How to hunt for 100-baggers, an investment check-list

Buying great companies

One of my favorite books on investing is 100-baggers by Christopher Mayer. The idea of finding them is of course exciting, but most importantly, there are lessons in there that can help our investment strategy.

Every investor should have an investment checklist and more importantly, stick to it (which is not easy).

We’re bombarded every day with multiple ideas and “the next best thing”. It’s essential to be able to say NO to almost all of them until you come across one that deserves your YES. I think a checklist is highly personal. The list needs to suit your temperament and investment philosophy.

Let’s take a look at the checklist based on this great book and add some additional insights based on my own experiences.

Short Summary of 100-baggers

100-baggers is based on an older book named 100 to 1 in the stock market. “A Distinguished Security Analyst Tells How to Make More of Your Investment Opportunities” by Thomas William Phelps. I like the title of this old book.

The “Distinguished” gives it some flair.

Both authors use a dataset to do their analysis:

• 100 to 1: 1932 to 1971 US stock market

• 100-baggers: 1962 to 2014 US stock market

It is not a statistical analysis because there is significant survivorship bias. The goal is to look for traits in the different companies that can explain why they outperformed the market.

The main lesson from both books is this:

• Buy right

• Hold on (longer than you think)

That’s probably the shortest summary ever of an investing book!

How to buy right will be discussed further when we look at the 100-bagger investment checklist.

Holding on refers to the power of compounding. 

Our favorite holding period is forever (Warren Buffet)

Time in the market is more important than timing the market (Ken Fisher)

Business life cycles are shortening. Instead of holding on for 30+ years maybe you could hold on for 10-15 years. Is 10 years a long time to hold on to a stock? 

It appears it is.

The average US equity holding period has decreased significantly over the last decades.

Source: A Wealth of Common Sense

Before diving into the 100-bagger checklist, why do you need a checklist in the first place?

Why do you need an investment checklist?

You can view the market as having lots of buyers and sellers. As an investor, your edge toward a fellow investor can be described in three parts (source: Nomad Partnership letters):

1. Informational edge: You have more information or more knowledge on a specific company or business than anyone

2. Processing edge: Your process or the way you handle this information is faster or superior to what others are doing

3. Temperamental edge: You are non-emotional, make rational decisions, and know that investing is a relative game of probabilities. You stick to a clear investment strategy.

Let’s discuss these 3 traits in more detail and make the link to finding 100-baggers:

1. Maybe you work at a company and you indeed know the business better than 99% of other investors out there. This gives you an edge, but beware of company bias! If you’re retrieving information about any other company, there are a plethora of resources available. The gap between the information a retail investor has and a professional investor is closing each year.

   You could argue that professional investors have the means to use services like Capital IQ to get financial data or services like inpractise.com to do expert interviews. They can also go in the trenches, to the company, meet with the management team, and do in-depth research.

   In the end, the edge you might have versus someone else is not significant.

2. Maybe it’s the way you process the information. Maybe you developed some sort of magic formula? Putting aside algorithmic trading (the Medallion fund, a 66% CAGR by Jim Simons), if you know the language of business (accounting), and you’ve learned how to define the value of a company, you will not have a significant edge based on your process alone.

   This doesn’t mean this isn’t an important step and it requires continuous learning. There is a connection between temperament and process and it is called an investment strategy.

3. On average, investors only hold for short periods. This means on average, in the best case, they take their winnings off the table pretty quickly. The magic of compounding, the 8th world wonder,  has not taken effect yet. Because on average, prices for a company fluctuate about 50% around their mean value, your winnings are based on the movement of the market. The company itself, within a year, hasn’t changed that much. Compared to information and process, this is the main characteristic where you can gain a significant edge over most of the other investors. Time is your friend. How can you implement this 3rd part, and gain an edge? By holding on.

100-baggers talks about picking the right company, and this you do by using information and processes. Then it says to hold on for dear life. To remove emotion from the equation, an investment checklist (process) can help you hold on and let the compound do its work.

