebody is willing to pay for it. Theoretically the economic value of an asset and what somebody is willing to pay for it, the "market value", should be one and the same thing. But as we saw in the dot-com boom, the two can diverge wildly. Such divergence is possible because perception and expectations drive the market, and these may bear no relationship to reality in the form of cash flow potential either because perception is distorted by mistakes or expectations have become trapped in a greater fool spiral where the market is guided by perception of its own behaviour rather than fundamental reality. If this sounds to you like philosophy, you are right. The market cycles perpetually between a mode where reality operates as an extension of the imagination and a mode where the imagination shrinks to a time bound sliver trapped on the surface of an opaque, ubiquitous and immovable reality. This flip-flopping between unbridled "idealism" and inertia soaked "realism" is what gives the "efficient market hypothesis" a bad name. Speculative value arises through the imperfect interplay between economic and market value.

A contemporary version of these extremes is the "new economy" dot-com mania of yesterday that envisioned the Internet rewriting "old economy" rules, and the dot-bomb gloom that sees the Internet sinking into an old economy morass. A fundamental principle that keeps the market alive is that in the long run the market value, namely what somebody is willing to pay for an asset, converges with the economic value that measures the asset's ability to generate cash flow. It is thus very meaningful to describe an asset as under, fairly, or over valued.

How can something that only potentially exists have value?

The same cannot be so obviously said about a speculative venture, which is a project that merely has the "potential" to become an asset. Whether or not the speculative venture becomes an asset, what the scale of the asset's cash flow ability will turn out to be, and when the asset shifts from "potential" to "actual" are all uncertain. Consequently, a speculative venture has no economic value. Classic examples of a speculative venture are mineral plays and biotech research projects. Such and such a grassroots property could very well host a world class diamond project, but the diamond deposit's existence is not yet demonstrated. Even when a kimberlite is found it must still go through a series of exploration steps that quantify its cash flow potential and eventually demonstrate its cash flow ability through production. Such and such a promising drug could be a cure for AIDS, but until it passes all the milestones in the approval process, it remains just a potential asset.

Gambling and venture capital speculation both bet on uncertain outcomes

Speculative markets resemble gambling forums in that they allow individuals to bet on an uncertain outcome. But there are also important differences. In the case of junior exploration companies the objective is to create new wealth by combining creativity and capital in an effort to discover or establish an orebody that can be turned into cash flow. When an exploration venture is a fundamental success, all the shareholders go home as winners. This never happens in gambling forums, which merely reshuffle the ownership of existing wealth. What also never happens in gambling forums is that the bettor can collect a payout before the outcome is known. To win anything a gambler has to be put at the mercy of fate. Either the horse wins the race or it doesn't. Either the winning cards come up or they don't. Betting stops when the dice are rolled or the race begins. To break even in the long run a gambler must understand the probabilities of a game's possible outcomes and bet accordingly. To win in the long run a gambler must cheat or play only against "handicapped" gamblers in a forum such as poker where the human factor is a partial contributor to the outcome.

Racetrack Gambling: a perfect analogy for the rational speculation model

Speculative ventures and horse races are very similar in that people bet on the outcome and get paid out according to the odds of success. The stock market, however, is different in that stock prices can go up before the outcome of the "race" is known. It allows investors to bet not just on the fundamental outcome, but on probabilities that actually change as exploration progress is made, or that are perceived by the market to have changed. Furthermore, speculators can collect their reward anytime by simply selling their stock. The stock market is a horse race where betting never stops until the race is finished. Stock market bettors can collect payouts in the middle of a race when a "horse" is merely leading. Furthermore, in speculative ventures all bets are to win, show and place. You can set your hopes on a billion dollar world class discovery, and still go home very happy when only a $200 million deposit is found. In horse racing a win bet means a horse has to finish first for you to get a payout. A place bet means a horse can come in first or second for the bettor to receive a payout. For a show bet the horse can finish first, second or third. The payouts for a horse are higher on a win bet than a show bet. Owning a speculative stock is like placing a single bet with three different payout possibilities.

An exploration venture has a fundamental track and a market track which are supposed to move in tandem. Often they do not, such as when a speculative bubble prices a stock as though the expected outcome had already been achieved, or when deep pessimism causes the market to ignore major milestones that significantly boost the venture's success potential. Rational speculation is all about understanding and monitoring the relationship between the two tracks. The interplay between the fundamental and market tracks makes possible speculation on speculation, which is what technical analysis ultimately is all about.

