How to hunt for 100-baggers
and 50 companies from Joel Greenblatt
Most people recognize this sign.
It shows opposing but complementary forces working together to bring forward a balanced life.
In my investing strategy, once I discovered microcap investing (yin, the black) and quality investing (yang, the white), something clicked. Both strategies are different but can complement each other. You can look at it from different angles:
Young Buffett, Old Buffett
Greenblatt vs Smith
I could go on and on with the comparisons. Since Joël Greenblatt was known for hunting for small companies and Terry Smith is a well-known quality investor, we are going to compare both.
Let’s look at their past performance:
Terry Smith invests in the best companies in the world. He looks for quality at a reasonable price (QARP). Since its inception in 2010, he achieved a CAGR of 15.4%. Fundsmith currently has about 45 Billion USD under management.Joel Greenblatt is a value investor, looking for special situations or changes. Gotham Capital, from 1985 to 1994 had a yearly return of 50% before and 34% after fees. In 1994, Gotham Capital had about 500M USD under management. The law of large numbers cannot be avoided. More capital means the money manager needs to go away from small caps into mid and larger caps, and he will see his returns diminish due to more efficiency in the market.If you haven’t read Joel Greenblatt’s class notes, I highly recommend you to. Even if you’re not into his investing strategy, Joel focuses on one thing, and one thing in particular: Valuation. How to value a company. Just like Damodaran, he considers valuation a craft, so doing lots of them is like flexing your muscles and getting better at it.
The difference in strategies
To illustrate the difference between Smith and Greenblatt’s strategy:
The chart shows all the S&P companies, divided per decile according to their ROE. Eventually, all companies converge to an average ROE of about 10 to 12%. What does this mean?
Companies that are earning a high ROE will see competition come in, competition will erode returns, and reversion to the mean occurs.
Companies with low ROE have problems, and they are trying to fix these problems. By fixing these issues, they will also gravitate towards the average ROE
Now you can relate this to the quality and value investing strategy:
Terry wants to find companies, whose quality is so high that reversion to the mean occurs more slowly. Companies with a big competitive advantage period as we previously discussed. You usually won’t have the benefit of multiple expansions, but time is your ally. You’ll earn through EPS growth.
Why does this work?
The human brain will extrapolate what has happened in the past. When valuing these companies, most will underestimate their power to fend off reversion to the mean and undervalue. If you can get in at a good price and hold on to the company longer than most, you can make a nice return.
Joel wants to find companies where a change is happening. They look bad on paper, but when digging into the details of the financials and company reports you’ll find signs of a change going on. New management has stepped in. Divestments are ongoing. Bad business segments are being closed down. Special situations like spinoffs provide some sort of arbitrage opportunity. In these situations, the company ‘inflects’ and goes from a low ROE to a higher ROE.
Why does this work?
The human brain will extrapolate what happened in the past. A company that looks like a low performer, will be extrapolated into staying a low performer. By looking for hidden gems in the rough, an investor can find value. It will receive value to a multiple expansion. As depicted in the graph, this occurs pretty quickly, over 1-3 years.
In other words, quality investing means holding on for longer periods with a lower turnover in your portfolio. Quality is usually found in bigger companies as the company has a proven past of winning.
Value investing means shorter holding periods with a higher turnover in your portfolio. Opportunities can be found in smaller companies where there is less competition and markets are less efficient.
100-baggers
So where do 100-baggers come from?
As explained in Chris Mayers book, 100-baggers are born from smaller companies that have a twin-engine of growth. These companies combine EPS growth with multiple expansions. You can find our checklist below ⬇️
Here’s an example from Chris where he explains a 120x bagger over 12 years. The company was Armor Holdings Inc. and it showed incredible results:
EPS growth at 49% per year
A multiple expansion from 10 to 24
This is an outlier as the median 100-bagger needs 26 years to get to that level. Armor was acquired by BAE Systems in 2007 (Ticker BA, which by the way has tripled since the war in Ukraine).
So what if, you find a company through Greenblatt’s strategy, a company where change is happening? The company will not be priced high in the market as it does not screen well. It’s probably too small.
Now most of the time, you would sell these after a couple of years. You might get a 100 or 200% return and once intrinsic value has been reached, you get rid of it.
But if the company shows more and more signs of quality and you hold on a little longer, you might get this:
These occasions are rare. The timescale for this to happen will be at least 10 to 20 years. The biggest challenge is holding on. Imagine you buy a company on an inflection point, and after 3 years, you get a 200% return. That 200% mainly comes from a multiple expansion. It will be hard to not look at the opportunity cost, and switch it out for something better.
And we haven’t even talked about drawdowns. The example of Armor Holdings Inc. above was easy. It just kept on performing. But when you’re looking at the markets, ALL the 100 baggers experienced significant drawdowns. Even if you’ve managed to call volatility your friend, you will be tested.
An example: Universal Insurance Holdings (Ticker: UVE)
Look at the chart. For it to be 100X in your portfolio, you had to buy it between 2000 and 2005 and then at least hold on to it until 2016 while NOT selling through the great financial crisis.
The 50
Let’s use Greenblatt’s Magic Formula and look at the top 5 companies that the screener generates.
As a reminder, Greenblatt tries to keep things simple:
What is the price I pay? Earnings yield: EBIT/EV
What am I earning? Return on invested capital: EBIT/CAPITAL
In theory, it’s easy: Buy high quality at a low price. If we put it like that, it’s exactly what Terry Smith is doing! But you’d need to get lucky, as high quality in an efficient market should be priced in.
Here are 5 companies from the list (I’ve excluded those outside of my circle of competence). You can use his screener for free.
Altra Group (Ticker: MO) owns the Marlboro brand. They sell all kinds of smoking products. ROIC of 20%. Free cash flow machine. Limited reinvestment potential.
AMC Networks (Ticker: AMCX) video entertainment company is in a significant downturn. I would not go near this one except if you can see hidden inflection points.
Betterware de México (Ticker: BWMX) is a Mexican direct-to-consumer company with a focus on home organization products. It was a 5-bagger during COVID, but then it all came crashing down. Its financials seem to have normalized. But retail is always difficult.
The Buckle (Ticker: BKE) is another retailer focusing on casual apparel. Trading at a 10% FCF yield but growth is slowing.
Cerence (Ticker: CRNC) has crashed from a high of 120 USD at COVID peak to now 3 USD. it provides AI-powered virtual assistants. Growth has come down a lot. ROIC has started to increase towards 6%. But how defensible can a business that provides virtual assistants be?
You can download the full list of the 50 companies here: ⬇️
Keep in mind, that our goal is to forecast the future. Earnings yield and ROIC should be estimated based on future earnings. That’s the big challenge for us as investors, to predict what next year's normalized earnings will look like.
Terry’s holdings
Terry Smith’s top 5 holdings in Fundsmith are the following:
Just to emphasize at what price he first bought some of them:
Microsoft was trading at a P/E of 15 (now 34!)
Meta was trading at a P/E of 16 (now 27)
When he says:
Buy great companies
Don’t overpay
Do nothing
He means it. Be careful with the price you pay as a quality investor…
So, what do you think? Does this Yin-Yang investing make any sense?
May the markets be with you, always!
Kevin
Further reading
The best lessons from Terry Smith
The greatest investments by Joel Greenblatt
The hardest thing with quality is that it rarely trades at reasonable price. In the meanwhile, you have to search for special situations and more hidden micro/small/mid caps. I prefer to keep some cash in case a big opportunity to buy quality comes.
thx