Last year, Texas-based investment manager Alta Fox Capital Management published a 645-page internal case study titled "The Makings of a Multibagger." The report is fascinating, and I think it is well worth a read for any investors interested in learning about the qualities and developments behind the market's top-performing stocks. Here are my takeaways from the piece.
What makes a multi-bagger?
The idea behind the report was simple: Alta Fox wanted to try and understand what qualities are present in multi-bagger stocks.
To do this, the hedge fund's analysts looked at 104 different equities across international markets with market capitalizations of between $150 million and $10 billion. These equities produced an average return of 922% between June 2015 and June 2020. The highest performer returned 9,199%.
The report showed that over 80% of the businesses studied had high barriers to entry. They owned a unique product or provided a service that was difficult to replicate.
The study also showed companies that leveraged acquisitions to improve returns generated better results. Companies with strong balance sheets also produced better results.
Searching for financially healthy companies that had the financial firepower to pursue acquisitions and deepen the moat surrounding the business produced better returns than risky turnarounds.
None of these findings are particularly surprising. However, the one finding that I think is quite surprising is that in the study, a company's valuation at the time of purchase did not necessarily determine its future performance. Specifically, the report noted:
"While it is always better to buy a great business at a low multiple rather than a high one, many of the top-performing stocks began with already healthy multiples – those multiples often expanded even further."
To put it another way, the analysis seemed to suggest that finding a company with a wide moat, a strong balance sheet and a good track record of completing successful acquisitions was more critical than buying stocks cheaply.
This does not necessarily mean that valuations should be ignored entirely. After all, there is survivorship bias to consider. However, the findings seem to suggest that investors should not overlook stocks just because they appear expensive.
Examples from history
We don't need to look very far to find evidence to support this conclusion. I could pick any number of high-profile tech companies that looked expensive 10 years ago but have since gone on to generate market-beating returns (again, investors should be wary of survivorship bias here).
My favorite example from history is Warren Buffett (Trades, Portfolio)'s acquisition of See's Candy in 1972. According to various accounts, Buffett had to be convinced to pay up for See's, which he thought was overpriced. The investor paid around six times earnings for the business, which might not seem expensive today, but the stock was also trading at a multiple of several times book value. In the mid-1960s, Buffett was still following Ben Graham's deep value style of investing, which required that stocks should be trading at a discount to book value.
Buffett's decision to pay a high price for See's worked out incredibly well for the investor. By 2019, See's had generated over $2 billion in profits for Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial).
This is just one example, but I think it illustrates the point well. See's was expensive by a certain metric (book value), but it had a wide moat and a strong balance sheet. As far as we know, it hasn't completed many acquisitions, but that hasn't mattered. The company has thrown off vast amounts of capital for Berkshire to re-invest.
Paying a high price for an asset might seem unwise at first, but we should keep in mind that a "high price" is all a matter of perspective. There are plenty of examples where paying a high price may be the only choice to hop on the train of a company whose stock price will soar even higher in the future.
Unfortunately, there are just as many (if not more) examples where overpaying for an asset can lead to disastrous results.
Disclosure: The author owns no share mentioned.
Read more here:
- A Look at One of Baupost's Smallest Equity Holdings
- A Look at Berkshire Hathaway's Smallest Investments
- Can the Market Continue to March Higher?
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