A racetrack gambling example involving Horse A and Horse B

Here is a good example that intuitively explains how rational speculation works. A "smart" racetrack gambler studies the race history of horses in a race lineup and assesses the fundamental odds of winning the race for each horse. Based on the gambler's analysis of the "fundamentals", Horse A is the favorite with 2:1 odds while Horse B is a longshot with 10:1 odds. Other gamblers have similarly done their homework, though their conclusions may be different. Handicappers have published what they think are the fundamental odds. As the gamblers place their bets, the pari-mutuel betting system posts the payouts that would happen for each horse if it should win. Because gambling is a zero-sum activity minus the racetrack percentage, the proposed payouts adjust according to how gamblers place their bets. Theoretically, the payout ratio (ie 10:1) for each horse is the same thing as the fundamental odds of winning the race. The riskier "longshot" horse pays higher if it wins than the lower risk "sure thing" horse. But the payouts that stand when betting closes and the race begins are created by the collective betting activity of gamblers who act both on their own assessment of the fundamental odds and the changing implied odds on the payout board. It is thus possible that Horse A, which our gambler gave 2:1 odds, will pay out 10:1 while the gambler's 10:1 longshot will pay only 2:1 if it wins the race. The collective wisdom of individual bettors has assigned a new set of odds for Horses A and B.

A venture capital speculation example involving Stock A and Stock B

The stock market operates in a manner similar to the pari-mutuel betting system. Let's substitute Stock A and Stock B for Horse A and Horse B. Stock A has a diamond prospect in an area with exceptional indicator mineral chemistry that suggests a world class kimberlite may be present. Stock B is a proximity play with no evidence of similar indicator minerals on its property. In fact, Stock A's exploration team ignored Stock B's ground when their regional sampling failed to turn up anything of note. Both stocks have the same number of shares fully diluted and the same net interest in their respective projects. Stock A trades at $2 reflecting investor expectations that the odds of finding a kimberlite that makes Stock A worth $6 are 2:1. Stock B trades at $0.55 reflecting investor expectations that the longer odds of a kimberlite discovery on Stock B's ground making Stock B worth $6 are 10:1. Both companies are set to drill geophysical targets that could be kimberlite pipes. At this stage the market track is pretty much in line with the fundamental track.

Holy mackeral, the longshot is soaring and the favorite is plummeting!

Who has bought Stock A and who has bought Stock B? Speculators buying Stock A prefer a more modest 200% profit potential in exchange for a lower failure risk, while Stock B buyers prefer the 1,000% profit potential of their longshot while accepting a much higher failure risk. (A fundamental principle is that a high reward comes with a high failure risk while a low failure risk delivers a low reward. A prudent investment strategy always sticks to this rule. Almost every successful fraud can be traced to the victim believing that high reward and low risk can co-exist in an investment opportunity. Because of market inefficiency this condition can exist, but, because it is so rare, nobody who discovers such a situation will ever share knowledge of it with a stranger.) In our example the risks and rewards are nicely balanced, but then a strange thing happens. Stock B starts to go up while Stock A declines even though the drills are not yet turning. There is no new information that a kimberlite in this region could be worth more or less than $6. But there are rumours on the street that a new government geological survey study is forcing a rethinking of the glacial history of the region where Stocks A and B have their diamond projects. Could it be that the exceptional indicator minerals on Stock A's ground actually originate from Stock B's ground? How does that affect their respective probability of finding a diamond pipe worth $6 per share? By the time the scheduled drilling date arrives, Stock A has sunk to $0.55 and Stock B has soared to $2, reversing the implied probabilities of a $6 payout for each project. Stock A is now the 10:1 longshot while Stock B is the favoured 2:1 bet, the same situation that prevails at the start of the race in our racetrack example.

Stock market bets can be changed without betting more money but not so with gambling bets

As betting closes and the race begins, which racetrack gamblers are happy and which are not? Unlike the stock market where speculators can change their bets by buying and selling stock, the racetrack gamblers can change their bets only by making more bets. Once a racetrack bet is made it cannot be withdrawn. For an individual gambler his personal outcome depends on the outcome of the game. For the individual speculator who owns free trading stock his outcome is determined continually by the stock's price and liquidity, and only additionally by the fundamental game of drilling the kimberlite targets. The racetrack gambler can modify his risk exposure only by placing more bets, but the speculator can modify his risk exposure by changing his bets, not just before the "race" but also during the "race".

How a fair value bet can turn into a good value bet

For the racetrack gambler his happiness at the start of the race depends on what fundamental odds the gambler assigned a horse, which bets he placed, and the degree that his assessment of the odds has changed as a result of watching the payouts change and picking up additional information during the betting window. It boils down to this simple formula. The guy who played it safe and bet on Horse A with 2:1 odds will be thrilled to see a win set to pay out 10:1, provided he remains convinced that Horse A's real odds remain 2:1. Perhaps the other gamblers are mistaken, picked up a false rumour that Horse A has been doped, or went just plain gaga about that new hot to trot Horse B which our gambler had dismissed as a 10:1 longshot. This guy's bet represents good value. Note that the assessment of "good value" is relative to the gambler's actual bets, his perception of the success probabilities, and the payout pricing established by the pari-mutuel betting system at the close of betting. His fair value bet has turned into a good value bet.

