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Finding the next 100-Bagger

The holy grail of investing is to find a stock that can deliver life-changing returns. You don’t have to look far to see recent examples of companies that have achieved this feat. The chart of stock market darling, Nvidia, is something to behold.


Source: Morningstar

Over the past decade, Nvidia’s share price has increased 192x. In 2014, it was already a large company with a market capitalization of close to US$11.5 billion that few investors, barring institutions, had heard of. Now it’s worth US$2.2 trillion and everyone is talking about it.

There are examples in Australia too. Pro Medicus’ share price has risen 126x over the past 10 years. It’s grown from a small company with a market capitalization of close to $80 million into a top 50 ASX stock worth $10.1 billion.


Source: Morningstar

Some people see charts such as these and they invest in the market like they would the lottery – betting on a 1-in-a-million shot at hitting the next big thing. For instance, buying into a new technology, a new pharmaceutical drug, or a new mine. That kind of speculation often leads to poor results and disappointment.

What’s a better way of unearthing the next Nvidia or Pro Medicus? Here are four methods that can help find quality investments set to deliver strong long-term returns:

1. The Peter Lynch Way

Recently, Andrew Mitchell from Ophir Asset Management mentioned in a LinkedIn post that the one book he recommends to people who are new to investing is One Up on Wall Street by Peter Lynch. I agree.

Lynch is a former fund manager at Fidelity whose main fund returned 29% per annum from 1977 to 1990. He looked for growth stocks whose earnings were set to take off, and the book details how he identified these stocks.

One method still resonates with me. Lynch suggests investigating companies that you use every day. For example, you may own and run a small business. There’s a good chance that your accountant switched your accounting software to cloud provider, Xero, up to a decade ago. Back then, Xero wasn’t well known, and may have been worth exploring as an investment.

Taking the example further, you may operate this business in tourism and accommodation and know of other suppliers that are doing well. For instance, you might deal first-hand with Booking Group, which operates booking.com, and has been taking share from Expedia and others since Covid.

And your wife or children may come home one day raving about a new shop that offers a unique product or service. That could turn into the next Smiggle or Lovisa.

Lynch thinks that investors can get an edge by getting to know companies before they appear on the radars of institutional investors and brokers. And one way to do that is by keeping an eye on growing companies that you encounter in daily life.

2. The Warren Buffett way

When it comes to finding stocks that can deliver outsized long-term returns, there is no better teacher than Warren Buffett. In a recent article, Morningstar’s Amy Arnott, outlines the DNA of a typical Warren Buffett company. She sees five common traits of companies which make it into Buffett’s investment portfolio:

  • An economic moat. This means a company that has a sustainable competitive advantage. For example, Berkshire Hathaway insurance subsidiary Geico enjoys a durable cost advantage by selling policies directly instead of paying sales reps.
  • An outstanding management team. Buffett has always sought outstanding CEOs. He admired Katherine Graham, who ran The Washington Post in the 1970s, Tomy Murphy and Dan Burke at media outfit, Capital Cities/ABC, and Coca-Cola’s late Chairman Don Keogh.
  • Thoughtful capital allocation. This means companies that deploy capital to build shareholder value over time. Buffett deplores empire building acquisitions, dilutive share raises, and managers who put themselves first rather than shareholders. Instead, he likes those businesses that make thoughtful acquisitions and buy back shares when their stocks are undervalued.
  • Earnings power and financial strength. Buffett avoids companies that use accounting tricks to fudge their financial numbers. He prefers using measures such as operating earnings, return on equity, and free cashflow, to assess a company’s earnings power and strength. A famous example of earnings power comes from one of Buffett’s initial investments, in See’s Candies. Millions of repeat customers for its boxed chocolates and its low-cost structure means See’s has been able to consistently raise prices over time, enabling growing profits and returns on capital.
  • An easy-to-understand business. Buffett has always favoured simple business models. For this reason, he shunned tech companies for a long time. He has also generally avoided rapidly evolving industries like airlines and investment banking.

3. Find great companies in the best sectors

One shortcut to finding a Buffett-like stock is to identify the best and worst sectors to invest in. The best sectors are those that have a capacity to defy the laws of capitalism and retain high returns on capital over a long period of time. The below chart from finance professor, Aswath Damodaran, covers sectors in the US.


Source: Aswath Damodaran, Professor of Finance at Stern School of Business at New York University.

