Shares of Quindell (LSE: QPP), the insurance services company, are down 25% in 2014 on allegations of dubious accounting methods. Such was Quindell’s rise, however, that the shares are still up a staggering 67% since last June.
The firm has a market cap of a little over £900m, and small-cap stocks — unlike their tanker sized blue-chip peers — are typically more able to grow profits and earnings by two, three or more times the present level — if you pick the right company.
You wouldn’t invest in GlaxoSmithKline and expect it to become a ten-bagger. But if you look to the AIM market and leaf through earnings reports, enter a few sums in a calculator and conclude that the prospects look solid, then you could uncover that rarest of success stories. Imagine if you’d invested in ASOS at under 300p in 2008 before it sailed to 7,000p earlier this year? This is the dream.
Value trap?
At current prices (around 14p), Quindell trades at seven times last year’s earnings. This is firmly in value territory, but keep in mind that Quindell has nearly 6% of its stock with short sellers, who are backing further losses.
Not every stock with an attractive P/E ratio (share price divided by earnings per share) will deliver dazzling gains. Cheap, as the shorters anticipate, can always end up cheaper. Think ‘value trap’. Worst-case scenario: a company goes bust and you say goodbye to your capital.
I’m not, by any measure, saying Quindell is going to go under. Horror stories abound, however, about naive investors losing tens of thousands of pounds in Quindell shares. When it comes to constructing an optimised share portfolio we want to minimise the risk for such heavy losses.
Minimising risk
Let’s consider that the majority of people say they would need a £10,000 income to maintain a reasonable standard of living in retirement. That would require building a pension of £160,000.
Imagine you’re halfway there — so the total amount of your wealth is £80,000 — and tomorrow your Quindell shares gain £1,000. That’s would be exciting, I’ll bet. But is increasing your wealth from £80,000 to £81,000 quite so remarkable?
It’s the sum total of your wealth that matters. Bearing that in mind, I’d limit my exposure to volatile shares like Quindell. How much could you truly risk losing?