Three Clues to Finding the Next 100-Bagger

I get one question from readers over and over again…
Why invest in stocks if the world is going to pot?
I'm going to cite one piece of remarkable evidence I uncovered in my own massive study of the stock market's biggest winners.
I call these winners "100-baggers" (stocks that returned 100-to-1). And after spending three years and $138,000 to investigate them, I discovered they all have certain features in common.
As for the world going to pot, let's agree that there is plenty to worry about. And the stock market is not cheap.
The S&P 500's "CAPE" ratio (a stock valuation measure designed to smooth out earnings volatility) has only been this high or higher three times in the last century – right before the crashes of 1929, 2000, and 2007. That means many stocks are expensive.
But just because a stock market index like the S&P 500 is pricey doesn't mean there aren't good values out there. Unless you're a buyer of the index itself, it is not relevant to the business of finding great stocks today.
Let me give you a historical example…
The 17-year stretch from 1966 to 1982 was dead money for stocks – or so many people would have you believe. The Dow Jones Industrial Average basically went nowhere. And if you factor in the period's high inflation, the performance was even worse. Based on this, you might think that you didn't want to be in stocks at that time.
But here's what my research on 100-baggers found: There were 187 stocks you could've bought between 1966 and 1982 that would have multiplied your money 100 times.
In fact, during that 17-year stretch, you'd have had at least a dozen opportunities each month to multiply your money 100 times if you just held on.
In some cases, you didn't even have to wait very long. Southwest Airlines (LUV) returned more than 100 times in about 10 years beginning in 1971. Leslie Wexner's L Brands (LB), owner of Victoria's Secret, did it in about eight years starting in 1978. In 1966, you could've bought H&R Block (HRB) and turned a $10,000 investment into $1 million in less than two decades.
So the indexes can tell you what kind of environment you are in. But they don't predict what will happen to individual stocks.
It's certainly harder to find great opportunities in highly priced markets. And it's easier to find big winners at market bottoms (but perhaps not so easy to make yourself buy them, as fear is rife at such times). These facts should surprise no one.
Southwest Airlines, L Brands, and H&R Block had something in common…
•   Southwest Airlines recorded $6 million in sales in 1972. By 1975, it did $23 million in sales. And by the end of the decade, it hit $200 million in sales.
•   L Brands had sales of $210 million in 1978. It hit $1 billion in sales in 1980. By the end of the 1980s, it hit $5 billion in sales.
•   H&R Block did just $14 million in sales in 1967. In 1975, it passed the $100 million mark in sales.
See the pattern here?
All three were small companies with lots of room to grow.
For larger companies, the condition of the economy can be a constraint. They depend on broad-based economic growth. It is hard for Coca-Cola (KO) or McDonald's (MCD) to grow faster than the overall economy because they're already so big.
It's really just a matter of scale.
McDonald's did about $25 billion in sales in 2015. To double that number, it would have needed to sell an extra 5 billion Big Macs the next year. Granted, this is an oversimplified example, but you get the idea.
But it's not as hard for a small company to increase its sales by double, triple, or more.
Not all small companies become big companies, of course. But after studying more than 360 companies that have become 100-baggers, I have a few basic clues to look for…
1.   The ability to expand into national and/or international markets.
Think about the three big winners above. You had a small tax preparer, an airline, and a retailer. All three started as local, or regional, businesses. And all three grew into national brands. To get those big returns, even in lousy economic environments, you need to have room to grow.
2.   Strong returns on the capital invested in the business.
If you invest $100 in a business and it generates a cash profit of $20, that's a 20% return on equity, or "ROE." You don't need to know a lot about finance to know that is a very good return.
Nearly all of the stocks in my 100-bagger study were good businesses by this measure. They earned returns of 20% or more.
H&R Block, for example, earned astronomical returns on its equity – especially in the early days. Its ROE was more than 30% in most years. For L Brands, ROE was over 25% for years and years. And low-cost Southwest Airlines had – and still has – among the best economics of any airline.
Which brings me to the final – and perhaps most important – clue I'll share with you today…
3.   The ability to reinvest profits and earn high returns again and again.
This one is just math. If you can earn 30% on your equity and reinvest your profits and earn 30% again… well, the dollars start to pile up really fast.
Year 1
Year 5
Year 10
Year 20
After 10 years, you'll have 14 times what you started with. After about 18 years, you'll have a 100-bagger. This is how you power through bad economic times.
Finally, there is a great Charlie Munger quote I want to share because it shows the importance of this concept of ROE…
Over the long term, it's hard for a stock to earn a much better return than the business which underlies it earns. If the business earns 6% on capital over 40 years and you hold it for that 40 years, you're not going to make much different than a 6% return – even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you'll end up with a fine result…
So there you have it. Even though the overall market looks expensive, remember that you are not buying the market. You're buying individual stocks.
That's why you should look for great small-cap stocks with the traits I've shared above.
If you find a business that can earn 25% or so on its capital over many years, what happens to the overall market won't matter.

Chris Mayer

Editor's note: Chris is looking for investors to join him in the search for 100-baggers. In his newest investment advisory, Chris Mayer's Focus, he's building a concentrated portfolio of small companies with the potential to become the next Apple – the kind of companies that can fund your retirement with just one win. To get started, click here.

Source: DailyWealth

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