Finding a tenbagger, a stock that returns ten to one, is like finding a big lump of Gold in the Mississippi, in the late 1800s. But perhaps surprisingly is that tenbaggers are quite often dwarfed by their big brother, the 100 bagger. Stocks that return 100 to one.
Background
When Peter Lynch coined the term tenbagger, he described a stock that grows to be worth ten times the original investment. A 100-bagger, on the other hand, is a stock that grows to be worth one hundred times the invested amount.
To find these stocks we can use a few books and some research of our own, to study what 100 baggers looks like and what they all have in common. The book “A 100 to 1 in the stock market”, by stockbroker and investor Thomas William Phelps, from 1972 , and Chris Mayer’s more recent book “100 baggers: Stocks that return 100 to 1 and how to find them”, are good starting points.
What is a 100 bagger?
A hundred bagger is a stock that increases its value a 100 times over. Or in other words a return of 100 dollars for every one dollar invested. That means a 1000 dollars invested at the start of its journey turns into 100 000 dollars at the end of 100 baggerdom.
100 baggers common traits
In Chris Mayers’s book he looks at every 100 bagger, between 1962 and 2014, and what he found was that 365 companies had made this journey. This might be a bit surprising, since it is the exact same number that Thomas Phelps found, when he studied stocks between 1932 and 1971, more than 40 years earlier. Further, 100 baggers share a few common characteristics are delved into below.
High growth
A company needs to have an extended period of high growth to become a 100 bagger. The average time-period, to become a 100 bagger, was 26 years, in Chris Mayer’s study. But interestingly, some stocks became 100 baggers in a much shorter timespan.
PE ratio expansion
According to Phelps most big stock price increases arises from increasing earnings alongside an increasing PE ratio. Because when they are both rising sharply, at the same time, the stock price explodes. A stock can increase a hundredfold if its earnings increases twenty-five fold in the same time period that its PE ratio increases by a factor of four. (25*4=100). Take Amazon as an example. Its PE ratio has averaged over a 100 in the last years. And it is actually now well above a 2 500 bagger, since it was listed in the nineties. But its PE ratio started out low back then.
PE ratio
PE ratio expansion happens when the growth and expectations are high. Therefore a future 100 bagger should ideally be bought at a low PE ratio. Preferably 15 or lower. But there are cases where the PE has been quite high as well. But where the stock had a lot of runway to grow into a 100 bagger, despite the high PE ratio. Amazon might be the best example of that, since its stock could have been bought at a high PE for a very long time of its History, but still became a 100 bagger many times over after that point.
Smaller companies
In Mayer’s book he concludes that out of the 365 businesses the median market capitalization at the beginning of the rise was around 500 million dollars. A 100 bagger needs room to grow. As a result they usually start out small, growing at the local level, and later expands its growth internationally.
Smaller companies are riskier than their larger counterparts. But they are also likelier to become 100 baggers, because of their longer runway. Of course they also bear the risk of failing completely or to go bankrupt. Therefore you need to know what you are doing if you are looking for 100 baggers among these stocks.
Reinvestment
Amazon did not report a profit for many years. That’s because it kept putting money back into its own research, development, marketing and growth. It could have paid a high dividend, but instead, it chose to reinvest. This helped grow the company and increase shareholder value over time. A high return on invested capital is common among 100-baggers. These companies often skip dividends because they know how to put that money to work and reinvest it back into the business.
Dividends and growth
“It is simple arithmetic that a company with a book value of ten dollars a share earning 15 percent on its invested capital will have a book value of 11.50 a share at the end of one year if it pays no dividends. At the end of the second year its book value will be 13.22 dollars and at the end of the third year 15.20 dollars. In five years the company’s book value will have doubled. In thirty-three years it will be up one hundredfold. If the same company pays out a third of its earnings in dividends, reinvesting earnings at the rate of ten percent of its book value each year, its book value will quadruple in fifteen years instead of ten.” – Thomas Phelps, 100 to 1 in the Stock Market.
There is a case to be made that less dividends does not automatically give the investor more money in the pocket in the long run. A dividend growth strategy might work just as well, but only if you pick the right company.
Dividend example
A good example is Warren Buffett’s investment into See’s candies in 1972. Because See’s candies haven’t grown much since it was bought by Buffett, but it has still made huge returns for its owner. These returns have come through dividends, and from its huge free cash flows. The takeaway is that when a business keeps cash from its owners, it better have a good reason for doing so. A good reason could be that it has a competent management which knows how to allocate that capital. For example, as is the case for Amazon.
Owner operators
Return on invested capital is the real reason why Jeff Bezos has been vital to Amazon’s success. Because Jeff Bezos is what Warren Buffett would call an “owner operator”. This means that he runs the company and at the same time is its majority owner. This is good for shareholders because high insider ownership will often protect against fraud. And it also makes sure that the company outperforms. Because owner interests are aligned with shareholder interests.
Gross profit margin
According to Mayer, companies with high gross profit margins were common among the 100-baggers he studied. For some reason, these companies also tend to be stronger in other ways. Often, they have higher profits and margins across the board. Further, over time, it is typical that they have the ability to keep their high profit margins. Which often stem from moats.