Professor Damodaran aggregates each sector’s return on capital employed (ROCE), which measures how efficiently a company is using its capital to generate profits. And he also calculates the cost of capital (WACC) for the sectors. Companies create value whenever they can generate returns on capital above their WACCs. The higher the spread between ROCE and WACC, the better.

As the chart demonstrates, tobacco has created the most value of any sector in the US. It’s followed by the technology and healthcare sectors.

Conversely, the worst sectors to invest in are those that can’t generate returns above their costs of capital. Sectors in this category in the US include investment banking, banks, airlines, and oil gas.

The importance of the above is that higher ROCE-WACC spreads result in better long-term EPS growth, and higher share prices. It’s no coincidence that tobacco has been the best performing sector in the US over the past century.

While Professor Damodaran’s work focuses on the US market, it’s equally applicable to the ASX.

What allows an industry to produce high returns over a long time? It varies, though it can involve barriers to entry creating a consolidated industry. For tobacco, government restrictions on advertising favour incumbents as they make it hard for any new competitors to get traction with their brand. Increased taxes on smoking creates a further barrier for newer entrants to the industry.

Other consolidated sectors offering barriers to entry include payment networks with Visa and Mastercard, North American railroads, credit ratings with S&P Global and Moody’s.

Banking offers commoditized products, though the industry in Australia delivered outsized returns for a long time thanks to the government’s ‘four pillars’ policy. The sector’s structure is an oligopoly which has helped returns stay above the cost of capital.

Some of the best investments have involved industries where there is slow growth, discouraging new competitors and encouraging consolidation. A great example of this is in US auto parts retailers, where O’Reilly Automotive and AutoZone have delivered spectacular long-term returns.


Source: Morningstar

Locally, examples of consolidating industries include insurance brokers, such as Steadfast and AUB, as well as funerals (Propel, and the formerly listed, InvoCare).

4. Linear stock prices

Recently, I came across a short book, The Intelligent Quality Investor, which looks at how to invest in the world’s best companies. The book focuses on the best stock performers of the past 40 years, and what they have in common. Besides the Buffett-like qualities of high returns on capital and prodigious free cashflow generation, the book also zeroes in on the concept of linearity. To illustrate the concept, let’s take the two charts below. The first is Constellation Software, a global software company, and the second is United States Steel.


Source: Morningstar

Linear charts are like the first one of Constellation Software. They go up and right and are relatively smooth. These types of charts often demonstrate companies that are consistently profitable, reinvest their profits at higher returns, and are resilient to economic downturns.

Non-linear charts such as United Steel’s, tend to show companies whose profits go up and down, are often capital-intensive, and are highly susceptible to recessions or downturns.

I would never suggest that price denotes value. However, the point here is that price charts can be a useful tool to identify quality companies.

Holding onto quality companies can be the hard part

It’s one thing to find the next Nvidia or Pro Medicus; it’s quite another to have the patience and conviction to hang onto a stock for the long haul and let compounding work its magic.

In his book, 100 Baggers, Chris Mayer says that the average US stock that’s gone up by 100x has taken 26 years to reach the milestone. 26 years on average.

Going back to the Nvidia chart at the beginning, despite the stock rising 192x over a shorter period of a decade, it still had multiple drawdowns, including when it dropped 65% in 2021-2022.

Few investors can withstand 65% stock price falls, and that may be the biggest lesson of all. As the late, great Charlie Munger once said: “if you can’t stomach 50% declines in your investment you will get the mediocre returns you deserve”.

 

James Gruber is an assistant editor at Firstlinks and Morningstar

 

20 Comments
Steve Teague
March 24, 2024

One up On Wall Street was a very good book with great tips on what/where to look, I found one recently at 12c. 100 Baggers was also a very good book. Looking for companies with the characteristics and metrics outlined in this book has helped me tremendously, following on from education on Value Investing characteristics.

Ian
March 24, 2024

I think it is pretty hard to "research" companies that will make the really great gains. To get into new/future technologies at an early stage is a real gamble. Against my brokers strong advice, I bought REA when they nosedived to $0.16, based on a hunch that the technology would be adopted in the housing sales industry. But there was no research to demonstrate whether that would occur. Fortunately it did.

Dudley
March 24, 2024

Having latched on to a prospective 100 bagger, the growth rate required is dependent on the time available.

