Definition: Coined by Peter Lynch in his book “One Up on Wall Street”, a bagger is used to describe any investment that appreciates or potential to increase one-fold.

Introduction

When I started investing, I have not thought about earning high returns. The best return that I conceived was about 100% ~ 300% or 1 – 3 baggers in any stock over a long run. A book recommendation by my colleague led me to discover this book called “100 Baggers: Stocks That Return 100-to-1 and How to Find Them”. Special credits to Chris Mayer for writing this book!

Here are some 100 bagger businesses that blew my mind:

Take, for example, if I were to buy Monster Beverage Corporation at $0.26 in the early summers of 2002, and held it up to today. What would be my return?

US$136.32 / US$0.26 = a stunning 525x bagger!

Are these isolated company case studies? Definitely no. The book produced 365 of such companies, but here are just a few more I wish to mention:

There are several more with the likes of Qualcomm, Vector Group Ltd, Southwest Airlines, Newmarket Corp, Wal-Mart Stores, Altria Group, and Kansas City Southern.

Alchemy of 100-baggers

Ultimately, I want to discover for myself what is the alchemy of such super stocks. The book shared four ingredients:

1. The most powerful stock moves tended to be during extended periods of growing earnings accompanied by an expansion of the P/E ratio.
2. These periods of P/E expansion often seem to coincide with periods of accelerating earnings growth.
3. Some of the most attractive opportunities occur in the beat-down, forgotten stocks, which perhaps after years of losses are returning to profitability.
4. During such periods of rapid share price appreciation, stock prices can each lofty P/E ratios. This shouldn’t necessarily deter one from continuing to hold the stock.

To illustrate:

Think about that. Earnings went up 25-fold, but thanks to the market putting a bigger multiple on those earnings, the stock went up 125-fold. It relates back to point 1. The book calls it the “twin engines”.

Is that so simple? Here are more ingredients (SQGLP):

• S – Size is small (acorns seed start small, but wind up as oak trees)
• Q – Quality is high for both business and management
• G – Growth in earnings is
• L – Longevity in both Q and G
• P – Price is favourable for good

The size is extremely important because when a business is too big, the laws of large number actually works against it. Also, I have to envision for myself whether the market size is big enough for my businesses to expand in a meaningful way.

As of 1 November 2015, Apple Inc’s market capitalization is around 666 billion. As good as Apple is, it won’t become a 100-bagger from the current levels. A hundredfold return would take it to $66billion. That is almost close to four times of the size of the United States of America economy.

In summary, it comes down to growth, growth and more growth. I do not want any growth but value- added and quality growth. It means growth in sales and earnings per share. When the growth happens, along with a re- rating of the P/E, I will really get some great lift in the valuations.

Importance of High Return-on-Equity Businesses

To start off, I need to look for businesses that are able to sustain its high ROE for a long, long time. To put it simply, a 15 per cent ROE means the business doubles in 5 years and quadruples in 10. In 20 years, the business is 14 times larger than it was at the start.

At this pace of growth, Mr. Market is likely to reward and re-appraise the share price of the business.

An important for all investors to grasp is… reinvestment risk.

[Year 1] If I have a business with $100 million in equity, and I make a $20 million profit. That is 20% ROE.

[Year 2] If the business is too big or there are no reinvestment opportunities to grow its market, it will take the $20mil profit in Year 1 and place it in the bank to earn 2% per cent interest. The rest of the business will continue to generate $20mil in profit.

Due to that, the 20% per cent ROE (year 1) will come down to about 17% in the second year, then 15% in the third year as the cash earning a 2 percent return blends in with the business that earns a 20% return.

If there are no reinvestment opportunities, the cash will pile up and the company pay start paying more dividends. This is a sign that the best growth years of a company is likely over.

When I notice a business maintained its ROE of 20% year after year, this means the management is taking the profit at the end of the year and recycling it back into the business to grow. The magic of compounding will then work its magic and shareholders will be rewarded in a big way.

The key is we would like to see longevity in the company’s growth. This comes when they are operating in growing industry or it is gaining more market share in a stagnant industry. This is more likely to happen for high-quality companies, the growth is more structural as opposed to cyclical.

In summary, it is important to have a company that can reinvest its profit at a high rate for a long time.

Owner-Operator Preference

(Figure 1)

When I invest in businesses, it is not enough to dive into the numbers. I need to focus that investing in the business eventually means it is a proxy to “invest” in the people who are running the businesses. They are as important as the numbers.

Peter Doyle from Horizon Kinetics shared “Owner-operators, over an extended period of time, tend to outpace the broad stock market by a wide margin.” How come?

For founders of several businesses such as Sam Walton of Walmart, Warren Buffett of Berkshire Hataway, Bill Gates of Microsoft, their wealth is not created through extravagant compensation packages such as bonuses or salary increases. Rather, their wealth is created, sustained through share price appreciation over the long-term. These founders run their businesses markedly different from hired CEOs because their wealth is being at risk all the time.

By this simple fact, as shown in Figure 1, these founders focus on building long-term business value. It is also comforting to know that the founders have enormous skin in the game, and very likely, be aligned with me.

Acquisitions are carefully scrutinized and purchased at a distressed price for value-add to the company, as opposed to value-destroying acquisitions practised by some hired managers.

Patience; Don’t Get Bored

Most of us, including myself, sabotage ourselves because we are simply impatient and desire instant gratification. In our pursuit of fast returns, we lose our investing compass and get burnt during the process. I remember losing $2,000 because I was bored and impatient.

Don’t we recognize, occasionally, we have a drama hook that creates the urgency or the need for “action”, or the powerful feeling that we need to do “something”. If all is good, there is absolutely no need for you to sell your stocks. Even trees need time to grow, so don’t sell them off too early.

Why do people buy and sell stocks so frequently? Why can’t they just buy a stock and hold it for at least a couple of years? People often do dumb things with their portfolio just because they are bored.

If you know you have a good business, find ways to fight your boredom and not take it out on your portfolio, your returns will benefit.

 All men’s miseries derive from not being able to sit in a quiet room alone

– Pascal

Conclusion

To accelerate the goal of a bagger, we need to identify:

• The market size where the business operates: for example, it is impossible for Singapore Press Holdings (SPH) to grow the size of Singapore’s economy. Eventually, the growth rate of SPH will slow down. Walmart, McDonald’s, Hartalega, Major Cineplex operate in big markets. Not just domestic markets but international markets. Find a company that operates in a big market where they do not have a huge market share yet.
• Consistent high ROE: this relates back to the market size because the company MUST be able to reinvest their profits at the same profitability or not, better. When the market size is small, the company will find it increasingly harder to achieve similar ROEs.
• Owner-Preference: we want owner-operators that focus on building long-term shareholder

Reference:

Mayer, C. (2015. 100 Baggers: Stock That Return 100-to-1 and How to Find Them. Laissez Faire Book.

The Horizon Kinetics ISE Wealth Indexes. (n.d.). http://wealth-index.com/wp- content/uploads/2014/06/Horizon-Kinetics-Wealth-Indexes-At-A-Glance-20140331_Added-Intl-Global- Asia-FINAL.pdf. Retrieved November 1, 2015.