The 100-bagger investment checklist

In the following paragraphs, numerical thresholds are mentioned. These are the ones I use, it is up to you to define your own.

It’s all about growth, growth and growth

For a stock price to develop 100x, the company itself needs to be able, at the minimum, to significantly increase its sales, year over year, for a very long time. Sales growth and future sales growth potential are therefore the first yardsticks.

The company is therefore actively looking to introduce new products and services in the same market, or expand its products and services in new markets and geographies.

Ideally, the market the company is operating in is expanding. This doesn’t mean it’s impossible in a mature market, but then the company will need to take away significant market share from competitors. 

When talking about growth, it’s worth taking a look at the company life cycle:

Source: Aswath Damodaran - Business life cycle

We can define 6 stages. Looking at sales growth percentage, the highest sales growth occurs before the inflection line, meaning from the startup stage  up until somewhere within the mature growth stage. Companies in stage 1 and 2 usually are not public. This is the realm of venture capital. So is your company in stage 3 or stage 4? 

We do not distinguish value from growth. Value equals Growth!

Based on these insights, here are our thresholds:

In addition to these thresholds, we check if the company is actively pursuing growth in the future.

High gross margin preferred

Gross margins are sticky. In other words, companies that start with low gross margins will have a hard time increasing them. Those with high gross margins have more space to breathe. High gross margins are preferred, but are not an absolute necessity (Walmart is a 100-bagger and has low gross margins)

Our thresholds:

High EPS growth

Growing sales and having high margins is great, but does it translate into the bottom line? Can the company grow earnings year over year? More importantly, can it grow earnings per share? This is one of the most important factors for 100-bagger stardom.

Our thresholds:

The three criteria we just discussed are related to the performance of the company. It doesn’t talk about the efficiency of the company. We’ll take a look at two other factors, Return on Equity and Return on Invested Capital.

High Return on Equity

A high earnings growth is a great first indicator. But earnings by themselves are not useful. What is interesting is to see how earnings grow divided by the equity value of the company. If the company is delivering high ROE year over year, you have a good chance of getting high returns. 

What is a high ROE? 

It is a measure of the efficiency with which a company can generate profits from its equity financing. In relative terms, you need to look at other companies in the market. If your company has a ROE of 15%, and the others in the market only have 5%, then your ROE could be considered high.

In absolute terms, if we want to find a 100-bagger, we need to look at the compounding effect. Here are the results after 15 and 25 years, for different ROEs.

Every time I look at a table like this, I’m always amazed at how big the difference is at the end for a percentage increase. Compounding is the 8th world wonder!

If you know of a company, compounding at 30% each year, please let me know.

If I add a ROE of 20% and a 10Y sales growth of 25% in a screener, here are some of the companies that are shown in the list:

• Winnebago industries (WGO):

  • RV-motorhomes manufacturer

  • 2 billion market cap - 

  • 33% ROE

  • 23.9% 10Y sales CAGR

• Gravity Co. (GRVY):

  • Mobile game developer and publisher

  • 517 million market cap

  • 28% ROE

  • 24.4% 10Y sales CAGR

• Kelly Partners Group Holdings (KPG):

  • accounting group

  • 129 million market cap

  • 31% ROE

  • 20.8% 10Y sales CAGR

Note: The list contained a lot of energy and resources companies which is not surprising.

If a company displays a high ROE, it’s important to dive deeper and understand how it can do so.

1. The company is increasing returns for the same equity value

This is looking good. The high return on equity comes from its ability to increase returns.

2. The company is not increasing returns but the equity value is decreasing

There could be two reasons : 

• They are buying back shares. These can be a good sign IF they buy back at a cheap (or maybe fair price). If a stock is priced high, and the company is buying back, it is not a good sign of a great capital allocation strategy. Advance Auto Parts is a company that was buying back shares when the company was priced between a 17 and 21 PE. The stock has come down hard in the last year, and one might argue in hindsight if they were not buying their own shares at too high a price?

• They are increasing leverage, and thus reducing the financing part needed by equity. This is not necessarily bad but beware. Are returns increasing also? Are they taking on too much leverage? What do interest payments look like?

