How to find the next 10-bagger

It’s every investor’s dream to find a stock that doesn’t just double your money – or even triple it – but increases your investment 10-fold. It may take decades or just a few months depending on the situation, but there are plenty of examples on the ASX Flight Centre (FLT:ASX), Cochlear (COH:ASX), ARB Corp (ARB:ASX), REA Group (REA:ASX), CSL (CSL:ASX), and Ramsay Health Care (RHC:ASX) to name just a few.

What do these corporate rocket ships have in common, and is it possible to identify them ahead of time?

Quality

The companies above all have one thing going for them: they’re high-quality businesses. What we mean by ‘high quality’ is that they have good management, usually little debt, and lots of earnings power. Most importantly, though, they have sustainable advantages that insulate them from competition – things like economies of scale, strong brands, government licences, and patented technology.

High-quality companies tend to give pleasant surprises rather than disappoint, and it’s worth allowing them more leeway as their share prices rise. Just as you might bag a profit in a low-quality stock at the first opportunity, with high-quality businesses, it’s worth trying to cling on – high-quality companies tend to find new, creative ways to deploy their capital and can earn good returns over the long haul.

Ironically, ultra-low quality stocks might also be fertile waters to hook your next 10-bagger, but only under certain conditions, which we’ll get to in a moment.

Time

“The biggest thing about making money is time,” Warren Buffett, the billionaire American sharemarket investor and CEO of Berkshire Hathaway, has said. “You don't have to be particularly smart, you just have to be patient.” 

Sydney Airport (SYD:ASX) is a reminder that patience pays. We liked the stock from the get-go, making our initial upgrade all the way back in 2002 when it first listed at $1.00. We’ve held on ever since. The stock has risen seven-fold over that time, and returned more than 10 times the initial purchase price including dividends.

But Sydney Airport is really a lesson in grit – investors endured four 20% falls and one 60% plunge on the way to that return. Most 10-baggers don’t happen overnight and there will probably be speed bumps along the way; you need to sit on your hands, particularly if you own a high-quality stock, and just let them run.

Value

For most investors, targeting high-quality stocks and holding them for the long term is the surest way to land a 10-bagger. As always, though, buying with a margin of safety is key; even the best companies will turn into lousy investments if you pay too much for them.

So far, we’ve only talked about high-quality companies. But if you filter for all the stocks on the ASX that have 10-bagged, you’ll find they tend to fall into one of two camps high-quality stocks, held for the long term; but also low-quality stocks that were significantly undervalued at some point, such as NRW Holdings (NRW:ASX), Ausdrill (ASL:ASX) and Reverse Corp (REF:ASX).

To be clear, we’re not talking about run-of-the-mill undervaluation – to turn a poor company into a phenomenal investment, you need to purchase the stock when it’s ridiculously, obscenely cheap. Reverse Corp, for example, went up 15-fold between April 2013 and April 2014, but it started that period with a total market cap that was less than its cash in the bank minus its total liabilities (a so called ‘net net’). The company had plenty of problems, but investors were essentially buying a dollar for 30 cents.

If you’re going to try this method, be prepared for a lot of bad news, volatility, and your fair share of bankruptcies. To buy things this cheap, the company’s collapse usually seems imminent. For this reason – and even if they’re purchased with a large margin of safety – all your high-risk speculative stock positions combined should only make up less than 10% of your overall equities portfolio. Failure is the norm.

All the careful analysis in the world won’t guarantee you’ll find the next 10-bagger and, even if you do, you’re likely to reduce your holding as the stock rises so that it doesn’t become an unsafe portfolio weighting. Nonetheless, if you own a collection of high-quality businesses, bought when they were undervalued, and hold them for the long term, your brokerage statement should eventually show plenty of green.

To unlock more share research and buy recommendations from InvestSMART, take out a 15-day free membership.