Example: 100 bagger to be in the bag at 40 years after 1 bag initial investment;
= 10 ^ (LOG(100) / 40) - 1
= 12.2% / y

Another: at 10 years;
= 10 ^ (LOG(100) / 20) - 1
= 25.9% / y


RogerNg
March 24, 2024

I agree with the thrust of this article. I advise early stage companies to raise equity. We carefully select which companies we think will succeed. We only deal with fund/family offices/sophisticated/professional investors who use 5-10% of their wealth to invest in this riskier end of the market. We look for founders who've done it before and who have their eyes on a liquidity event (trade sale/listing) within 3 years and who also have connections in the US. This last point will maximise valuations. We're shown around 600 deals annually and we take on less than 10. Our fees are designed to be achievable for a company that's short on cash. Often we are paid half our fees in options. Which suits us just fine and means we're not transactional - we have skin in the game. I've only been doing this for the last 6 years. I'm now 61. My only regret is that I did't start when I was 40 when I was "successful" young investment banker.

Dudley
March 23, 2024

"Linear stock prices":

Better to look in log(total return) for the highest ratio of regression slope to standard deviation of residuals - if sufficient faith that the past foretells the future and have 100 bagger or bust lust.

Disgruntled
March 23, 2024

I had opportunity to get in on Sausage Software $10k. 50000 shares 20 cents each but passed on it. One that got away

Dudley
March 22, 2024

Will you be a 100 year old beggar before the 100 bagger is in the bag?

Time to increase from 1 to 100 with a yearly growth rate of 25%:
= LOG(100) / LOG(1 + 25%)
= 20.64 y

Anonymous - Prefer to remain
March 22, 2024

Surely using a phrase like 100-BAGGER does everything yiou shouldn't be doing when it comes to sane decisions about investing.

I have only known it happen when investing alongside founders in small private nbusiness that become successful and then have a trade sale. But phrases like 100 bagger just over exaggerate - how many times did Buffet or Lynch have a 100 bagger investing in public securities.

Kevin
March 23, 2024

Wow Anonymous,what else can I say,just.wow.
Buffett with hundred baggers,Geico probably,See,s Candies,Berkshire was a publicly listed company $14 ish to $600K. I could never understand why he didn't buy Walmart,I think he explained it around 2000,he waited for the price to come down 10cents more or thereabouts..Thumbsucking cost shareholders $10 billion roughly.,and a lot more since then as he says.

The ones mentioned in Australia,I don't own any of them,but I have other 100 baggers. CBA, Wesfarmers, Macbank.Why would you be insane to buy those companies?.Macbank isn't going to be a 100 bagger for me,I thought it was a bubble when it took off after the IPO.For the ones ( very very few ) that got in between IPO and 2000 then I would expect a 100 bagger by 2030,if you reinvested the dividends.

If WES just flatlines for the next 2 or 3 years that will be a 1000 bagger if you took a chance.Before the suits got in the old farmers would be at the AGM,have a beer with them and be prepared to be hammered with never sell any shares in WES son.Wesfarmers puts beer on at the AGM,it's a good party I miss the old farmers.

The bullet points are perfect The click bait to get people in,100 bagger. The 28 years on average.I'd go for a 30 year period if it keeps compounding at anything around 12% or more,40 years is just wonderful. Big black letters holding on to quality companies etc I'd split hairs there. Can be the hard part?.I'd say that is the impossible part for 99% of people.

Whenever compounding is brought up you can guarantee it will be denied .

The Roy and HG act,too much diversification is never enough.

I'm investing for the long term,3 to 5 years.Probably rebalance on an annual basis,perhaps every six months.

Erm what about understanding that compounding takes time.Are you not happy with turning $6K into 6-700K just by sitting on your hands.The answer of course is,concentration risk,you didn't rebalance,what about sequencing risk.You haven't got any bonds,or gold.You'll be paying tax,you aren't going to get the full pension.Enron went bust,what about the Japanese market.Where does the 4% rule fit into this strange thing called compounding.Why didn't everybody else do that.

Perhaps I'm just one of those insane old buggers that thought,well this is going well ,decade after decade. It ain't broke so I'm not going to try to fix it

Dudley
March 23, 2024

Wesfarmers:

Price:
Indexed to 100 https://www.marketindex.com.au/asx/wes/advanced-chart ;
02/07/1990 100
01/03/2024 2900
Bags:
= 2900 / 100
= 29.0 bags

Adjusted for splits and dividends (not tax):
02/07/1990 100
01/03/2024 18883
Bags:
= 18883 / 100
= 188.93 bags.

