Every serious investor knows this idea that one good investment (read multi bagger) can cover for many losers in the portfolio.
The question then is: how does one find such stocks?
The famous mathematician advised us to “invert, always invert” to solve a problem. I would like to do a little inversion for our problem here.
What won’t compound many times in a short period?
The first easy answer would be a company with a large market cap. You will ask what on earth a market cap is? It’s simply the valuation of a company based on its share price.
A company with a market cap of $1 trillion can not compound ten times in a short period of time. It’s just not possible mathematically.
If you are looking for a multi bagger, your chance will improve dramatically if you look at a stock pool of low-market caps.
The second thing to look at is their revenue growth and earnings growth. If a company’s earnings are not growing, it will be difficult for the stock price to increase. The simple fact is that the stock price follows a company’s earnings. If a company’s earnings are not growing, it will be difficult for you to compound your money. It’s as simple as that.
What else won’t compound many times? Let’s understand the next concept through an example.
You own a lemonade stand and you want to grow it ten times in, say, five years. You will need to open new lemonade stands in new areas to grow. Now, every time you are opening a new lemonade stand, if you find that you are not getting a very good return on your money, you will slow down or stop opening new lemonade stands. That gives us the key ratio — return on invested capital.
If a company has a low return on invested capital, growth through expansion won’t be easy. So what you are looking for is a company with a high ROIC. Now what is a high ROIC? I will let you all figure that out yourself.
What else won’t compound many times? If a stock is already selling at, say, p/e 50, you are in a bad position from a valuation standpoint because, at maximum, your stock price will grow at the rate of earnings per share (eps) to keep the valuation p/e. You want to start with a low p/e position so that if your eps grows five times, your p/e has room to grow, say six times.
Last, what else will slow down your growth? The answer is if it’s easy to enter your field. In the business world, we call this barriers to entry. Back to our lemonade shop example, if it’s easy to open a lemonade stand like yours, sooner or later, someone will open next to your stand, and your growth will stop, so you want to buy the stock of a company that has big barrier to entry.
For example, if someone wants to open a new Facebook, it will be very difficult because the new Facebook will need to have ~3B subscribers; otherwise, who would sign up for a social media company their friends are not there? Facebook is fun because your friends and family are there and posting cat pictures.
So to recap, you want to look for a small-cap stock that is consistently growing, selling at a low valuation, and that industry has a big barrier to entry. You will say now that that is so difficult. Who said that investing would be easy?
Thank you for reading!
I hope you liked the article, and if you did, feel free to leave a comment. You can also give a clap for motivation (yes, you can clap multiple times).
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