4 Key Qualities for Finding 10-Baggers
June 21, 2021
Finding companies that could ultimately be worth ten times an initial investment can power investors’ portfolio returns to impressive returns. Just one such investment can erase the ill effects of several bad investments. After all, the worst a stock can do is go to $0, giving an investor a 100% loss. A stock that reaches ten times its initial investment, or a 10-bagger using Peter Lynch’s terms, would provide an investor a 900% return. That’s pretty powerful math!
To get this math working for you, here are four qualities I look for when hunting for 10-baggers in my portfolio:
- Relative size to total addressable market. Some will say it’s essential to look for small or micro caps when looking for big winners. Others will say it’s important to look for companies with large addressable markets. I believe both of those statements get at the truth without precisely saying it because what matters is that a company is still small relative to the size of its market opportunities. This is why companies such as Alphabet (NASDAQ:GOOG) (NASDAQ:GOOGL) and Microsoft (NASDAQ:MSFT) can still make for market-beating investments, even with market caps clearing $1 trillion, ranking them among the largest in the world. Because when their respective opportunities are tallied up, I believe they still have lots of runway left to grow. Much smaller companies than these tech giants might not have nearly the same chance of being 10-baggers because their total addressable markets are not nearly as large relative to the company.
- Optionality. Rarely can companies become 10-baggers without growing new streams of revenue. South American e-commerce giant MercadoLibre (NASDAQ:MELI) grew into payments. Sea Ltd (NYSE:SE) took advantage of a popular video game by growing out a burgeoning e-commerce operation that now stretches across Southeastern Asia. When looking at some of the most significant companies dotting today’s investment landscape, almost all grew out new revenues from their first core products or services. Microsoft invested heavily in video games and cloud computing. Alphabet acquired YouTube and is now working to grow its public cloud business. Facebook (NASDAQ:FB) acquired Instagram. The list goes on and on. For exponential growth, companies will often need second, third, and fourth acts!
- Valuation. For great investments, it’s essential to find companies trading at decent valuations. The higher a company is valued, the more growth that is baked into its price. When companies are given lower valuations, it can be a nice setup for what some of history’s most successful investors have used to power meaningful returns. Shelby Davis turned his wife’s $50,000 inheritance after World War 2 into $900 million by the time of his death in the early 1990s, good for a compounded annual growth rate of greater than 20%. Davis liked to buy companies with low P/E ratios that would double their earnings growth over time. However, as the earnings grew, so did the companies’ valuation levels, as expressed by metrics such as the P/E ratio. When the P/E ratio and earnings both doubled, Davis would affectionately call this the “Davis Double Play.” Author John Rothchild wrote in his biography on the Davis family, The Davis Dynasty, that this could quickly become powerful math:
In 1950, insurance companies sold for four times earnings. Ten years later, they sold for 15 to 20 times earnings, and their earnings had quadrupled … What he’d bought for four times $1, they bought for 18 times $8. His $4,000 investment was now worth $144,000 in Mr. Market’s estimation … Davis called this sort of lucrative transformation “Davis Double Play.” As a company’s earnings advanced, giving the stock an initial boost, investors put a higher price tag on the earnings, giving the stock a second boost.
For a more recent example, in his interview with 7investing’s own Steve Symington, famed investor and bestselling author Chris Mayer called earnings growth and valuation re-ratings the “twin engines” of superior returns.
- Sustainable economic moat. Finally, don’t forget that time is on your side for winning investments, so look for companies with economic moats or competitive advantages that can withstand the test of time. Remember, even if a company takes 20 years to become a 10-bagger after an initial investment, that still represents a compound annual growth rate of about 12.3%, well above the stock market’s historical rate of return. So look for a company you can hold on to for a long-time.