Here’s an example of a company A and B. They have the same returns, but different ROEs because of leverage.

Our thresholds:

Return on invested capital

Instead of just looking at the equity part, let’s look at all of the invested capital. The goal is to dive deeper into the company’s capital allocation strategy.

ROIC is calculated as NOPAT/ Average Invested Capital

NOPAT is the Net Operating Income after Tax

Invested Capital on the financing side is defined as Equity + Debt - Cash or Cash equivalents

In other words, what is the return the company is making on actual capital invested?

Our thresholds:

Sound Capital Allocation

The most important thing a CEO needs to do is find the best way to allocate capital. Most CEOs are not great capital allocators.

So what does capital allocation even mean?

Cash comes in. A choice is made to spend cash to generate more cash. Here is an overview based on a great report on capital allocation written by Michael Mauboussin from Morgan Stanley :

Cash comes into your business from:

• Its operations

• Certain assets sales (one shots)

• Issuing equity

• Taking on more debt

Cash can then be used to:

• Invest to grow by spending on CAPEX

• Use it as working capital to operate the business

• Grow by acquiring other businesses

• Invest to grow by spending on R&D

• Pay dividends to shareholders

• Buyback shares

• Repay debt

For the capital allocation strategy, it’s difficult to set thresholds, but we’ll limit ourselves to this:

In short:

• No: it has a history of badly allocating capital, it is destroying value

• Sort of: It doesn’t have a clear strategy, but at least it is not destroying value

• Good: It has a strategy and value is created

• Great: Capital allocation is a top priority for management. They actively seek to create value. They talk about their strategy. They have a history of great capital allocation

Skin in the game

Quote, show me the incentives, and I’ll show you the outcome

In order to obtain a 100-bagger, you need a long term view; It will not happen overnight.

Here’s the data used in the book for the speed at which companies arrived at 100-baggerdom out of a total of 365 companies

In other words, for most of them, you had to hold them between 15 and 45 years. That is a long time, but my guess would be that if you would redo an analysis with updated data up until now, you would see a faster rate due to the internet and technology. (If you bought Nvidia in 2013, you would have a 100-bagger in 10 years)

One of the ways to ensure a long term view is a business that is operator owned. When an owner or even better, the C-level team has skin in the game, they directly benefit from building long term value per share. You as an investor therefore have a better chance that your goals are aligned.

What about the rest of the employees? 

A lot of companies provide stock options to their employees in their benefit package. This can add some dilution to the value, but if it allows to align interests, this dilution should be offset by long term value per share gains.

So let us come up with some categories:

• None : There is no skin in the game, employees receive short term bonuses or nothing at all

• Sort of: There is skin in the game but there are no known incentives used for the rest of the company

• Yes: There is skin in the game and actions are taken to align the company

• Holy S&: There is significant skin in the game and a compensation system is put in place that benefits the long term versus the short term

High long-term MOAT

Can you describe its competitive advantages? Do they have some sort of advantage they can easily defend in the long term? This category is related to the ROIC value. Both are linked together. A company with a MOAT can generate high returns on invested capital for a longer time.

• None: The company has no apparent moat. Entry into the market is easy. They could be disrupted in the short term. 

• Sort of: They may have a MOAT but it may not be long-term. It could protect them in the following years, but not for a decade.

• Yes: They have a clear competitive advantage which will hold for the coming years. It is difficult to see beyond 10 years, but they are okay for the next decade. They have monopolistic tendencies.

• Holy S&: The company has a very strong MOAT and it is hard to see how anyone will be able to compete. As a result, they have a sort of monopolistic or oligopolistic position in the market

Decentralized organization preferred

Decentralized organizations have more autonomous teams, faster decision making and overall are usually more efficient. 

I’m going to expand this a little bit and talk about a great or unique work culture in addition to a decentralized organization.

