Offer somebody the choice of £10 or a 50/50 chance of £25 and the majority will opt for the former. Or, similarly, 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'.
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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 last week when reading two research notes. The first concerned Avanti Communications (LSE: 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.
Tom worked as a fund manager in the City of London and in Hong Kong for over 20 years. As a director with Schroder Investment Management International he was responsible for £2 billion of foreign clients' money, and launched what became Argentina's largest mutual fund.
Now working from his home in Oxfordshire, Tom Bulford helps private investors with his premium tipping newsletter, Red Hot Biotech Alert.
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