Adjusted for inflation https://www.rba.gov.au/calculator/ :
1990 1.00
2023 2.34
= 188.93 / 2.34
= 80.7 bags

Real growth rate over 34 y:
= (80.7 / 1) ^ (1 / (2024 - 1990)) - 1
= 13.8% / y


Tim
March 25, 2024

I think you would be surprised how many household name stocks have been 100 baggers. Apple, for example, is a 500 bagger since the iPod was released in 2001. Was Apple an obscure stock no one had ever heard of at that time, no it was a household name and the iMac, released 3 years earlier was a popular product. It wouldn't have taken a genius to buy AAPL around that time. The problem, as mentioned in the article, is investor behavior. People are impatient and don't hold onto their winners. I read that the average holding period for stocks is something like 5 months, well short of the 26 years it takes the average 100 bagger to materialize. Also, as you suggest, people who try to find 'bagger' stocks gravitate towards speculative stocks instead of quality ones that are actually making money. So, it's not that the opportunities don't exist, it's that investors aren't good enough to realise them.

Jeff O
March 22, 2024

My rules for 100 baggers -
1. does it have good governance/mgt? with a lot of skin in the game?
PME's two founding drs still with 50% of $6bn company after over 20 years... paid virtually no dividend - to founders and rest of shareholders......!
2.Do they generate good/innovate ideas and turn into products...that have been tested and sold to real customers ...not related parties such as your family, equity partners, etc and strong investment/R&D plans.....PME had a number of ideas...and not all worked...started with paperwork...into tech/digital....radiology....and now into cardiology
3. Can it be scaled....hopefully globally ahead of potential competitors/entrants. PME....jumped from 50 to 100 once this became a reality amongst big US hospitals!
4. If it turns into a good company....get in early with at least a small stake.....be patient and this usually takes a lot of time ...maybe never sell unless forced by personal circumstances or taken over.....ride the ups and downs....adding during the downs ....and avoid the BS from brokers about rebalancing....and concentration risks...PME a 100 bagger and 2 founding drs still hold 50%
5 If 1,2,3 become negative ......sell on the way down...since these can be 20 or 30 or ...baggers
6. if you going to try and pick 100 baggers ....pick 10 and place some small bets ...and if you are smart and lucky and you may end up with ...with 5-10 baggers ....COH, CSL, DRO, SYR, ...to write off your loses...in stock picking
7 Very few stock pickers find 100 baggers and outperform over the long run - so set, bet and monitor a bit..and watch out for sell signals - 1, 2& 3

AndyB
March 21, 2024

The best candidate I can find to copy NVIDIA's success trajectory is Weebit-Nano which is listed on ASX as WBT. They have developed a great product called ReRAM to replace the ageing computer memory called Flash. They have a Board of directors second to none, first class management, a large moat and have commenced commercialisation. They have progressed talks and negotiations with some of the world's largest computer chip manufacturers and are starting to receive revenue from license fees. Some time spent researching this company should be well worth it.
I hold Weebit-Nano shares.

James
March 23, 2024

"ASX hater Weebit Nano must be a wee bit joking" - AFR 21 March 2024. 

AndyB
March 24, 2024

James, the stuffed shirts at AFR know nothing outside of banks and digging holes. Semiconductors are the future - just have a look at Nvidia, Also, do some actual research on Weebit-Nano. I won't try to persuade anybody to buy WBT shares, but I will enjoy looking back in a few years and saying I told you so. You can enjoy a play on Weebit's name while I enjoy a multi-bagger.

James
March 26, 2024

You might want to read the article, some pretty colourful antics of the leadership were discussed...but interesting that you automatically assumed my position on it. Sounds like you are trying hard to convince me and others...

Greg
March 21, 2024

I have owned NVDA for several years now (7x gain), and the reality is that the reasons why it's price is going through the roof (AI) didn't exist when I bought them. I thought they were a good company and the video graphics market had potential. Good investing means a gain of 20%/yr. When you have a win like NVDA, it's mostly luck. I find the key is to good gains is understanding what makes a bad stock (untrustworthy management, limited growth potential, low barriers to entry etc.). Occasionally one of these stocks will do something surprising.

Vis
March 21, 2024

Excellent comment. Sometimes we congratulate ourselves for far too much luck.

Tim
March 22, 2024

Yep, it was a gaming stock when I bought it, then a crypto mining play, and now an AI stock.

Disgruntled
March 21, 2024

Not financial advice and certainly do your own research but I'm liking ASX PCL and ASX IMU as speculative plays with big potential.

Yes I hold these 2 in my portfolio.

 

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