How a fair value bet can turn into a poor value bet

The gambler who bet on the 10:1 longshot only to see the payout plummet to 2:1, will be very unhappy, especially if he still thinks Horse B is a 10:1 longshot. His fair value bet has turned into a poor value bet. On the other hand, a gambler who had privately assessed Horse B as a 2:1 ringer even though the other handicappers had pegged it as 10:1, but then watched the payout plummet to 2:1 as word got out among the gambling crowd that Horse B was a ringer, ends up with a bet that represents fair value. This gambler watched his good value bet turn into a fair value bet. He is disappointed, but not unhappy. Gambling strategies all have a similar quest: to place a bet where the fundamental odds of losing are much lower than the reward paid out by a win. Do that consistently and in the long run you will theoretically be a net winner. In reality, because of operator leakage in zero sum gambling systems and because the racetrack gambler cannot know that he has scavenged all relevant information and properly evaluated their relationship to establish the success probabilities, the racetrack gambler will be a net loser.

For gamblers it ain't over until it's over

The racetrack is similar to the venture capital market because in both forums the gamblers and speculators are largely unable to influence the outcome of the race itself, but both forums offer a rich abundance of fundamental information whose interpretation by the gamblers and speculators has a tremendous effect on the percentage payouts associated with the actual outcome of the race or venture. The difference is that in the horse race the payout is made after the race is won, hence the saying, "it ain't over until it's over". But in the speculative stock market the payout is continuously available.

For speculators it can be over before it has begun

The speculator who bought the 10:1 longshot Stock B at $0.55 and does not believe the glacial history story can cash out at $2 for a 264% gain without having to wait for outcome of the drilling program. On the other hand the speculator who bought the 2:1 favorite Stock A at $2 is facing a 73% loss on paper. The fact that the loss is still only on paper is no consolation, even if this speculator does not buy the new glacial history story and remains convinced that the fundamental odds are still 2:1 that Stock A's drill program will deliver a diamond pipe worth $6 per share. The reason this is no consolation is the fact that had he waited and not placed his bet while Stock A was at $2, he could have bought nearly four times as much stock for the same amount of money. And if he agrees that the glacial history story has indeed reduced Stock A to a 10:1 longshot, then his unhappiness is even greater, for not only has he already lost money but he is stuck with a bet that represents poor speculative value. The speculator who bought Stock B at $0.55 because his private research gave him reason to mistrust the conventional interpretation of ice directions, with the result that he assigned the much more optimistic 2:1 odds to Stock B, is the happiest of the lot. At $2 his bet remains fair speculative value, and he has the option to take sufficient profits to reduce his financial loss risk on his original investment to zero.

The common denominator in rational speculation: the implied project value

Because of the uncertainty associated with speculative ventures and the rich variety of fundamental information available on the venture, there will be many different opinions about the outcome potential of a speculative venture. Not only will there be different opinions about the success odds, but there will be different opinions about the size potential of the prize. There will, however, be one figure common to all possible outcome scenarios, and that figure is the value assigned to the project by the market. The value implied for a project by the market is based on the stock price, the company's fully diluted capitalization, and the net interest the company has in the project. If a company has a market value of $100 million and a 50% interest in its project, that is the same thing as saying the project has an implied value of $200 million. It is much easier to evaluate speculative ventures if their market valuations are normalized to a 100% basis. No matter what outcome fantasy and success probabilities a speculator holds, they all share the same project value implied by the stock price times fully diluted capitalization divided by the net project interest.

A three step rational speculation model

Rational speculation starts with an analysis of what the potential outcome of a speculative venture might look like and what it would be worth if it became a reality. This analysis can be generated by applying personal knowledge and experience to raw data, or it can be gleaned as a consensus compilation of outcome analyses prepared by other "experts". Rational speculation then evaluates the probability of this potential outcome becoming reality in the context of where the project is in the development cycle and what fundamental evidence supporting the potential outcome is available. This analysis is done by investigating the particulars of a project and comparing them to experience. Finally, the speculative value is assessed by comparing the fundamental probability of the potential outcome with the payout implied by the project value assigned by the market. The first number is tricky to obtain, but the second number involves only looking up three published figures, plugging them into a simple equation, and dividing this implied project value into the ultimate project value imagined through the potential outcome analysis.

If the implied payout ratio is greater than the fundamental success probability, the stock represents good speculative value (for example, the stock will pay a high reward of 10:1 but the fundamental odds are a lower risk 2:1). When they match the stock represents fair speculative value (for example, the stock will pay a high reward of 10:1 and has an equally high risk 10:1 success probability). When the implied payout ratio is less than the fundamental success odds, the speculative value is poor (for example, the stock will pay out a low 2:1 reward, but the success probability is a high risk 10:1).