Moats
100-baggers often have what Warren Buffett calls a “moat.” A moat protects a business from its rivals. It could be a patent, a secret recipe, a brand name, or even a location. One good example is the Coca-Cola brand that is both a brand name and a secret recipe. A moat can also be a kind of unofficial monopoly. A company might own the only railroad in a certain area. For example, Kansas City Southern has become a 100-bagger many times over. Because it controls most of the rail freight between Mexico and the U.S.
Kansas City Southern owns a small route and is one of two major companies that have cross border rail connections between Mexico and the United States. It has a 50 year concession granted by the Mexican government to operate that railway. The route is well-placed to take advantage of NAFTA trade and has increased enormously in value since 1974. It is a 100 bagger many times over and even north of a 16 000 bagger today. Further, even if you bought it as late as 1997, you would have still made a 100 bagger on it by now.
Share buybacks
Buffett said in the past that share buybacks are beneficial when done below intrinsic value. But that they can ruin a company if done on overvalued levels. Therefore share buybacks on undervalued price levels are often a sign of competent management. While buybacks at high levels are a sign of the opposite. Many 100 baggers have done share buybacks successfully, on undervalued levels.
Acquisition through your own stock
According to Thomas William Phelps most 100-baggers have had good managements. The leadership often bought other companies at lower prices than their own. One way to do this is by using their own stock to pay for deals. Jeff Bezos used this to his advantage in the past. When Amazon’s stock was highly valued, he used it to buy other businesses, getting other companies at a discount.
Discovery exploration stocks
Phelps mentions Discovery exploration stocks in his book. Discoveries in the Gold, Oil and natural resources space can make a stock price soar a hundred times over, if that discovery is good enough. And although these companies often enjoy a great deal of luck, the ones that hit the jackpot often have great managements. Therefore it is smart to invest with the guys that have done major discoveries in the past, to increase the chances of a jackpot, in this space.
New inventions and monopolies
New inventions, processes and ideas can also create a 100 bagger. Apple and Microsoft are good examples, but also companies that get contracts from governments to do monopoly type like business for a certain amount of time. For example, the monopolised building of facilities or big infrastructure projects can be very profitable.
Earnings power
Earnings are the reported profits of a company. But the “earnings power” refers to the inherent power of a business, to create the earnings, necessary for growing it into a 100 bagger. The return on invested capital, cash flows, margins, sales growth and the capital structure creates the earnings power.
Examples of earnings power differences
Two companies could be earning ten dollars a share and both could be paying out five dollars a share in dividends. But only the second company is increasing its sales by ten percent a year. The earnings are not created equal in this example. Even if it looks that way on the surface, which is important to spot.
The second company obviously has something going for it. Maybe it has reinvested its capital at a higher rate, which often can be seen in the numbers. Or it has been able to cut costs or raise prices. Needless to say the first company might have sold off some of its assets or taken on more debt, to keep its earnings as high as the second company’s earnings. And that is the reason why it is important to “Look through earnings”, when doing fundamental analysis.
Reinvestment
The second company might spend a lot of money on research and development. Therefore it looks like its earnings are the same as the other company’s earnings that spends nothing on research and new inventions. Either the company could get good returns on its research in the future, or in the worst case scenario it could cut down on research. Consequently when they cut that research they will usually increase their pretax earnings. Again, showing that all earnings are not created equal. Usually, the company that is doing reinvestments is in the stronger position.
Charts
What is interesting about Phelps is that he also used charts to complement his fundamental analysis. He describes technicals as a way to get additional information about the fundamentals. For example, it is very hard to know all that is to be known about an investment. Consequently, charts can help to warn us if something is wrong, according to Phelps.
“It seems to me important for the professional investor to know at all times not only what ought to be happening in the stock market, as determined by fundamental security analysis, but also what is happening in the stock market, as determined by technical work.”
However, according to Phelps, charts should not be the only tool in investing. They can make an investor loose focus on the real value behind the stock. Charts can also lead to overtrading or selling a good stock too soon. Worst of all, they can make you forget the rule of “buy right and hold tight.” That’s why we should never ignore the fundamentals.
Buy right and hold tight
“Buying right will do you little good unless you hold on. But holding on will do you little good – and may do you great harm – unless you have bought right.” – Thomas Phelps
The words above are full of wisdom. But how do you buy right and hold tight? To buy right, you need to find a good stock. This is the easiest part. Holding tight, year after year, is much harder. To hold through the ups and downs, you need to know the investment well. If you don’t, you might sell too soon when things get tough. That’s why knowing the intrinsic value is so important.
Conslusion
According to Phelps the little man has an advantage over the big guy on Wall Street. Because he does not make any noise. And noise is what scares of the big elephants. Therefore a poor man can make big money in Wall Street if he does his homework. But he needs to stay with the right stocks and not stray from the course and only invest in the very best names to score a 100 bagger. A quote from Thomas Phelps summarizes this well:
“When I was paving my way through equatorial Africa by shooting elephants for ivory, I learned this simple principle: When looking for the biggest game, be not tempted to shoot at anything small. Elephant ears are very keen. Never after firing a single shot at a Guinea hen, a colobus, monkey or an antelope did I see an elephant that day.”
To read more about 100 baggers, stay tuned for part two of this post.
