Why Certainty is a Dirty Word in the World of Penny Shares

Date 18/01/2010

The Right Side

Tom Bulford

Offer somebody the choice of £10 or a 50/50 chance of £25 and the majority will opt for the former. offer them £10 now or £25 in five years time, and again they are likely to go for the £10.

This should not be thought foolish. If we choose to put greater value on certainty in the here and now, who is to say that we are wrong?

But if you want to make serious money in the stock market you have got to overcome the natural inclination to overvalue certainty. In other words you should ignore the little voice in your head that tells you ‘a bird in the hand is worth two in the bush’.

Consider the two choices above. The value of a 50/50 chance of receiving £25 is £12.50 – more than the £10 that most would choose. In the second example, even if the £10 that we could receive now grew at a rate of 10% per annum, it would still be worth only £16 in five years time. This is well below the £25 that we could have accepted.

Investors in the penny share market should remember this. Why? Because the benefits of many penny share companies come in just these two forms. Companies either offer a high return but with a degree of risk attached, or else a high return that may be deferred for a few years.

I was reminded of this recently when reading two research notes. The first concerned Avanti Communications (ticker: AVN). This is a share that has already tripled since March 2008...

Why a tripling of value is only the start for this broadband innovator

Like most successful businesses, Avanti has a pretty simple proposition. Broadband communications are becoming ever more essential to modern life. Seventy million households and small businesses around Europe cannot get adequate broadband access because they are out of reach of terrestrial networks. So the best way to serve them is via satellite.

This summer Avanti will launch its first satellite, Hylas 1. Based on the price paid for bandwidth today, analysts at Equity Development reckon this will generate a profit of £6.3m in 2011. This should rise to £68m in 2013 as its capacity is filled.

But just before Christmas Avanti secured finance for a second satellite, Hylas 2. This one will have three times the capacity of Hylas 1 and will be able to reach the Middle East and Africa. This is scheduled for launch in April 2012. Equity Development forecasts that this will make a profit of £12.5m in that year, rising to £190m by 2015.

Put the two together and you have a business that could be making around £250m in five years time – and yet at today’s 500p share price it is valued on the stock market at just £500m.

Compare this with Severn Trent, another business making roughly £250m per year. It is valued at £2.5bn. Why the difference?

The difference exists because investors apply discounts. They apply one discount for the possibility that Avanti might fail to deliver its business plan. They apply a discount because they prefer the certainty of Severn Trent’s £250m today to the prospect of Avanti’s £250m in five years time.

But if you are a bold investor and place a proper value on £250m in five years time, you will choose Avanti. Equity Development reckons the shares are worth at least 830p today – but if it achieves that £250m in 2015, and then trades on a rating similar to that of Severn Trent, the shares will be 2500p.

A classic example of penny share potential

And now for a second example of a share that only needs to deliver on its business plan to deliver a massive return for shareholders.

This company has production rights over one of the largest unexploited coal fields in the world. Today it is valued at just four cents for every tonne of its proven coal reserves – far below the 64 cents per tonne average valuation of global coal producers.

Even if it were just to dig up this coal and sell it at the gate, the company’s valuation would look unreasonably low. But in fact it has much more ambitious plans – plans that not only make it a state-of the art energy project, but that also make it considerably more valuable than a mere coal mine.

A couple of weeks ago a financial analyst valued this company’s shares at about ten times the current price. Why the huge discount? Because the project is risky, and because the profits will not start to flow for a few years.

It is not, in other words, a bird in the hand. But it is not two in the bush either. It is about ten in the bush. It could make huge returns for shareholders. To learn more about it, read the January issue of Red Hot Penny Shares. Find out how to sign up below.

Good investing,

Tom Bulford
For The Right Side

P.S. If you’re not yet subscribed to my monthly investment advisory, Red Hot Penny Shares, I urge you to give it a try. In it I provide more in-depth recommendations on exciting pharmaceutical, natural resources and emerging markets opportunities. To claim your 3 month no-obligation trial subscription to Red Hot Penny Shares just click here.

Red Hot Penny Shares is a regulated product issued by Fleet Street Publications ltd. Your capital is at risk when you invest in shares, never risk more than you can afford to lose. Penny shares can be relatively illiquid and hard to trade. There can be a large bid/offer spread so if you need to sell soon after you’ve bought, you might get less back than you paid. This can make them riskier than other investments. Please seek advice if necessary. 0207 633 3600.

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