We’ll then divide the categories as follows:

• To avoid: There are reports of a toxic work culture

• OK: Nothing special, just like most of the other companies

• Unique: There is something specific to the culture that helps the business

• Cult-like: Some examples show a cult-like behavior that has a big impact on business outcome

A company that comes to mind that is high-performing and has a cult-like culture is Adyen. Sadly it’s always expensive.

Buy Cheap

Your entry price into an investment is the most important thing of all decisions you need to make. And price does not equal value.

The value of the company is the discounted value of the expected future cash flows. We could construct a simple or complex DCF. You can compare pricing in the market to its peers to get a relative cheapness indication.

For the checklist, let us keep it simple and use the PE and PEG ratios because these are the most widely used. 

Christophe Mayer talks about the twin-engine of 100-baggers. High EPS growth combined with PE multiple expansion.

When using a PE ratio, we look at the pricing in the market and it is a measure to assess relative value compared to other companies. There are two other factors to consider:

• Are you looking at trailing PE ratios or forward PE ratios?

• Is the PE ratio low, because the market is pricing it low (for some reason) or has earnings increased and pricing not followed suit (for some reason)

This is why we will combine the trailing PE ratio with the forward-looking PEG ratio. The PE ratio will let us take a look at what the market is pricing at this time. The PEG ratio will be defined by ourselves based on the growth we expect in the future.

Based on a trailing PE ratio, here’s the thresholds:

We’ll define relative cheapness as the PE ratio of the company compared to the median of peer companies in the market. 

Example: If the company has a PE of 10, and the median of a peer group is 13, then the company is 30% cheaper than the median group. Again, this on itself does not mean it is a bargain. But it’s a start.

Quality and Cheapness

Are quality and cheap not two opposites?

Imagine you find a company that displays:

• High Sales Growth

• High Gross margins

• High EPS Growth

• High Return on equity

• High Return on invested capital

• A great capital allocation strategy

• Operator Owned

• A high Long-term MOAT

Then I can bet you it won’t be cheap. 

Examples of companies that fit the above description:

• Copart

• Dino Polska

But they are both expensive. Are they 100-baggers? Maybe, but you had to buy them a long time ago. They won’t be a 100-bagger from now.

So the only way to find a quality company that is cheap is if:

1. It is underfollowed by analysts and thus unknown and mispriced by the market

2. There are short-term headwinds that have made it cheap, but there is no impact on the long-term value per share

3. you have such a deep understanding of a company and its market that may be you see future value drivers that the market hasn’t recognized yet (example: Nick Sleep describer the scale economies shares model before others did)

We therefore add another threshold to the checklist: The number of analysts following the company:

Now remember, if you can buy a high-quality company at a fair price, you’ll do just fine.

If you can buy a high-quality company at a cheap price, you may find a 100-bagger!

Buy Small, a long runway

Is Microsoft a great company? Yes. Can it become a 100-bagger from now on? Probably not. To find one, you’ll have to look for smaller companies, those that still have a long runway in front of them. Luckily, smaller companies also make out the majority of our possible investing universe.

In the dataset used in 100-baggers, the median size was a market cap of 500 million USD. But in more recent times, even some 5 billion dollar companies could become 500 billion dollar companies. Chris confirmed this in one of his blog articles.

You should look for smaller companies, ideally below a 1 billion dollar market cap. Here are our thresholds:

What is the business selling and in which market. How could it scale? If tomorrow the business does 10x or 100x revenue, how much market is it going to capture? Is it realistic?

These are some of the questions to answer to get an idea if 100-baggerdom is possible.

The final 100-bagger checklist

Conclusion

Chris mentions this is in his book, and it’s an important one. Do not dismiss the luck factor. In other words, you can buy a quality company, and you’ll do just fine but it may never become a 100-bagger. Or you could buy a company that at the time wasn’t that high quality, and became a 100-bagger anyway. Luck is a factor. 

The real value of these insights is to buy quality as cheap as possible and let the compounding do his magic.

This last part may be the most difficult one because a lot of the companies saw significant drawdowns in price during their lifetime. Will you be able to steer the ship and hold on?

Is there something you would add, or change to the checklist?

You can find the checklist here.

May the markets be with you, always.