Hunting For Super Stocks? This Is What You Need To Know.

IMPORTANT: Please read the disclaimer before continuing.

As a young analyst back then, I was intrigued by how great investors like Warren Buffett or Peter Lynch generated long-term portfolio returns. To be clear, they generated their returns by investing in good businesses and not trading the stock market. 

I read several investment books, listened to hundreds of investing videos, and spent time interacting with other investors. This discovery process did not yield any new conclusions. It’s always has been about profitable companies that can demonstrate persistent growth of at least 20% in their revenue and profits. 

In recent times, what has changed is investors’ appetite for loss-making companies. It’s not difficult to understand why. These companies are intentionally loss-making in order to pursue growth.

Here is an example using Cloudflare:

Assuming that 50% of the $92.2m marketing expenses is for growth purposes, it would account for $48.1m. If we add this $48.1m back to its loss from operations, Cloudflare would be profitable.

This is where some exceptions can be made as long as investors see a clear path to profitability for their loss-making companies.  

Another factor is the price multiples. For example, during a normal market, companies could be valued as high as 20x of their earnings. During a bear market, the opposite happens. The price multiples could shrink quickly and companies could be valued as low as 15x of their earnings. 

When a company is growing continuously, it is the price multiples that cause a wide swing in its share price. Unfortunately, we cannot control the market sentiments and correspondingly, the price multiples of companies. 

To keep our job as investors simple, we should pick companies that have a long runway for continuous growth. In the long run, the growth of revenue and profits is able to offset the negative effects of a shrinking price multiple. To understand more about this relationship between earnings and price multiples, check out my previous article here.

It’s more productive to spend time understanding businesses instead of predicting the direction of the market.   

Then, a thought occured to me: “Is it true a company needs to grow its revenue by more than 20% in order to be a multi-bagger?”

You may wonder, what’s a multi-bagger? It’s a term coined by Peter Lynch to describe companies whose share prices returned multiples of its initial value.

Now, let’s come back to what we were discussing. 

I went to test my hypothesis using Capital IQ, a financial data provider service. I screened companies that delivered huge returns of more than 200% in the past 3 years. Looking through the list, I have the usual growth companies and a few other interesting companies.

A company called Dillard’s doubled its operating profit without any revenue growth. It did that by driving operational efficiencies, resulting in higher profit margins. This means that they are more profitable on every sale today compared to the past. We also have IDT Corporation that announced spinning off one of its subsidiaries called Net2Phone. 

This is their performance benchmarked against S&P 500: 

While they have outperformed by a wide margin, their returns are likely not repeatable. There is a limit to how much Dillard’s can expand its operating profit margin. Similarly, IDT Corporation cannot spin off a company every year. It’s not feasible. 

This brings back my conviction that growth in sales and profitability are still two important factors contributing to a sustainable share price performance.

The research done by Morgan Stanley research also revealed the same conclusion. In the long term, revenue growth and profitability are the main factors for returns.

In order to prepare this article, I started tinkering with my Capital IQ again. I applied a stricter screening process by choosing companies that went up by 10 times in the past 5 years. 

Here are the results:

Apart from Ameresco and SolarEdge, the rest of the companies exhibit huge revenue growth for the past 2 years. In terms of operating profit growth, Tesla is the standout.

It’s noteworthy to mention the majority of outperformers come from sectors such as Consumer Discretionary and Information Technology. It could be a good hunting ground for future multi-baggers.

Now, the conclusion is as clear as daylight now. 

Without any revenue growth or profit growth, it’s difficult for a company to experience rapid growth in its share price. 

This is why my entire investment portfolio is geared toward Super Stocks. It’s a term I use to describe young, innovative, disruptive companies with a long runway for growth.

Through my blog and Telegram, I hope to inspire a way forward to generate superior returns for your portfolio.

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