For every investor, the Holy Grail of investing is to find a multi-bagger, a stock that can increase its market value by many multiples (hopefully over the period you end up holding the stock).
Of course, unless you have a crystal ball, you cannot discover these companies before you invest in them. You have to buy the best businesses you can find and hope management has the skill to be able to grow the business in a way that produces outstanding returns for investors.
Unfortunately, the odds are stacked against you. A report compiled by analysts at JPMorgan, which was published towards the end of last year, showed that over the long term, less than 5% of equities actually produce a net positive return for investors. Meanwhile, a large percentage of the equities that don't generate a positive return end up costing investors 100% of their investment.
The takeaway from this is that, as the universe of successful businesses is so small, it's easy to gain some idea of what makes the best companies quickly. And this is precisely what Kevin Martelli of Martek Partners set out to do last year.
In a presentation titled "A Perspective on Value Investing," Martelli analyzed the performance of some of the market's most successful multi-bagging stocks and tried to figure out what, if any, similar qualities they all possessed.
Beating the market
One of the most commonly held misconceptions about investing is that to achieve the best returns, you need to buy stocks at cheap valuations. If you buy at high prices, you'll end up with a mediocre performance as there's less room for multiple expansion and a slimmer margin of safety. While this is true to a certain extent, it's also misleading according to Martelli's research.
Martelli considered the performance of 21,000 listed companies around the world. Of these, 3,800 have produced returns of at least 10x from the low point in the past 15 years until their current market valuation (up till April 2014). Of these 3,800 companies, Martelli picked out 100 of what he calls "more predictable" multi-bagger stocks, which a rational and long-term oriented investor had a “reasonable chance” to identify, purchase and hold over the long term.
He was able to draw several conclusions from this data. One of these conclusions is that you don't necessarily have to buy a stock at a low entry price to make a good return. Buying a stock at a low price relative to its future growth potential is more important. This implies companies trading at a P/E of 20 can still have multi-bagger potential if they can continue to grow earnings at a rate of say 15% per annum in perpetuity. Therefore, rather than focusing on current valuation, it is more important to focus on a company's future revenue potential and quality of management (ability to be able to achieve this growth).
Some other qualities linked all of the multi-baggers considered as well. For example, Martelli noticed that, in general, a complicated investment thesis was not necessarily required. To put it another way, a company's potential should be obvious, and an investment thesis should be relatively straightforward. Warren Buffett (Trades, Portfolio) didn't use complicated Excel models to compute the value of Coca-Cola, American Express and Wells Fargo but he did read the annual reports carefully and became acquainted with businesses. Rather than putting your faith in spreadsheets and forecasts, it pays to understand the company and know what you are buying.
Two other factors also stood out. First, small companies are more likely to become multi-baggers. Of the companies in the selected sample, 86% were trading at a market value of less than $300 million at their low point -- which means that they are inaccessible to most investment funds that won't go below a specific market-cap barrier.
Second, patience is required. In every single case it took years for the company to grow and evolve and due to the effect of compounding, most of the returns occurred towards the end of the study period.
These common factors link multi-bagger stocks, but the critical thing to keep in mind is that there is no secret formula to finding multi-baggers. Every investment case is different, and there are various factors which lead to excess returns. With this being the case, more than anything else, it is crucial that you trust management, who should be high quality with a significant stake in the company's success themselves.
Disclosure: The author owns no share mentioned.
