Small caps specialist Keith McLachlan: Secrets to spotting a ten-bagger

Small cap stocks have a bad reputation synonymous with a roller coaster performance journey. Those of us who were alive in the late 90’s will remember the havoc they wreaked on investment portfolios back then. But as Keith Mclachlan, fund manager at AlphaWealth explains, if you want to uncover a ten bagger you can’t go with large, staid and solid companies because there isn’t much room for growth. Read on for a step by step guide to uncover a share that could rise by 1000%! – CP

By Keith McLachlan, fund manager, AlphaWealth

Johannesburg, 15 October 2014: A ‘ten bagger’ is colloquial for a share price that rises a thousand percent or, in other words, makes you ten times your money. In some ways the Holy Grail of investments, the key consideration is how do you go about finding a ten bagger?

Firstly, you are never going to have a ten bagger if you sell your investment as soon as you are up 10%, 20% or even 100%. The moment you exit the investment, you have given up the future upside of 990%, 980% or 900% respectively…

In other words, you have got to be invested into the position for a much longer time frame to enjoy the benefits of what is likely to a multi-year run on a company’s share price driven by both growing profits and a re-rating in its valuation multiples (e.g. a price earnings re-rating upwards).

So what are the attributes of a ten bagger?

The theory is simple: you are looking for shares in an undervalued, fast growing company. The more undervalued the shares are and the faster growing the company is, the better the investment probably is and the higher the odds are that the investment will achieve ten bagger status.

Sound simple? Well it is. But the complexity lies not in the theory, but in its execution.

It means that you are selecting shares fundamentally. You have to approach the market in a bottom-up manner, involving many  hours of research on each and every stock with no guarantee that there are any ten baggers out there (sometimes, unfortunately, there is simply nothing worth investing in). You are then building detailed forecasts, complex valuation models and after all this work is done, you are still subject to market and asset-specific risk as you wait patiently for your investment to play out.

And, at the end of the day, you can still be wrong.

That said here are some key attributes to consider when trying find a ten bagger:

• Good business, good investment, good odds of a ten bagger: In essence, a ten bagger is just a great investment into the equity of a great business. In the long-term, the better a business, the better the investment into its equity is likely to be. Thus, look for strong underlying fundamentals to the business, for example, profitability, cash generation, optimal debt levels, strong management, high barriers to entry, excellent competitive advantage, blue sky growth potential, and so on. This is not rocket science, but common sense research done thoroughly.
• Valuation: You make your returns on an investment when you buy. If you pay too much for a share, no matter how well the underlying business performs, you are unlikely to generate a fantastic return on your capital. Despite all their wonderful fundamentals, the early stage of a ten bagger investment tends to be one that is relatively ignored and unknown by the market. Hence, you can invest in the potential ten bagger share at a price earnings (PE) of, say, 5.0x that over the matter of five years when the profits have grown at 30% y/y and the share has re-rated to a PE of 15.0x will generate a price return of 1014%! (See table below) This is a Cumulative Average Growth Rate (CAGR) of 62% per annum with c.30% being attributable to growing profits and c.30% attributable to the market re-rating the share’s valuation. Hence, you made 30% per annum choosing the right business to invest in and you made 30% per annum by not overpaying for that business upfront.

Table : Ten Bagger example

• The base effect: The larger a company becomes, the slower a company tends to grow. This generalisation is simple to understand – in a closed economy, a company can never logically grow larger than the economy, thus as it gets bigger and bigger, its grow rate slows down until it eventually just tracks the growth rate of the economy. As ten baggers are predominantly built on growth stories, this implies that ten bagger are likely to be found in the early stages of a company’s life. In the listed environment, this means that a ten bagger will most likely be found amidst the small cap stocks.

Theory always sounds great, but the devil is in the execution. Most investors simply do not have the time, resources and, arguably, patience necessary to find, invest in and benefit from potential ten baggers.

So how do you go about getting exposure to potential ten baggers? You need to look to the experts.

We are in the process of launching a domestic small cap fund at AlphaWealth. As mentioned above, one of the key attributes of a ten bagger is that you have to find them early in their investment cycle when they are probably a small cap stock. While it is highly unlikely that every single stock we invest in within this soon-to-be-launched fund will be a ten bagger, we have a razor sharp focus on bottom-up stock selection that we believe raises our chances in selecting any potential ten baggers in this investment universe and, ultimately, generate superior long-term returns for all our investors.