Justin’s note: Today’s essay comes from our good friend and colleague Chris Mayer.
If you’ve never heard of Chris, he’s one of the best value investors on the planet. His proprietary investment strategy outperformed not only the S&P 500, but also legendary investors like Warren Buffett, Carl Icahn, John Paulson, and David Einhorn for 10 years straight.
In short, when he offers advice, we listen. Below, Chris reveals the three signs he looks for when searching for 100-baggers (stocks that return 100-to-1), even when the broad market is overvalued like it is today…
By Chris Mayer, editor, Chris Mayer’s Focus
There’s one question I get from readers over and over again…
Why invest in stocks if the world is going to pot?
I’m going to cite one piece of remarkable evidence I uncovered in my own massive study of the stock market’s biggest winners.
I call these winners “100-baggers” (stocks that returned 100-to-1). And after spending three years and $138,000 to investigate them, I discovered they all have certain aspects in common.
I’ll tell you about those attributes in a moment. For now, let’s agree that there is plenty to worry about. And the stock market is not cheap.
The S&P 500’s CAPE ratio (a stock valuation measure designed to smooth out earnings volatility) has only been this high one other time in the last century—right before the dot-com crash of 2000. That means many stocks are expensive.
But just because a stock market index like the S&P is pricey doesn’t mean there aren’t good values out there. Unless you are a buyer of the index itself, it is not relevant to the business of finding great stocks today.
Let me give you a historical example: 1966 to 1982.
This 17-year stretch was dead money for stocks—or what so many people would have you believe. The Dow Jones Industrial Average basically went nowhere. And if you factor in the period’s high inflation, the performance was even worse. Thus, you might conclude you didn’t want to be in stocks.
But here’s what my research on 100-baggers found: There were 187 stocks you could’ve bought between 1966 and 1982 that would have multiplied your money 100 times.
In fact, during that 17-year stretch, you’d have had at least a dozen opportunities each month to multiply your money 100x if you just held on.
In some cases, you didn’t even have to wait very long. Southwest Airlines returned more than 100 times in about 10 years beginning in 1971. Leslie Wexner’s L Brands (owner of Victoria’s Secret, among other retail properties) did it in about eight years starting in 1978. In 1966, you could’ve bought H&R Block and turned a $10,000 investment into $1 million in under two decades.
So, the indexes can tell you what kind of environment you are in. But they don’t predict what will happen to individual stocks.
It’s certainly harder to find great opportunities in highly priced markets. And it’s easier to find big winners at market bottoms (but perhaps not so easy as to make yourself buy them, as fear is rife at such times). These facts should surprise no one.
However, my point is simply this: Don’t fret so much with guesses as to where the stock market might go. Keep looking for those 100-baggers.
If history is any guide, they are always out there…
All 100-Baggers Have This in Common
As I mentioned above, companies such as Southwest Airlines, L Brands, and H&R Block have returned more than 100 times to investors during a period when the broader market went absolutely nowhere.
And there is something these three companies had in common:
- Southwest recorded $6 million in sales in 1972. By 1975, it did $23 million in sales. And by the end of the decade, it hit $200 million in sales.
- L Brands had sales of $210 million in 1978. It hit $1 billion in sales in 1980. By the end of the 1980s, it hit $5 billion in sales.
- H&R Block did just $14 million in sales in 1967. In 1975, it passed the $100 million mark in sales.
See a pattern here?
All three were small companies with lots of room to grow.
For larger companies, the condition of the economy can be a constraint. They depend on broad-based economic growth. It is hard for Coca-Cola or McDonald’s to grow faster than the overall economy. They’re just so big already.
It’s really just a matter of scale.
McDonald’s did about $25 billion in sales last year. So if it wants to double that number, it would need to sell an extra 5 billion Big Macs next year. Granted, this is an oversimplified example, but you get the idea.
But it’s not as hard for a small company to increase its sales by double, triple, or more.
Not all small companies become big companies, of course. But after studying over 360 100-baggers, I have a basic few clues to look for.
The ability to expand into national and/or international markets. Think about the three big winners above. You had a small tax preparer, airline, and retailer. All three started as local, or regional, businesses. And all three grew into national brands. To get those big returns, even in lousy economic environments, you need to have room to grow.
Strong returns on the capital invested in the business. If you invest $100 in a business and it generates a cash profit of $20, that’s a 20% return on equity, or ROE. You don’t need to know a lot about finance to know that is a very good return.
Well, nearly all of the stocks in my 100-bagger study were good businesses by this measure. They earned returns of 20% and above.
H&R Block, for example, earned astronomical returns on its equity—in the early days, especially. ROEs were well over 30% in most years. For L Brands, ROE was over 25% for years and years. And low-cost Southwest had—and still has—among the best economics of any airline.
Which brings me to the final—and perhaps most important—clue I’ll share with you today…
The ability to reinvest profits and earn high returns again and again and again. This one is just math. If you can earn 30% on your equity and reinvest your profits and earn 30% again… well, the dollars start to pile up real fast.
Take a look:
After 10 years, you’ll have 14 times what you started with. After about 18 years, you’ll have a 100-bagger. This is how you power through bad economic times.
Finally, there is a great Charlie Munger quote I want to share because it shows you the importance of this concept of ROE:
Over the long term, it’s hard for a stock to earn a much better return than the business which underlies it earns. If the business earns 6% on capital over 40 years and you hold it for that 40 years, you’re not going to make much different than a 6% return—even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you’ll end up with a fine result.
So there you have it. Even though the overall market looks expensive, remember that you are not buying the market. You’re buying individual stocks.
That’s why you should look for great small-cap stocks with the traits I’ve shared above.
If you find a business that can earn 25% or so on its capital over many years, what happens to the overall market won’t matter.
Editor, Chris Mayer’s Focus
P.S. Some of the world’s best investors email me ideas… But until now, I haven’t been able to share them with you.
Now, for the first time, I’m preparing to share three of these ideas from my private network… And I’m so convinced they’ll pay off for you, I’m putting $5 million on the line to prove it. Click here to learn more…
Today, a reader writes in with a question regarding our recent essay on the marijuana boom. It’s something you might even be wondering yourself…
If marijuana really becomes a big business, it will be taken over by the cigarette companies who are in the best position to market it on a large scale. It would be hard for a small company to compete with them.
Justin’s note: This reader is absolutely correct. When marijuana’s legalized at the federal level, big tobacco will go after marijuana profits. Big alcohol and big pharma will also fight for slices of the pie.
But that shouldn’t stop you from investing in marijuana. If anything, this is a reason to buy marijuana stocks now. Casey Research founder Doug Casey explained why in the October issue of The Casey Report:
My guess is that as cannabis becomes fully legal in all its forms in the years to come, that big food and drug companies will take over the leading players—at a big premium. When you’re a big company, it’s much cheaper and easier to buy expertise and production than to make all the usual—and numerous and inevitable—mistakes trying to get in at the ground floor. Someday—not far in the future—you’ll see a takeover mania in the area.
You’ll obviously want to own marijuana stocks before this “takeover mania” begins.
You can learn about the top marijuana stocks by watching this new presentation. As you’ll see, the best marijuana money-making opportunity isn’t in the United States. It’s north of the border, in Canada. To learn why, check out this free video.