The next 10-bagger

Buy­ing high-qual­ity com­pa­nies, and hold­ing them for the long term, is the surest way to hit the jack­pot

Money Magazine Australia - - CONTENTS - GRA­HAM WIT­COMB Gra­ham Wit­comb is an an­a­lyst at In­tel­li­gent In­vestor, owned by In­vestS­mart Group. This ar­ti­cle con­tains gen­eral in­vest­ment ad­vice only (un­der AFSL 282288). To un­lock In­tel­li­gent In­vestor stock re­search and buy rec­om­men­da­tions, take out a 1

It’s every in­vestor’s dream: to find a stock that doesn’t just dou­ble your money – or even triple it – but in­creases your in­vest­ment ten­fold. It may take decades or just a few months depend­ing on the sit­u­a­tion, but there are plenty of ex­am­ples on the stock­mar­ket: Flight Cen­tre (ASX: FLT), Cochlear (COH), ARB Corp (ARB), REA Group (REA), CSL (CSL) and Ram­say Health Care (RHC) to name just a few.

What do these cor­po­rate rocket ships have in com­mon, and is it pos­si­ble to iden­tify them ahead of time?

Qual­ity counts

The com­pa­nies above all have one thing go­ing for them: they’re high-qual­ity busi­nesses. What we mean by high qual­ity is that they have good man­age­ment, usu­ally lit­tle debt and lots of earn­ing power. Most im­por­tantly, though, they have sus­tain­able ad­van­tages which in­su­late them from com­pe­ti­tion – things such as economies of scale, strong brands, govern­ment li­cences and patented tech­nol­ogy.

High-qual­ity com­pa­nies tend to give pleas­ant sur­prises rather than dis­ap­point, and it’s worth al­low­ing them more lee­way as their share prices rise. Just as you might bag a profit in a low-qual­ity stock at the first op­por­tu­nity, with high-qual­ity busi­nesses it’s worth try­ing to cling on – high-qual­ity com­pa­nies tend to find new, cre­ative ways to de­ploy their cap­i­tal and can earn good re­turns over the long haul.

Iron­i­cally, ul­tra-low qual­ity stocks might also be fer­tile wa­ters to hook your next 10-bagger but only un­der cer­tain con­di­tions, which we’ll get to in a mo­ment.

Time is money

“The big­gest thing about mak­ing money is time,” War­ren Buf­fett has said. “You don’t have to be par­tic­u­larly smart, you just have to be pa­tient.”

Sydney Air­port (SYD) is a re­minder that pa­tience pays. We liked the stock from the get-go, mak­ing our ini­tial up­grade all the way back in 2002 when it first listed at $1. We’ve held on ever since. The stock has risen sev­en­fold since then, to just un­der $7.50 at the time of writ­ing, and re­turned more than 10 times the ini­tial pur­chase price in­clud­ing div­i­dends.

But Sydney Air­port is re­ally a les­son in grit – in­vestors en­dured four 20% falls and one 60% plunge on the way to that re­turn. Most 10-bag­gers don’t hap­pen overnight and there will prob­a­bly be speed bumps along the way; you need to sit on your hands, par­tic­u­larly if you own a high-qual­ity stock, and just let them run.

Value of a dif­fer­ent kind

For most in­vestors, tar­get­ing high-qual­ity stocks and hold­ing them for the long term is the surest way to land a 10-bagger. As al­ways, though, buy­ing with a mar­gin of safety is key; even the best com­pa­nies will turn into lousy in­vest­ments if you pay too much for them.

So far, we’ve only talked about high-qual­ity com­pa­nies. But if you fil­ter for all the stocks on the ASX that have 10-bagged, you’ll find they tend to fall into one of two camps: high-qual­ity stocks held for the long term but also low-qual­ity stocks that were sig­nif­i­cantly un­der­val­ued at some point, such as NRW Hold­ings (NRW), Aus­drill (ASL) and Re­verse Corp (REF).

To be clear, we’re not talk­ing about run-of-the-mill un­der­val­u­a­tion – to turn a poor com­pany into a phe­nom­e­nal in­vest­ment, you need to pur­chase the stock when it’s ridicu­lously, ob­scenely cheap. Re­verse Corp, for ex­am­ple, went up 15-fold be­tween April 2013 and April 2014, but it started that pe­riod with a to­tal mar­ket cap that was less than its cash in the bank mi­nus its to­tal li­a­bil­i­ties (a so-called “net net”). It had plenty of prob­lems but in­vestors were essen­tially buy­ing a dol­lar for 30¢.

If you’re go­ing to try this method, be pre­pared for a lot of bad news, volatil­ity and your fair share of bank­rupt­cies. To buy things this cheap, the com­pany’s col­lapse usu­ally seems im­mi­nent. For this rea­son, high-risk spec­u­la­tive stocks – even when pur­chased with a large mar­gin of safety – should only ever make up less than 10% of your port­fo­lio. Fail­ure is the norm.

All the care­ful anal­y­sis in the world won’t guar­an­tee you’ll find the next 10-bagger, and even if you do you’re likely to re­duce your hold­ing as the stock rises so that it doesn’t be­come an un­safe port­fo­lio weight­ing.

None­the­less, if you own a col­lec­tion of high-qual­ity busi­nesses, bought when they were un­der­val­ued, and hold them for the long term, your bro­ker­age state­ment should even­tu­ally show plenty of green.

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