Masters Series: How to Find the Next 100-Bagger in the Market, Part I

How to Find the Next 100-Bagger in the Market, Part I
An interview with Chris Mayer, editor, Chris Mayer's Focus

Sam Latter: Chris, you've spent a lot of time researching how to find stocks that return 100-to-1, what you call "100-baggers." What characteristics do these companies have in common?

Chris Mayer: These companies share a lot of characteristics. This one may seem obvious, but the first is that they started small. Think about McDonald's (MCD) when it had a few hundred restaurants. Or think about Southwest Airlines (LUV) when it had just a few routes coming out of Texas before it went national and eventually international and became a much, much bigger company.

But it is important to point out that these companies don't have to be tiny. I did a study of all the stocks that returned 100-to-1 from 1962 through 2014, and the median sales figure was about $170 million when they started their run. So these are substantial businesses. You don't have to invest in penny stocks or tiny biotech or mining stocks.

But probably the most important characteristic – the most important thing that came out of the study for me – is that these companies had the ability to earn a high return on the capital invested in the business. And they had the ability to take that return and reinvest it and earn that same high return again and again.

Let me give you a basic example. If you started a business and put $100 in it and in the first year, it gave you a profit of $20, you would say your return on investment or your return on equity was 20%. If you could take that $20 and reinvest it together with your original $100 and earn 20% again, that's where the magic starts to happen.

If you do that again and again, then the 100-bagger challenge simply becomes a math problem. If you compound 20% a year every year, you'll have a 100-bagger after 25 years.

Sam: What can you tell us about the process you use in order to find the companies that you recommend? We've heard you talk about the "CODE" test...

Chris: Yes, the CODE test is what I'm known for. It's an acronym that stands for four things...

"C" stands for cheap. We want to buy stocks when they are undervalued. The "O" stands for owner-operator. We want to invest in stocks where the people in charge have skin in the game. "D" is for disclosures. We pay attention to the public disclosures, we buy stocks that we understand, and we avoid companies with accounting red flags. And "E" stands for excellent financial condition, meaning we want to buy companies that don't have a lot of balance-sheet risk or debt.

That's the basic test. But I also apply that to the search for 100-baggers with some added wrinkles. The first thing is I cut off a lot of larger companies. We're looking at smaller companies. And again, I'm really focusing on the return on capital that I talked about before.

I'll give you one quick example of one of these elements that I think is important and underappreciated. When I did this research on 100-baggers, I paid attention to how many of these companies had a strong entrepreneur driving the company. There were a bunch. When you think of Apple (AAPL), you think of Steve Jobs. You think of Wal-Mart (WMT), you think of Sam Walton. McDonald's (MCD), it's Ray Kroc. With Amazon (AMZN), it's Jeff Bezos. Sure, there are exceptions, but if you have a talented entrepreneur who owns a lot of stock, it puts the odds in your favor.

Sam: We've heard that if you had invested $1 into Coca-Cola (KO) back in 1962, that would be worth nearly $900 today. But that's over a 52-year period... Most people don't have that kind of investment horizon. Is that the kind of time frame we're looking at on most 100-baggers?

Chris: In the study, there was a bell curve with most of the 100-baggers taking between 15 and 25 years to reach a 100-fold return, although there were a number that did it quicker. Wal-Mart did it in 12 years... Southwest Airlines did it in about nine and a half. Time Warner did it in six.

But don't get too hung up on how long it takes to get the 100-bagger. The idea behind this study was to find the best-performing stocks and figure out what characteristics these stocks had in common.

So maybe you don't stay around for the whole 100-bagger ride. But even over a two- or three-year period, these stocks can deliver big returns. Time is on your side. The longer you can hold on to these great stocks, the better you'll do. I don't want to hold stocks for 50 years, and I aim to deliver good returns much sooner than that.

Sam: As somebody who is familiar with your work, I've heard your idea of a "coffee-can portfolio." But for folks who don't know this phrase, can you explain what it is and how you use it in relation to your new Focus newsletter?

Chris: The coffee-can idea goes back to the Old West, when people used to put their valuables in a coffee can and bury it in the backyard.

The coffee-can portfolio is an idea that Robert Kirby, who was a money manager for the Capital Group, wrote about in 1984 in the Journal of Portfolio Management. He tells a story about how he managed a client's money. He would buy and sell things over time, and then one day the husband died. His client gives her husband's account to Kirby to manage.

When he sees the accounts, he's amused to find that the husband has been piggybacking the picks that he has put in his wife's account with one key difference: he never sold anything.

Some of these positions had become huge winners because he never sold them. One position alone was worth more than the entire other portfolio. He wrote his article about the power of leaving stocks alone.

One reason why the husband's account did so well is because of this sort of neglect. Nobody looked at it. They bought good stocks and left them alone. The coffee-can idea is an interesting way to get over the psychological hurdles to become better investors. Commit a portion of your portfolio to buying high-quality stocks and leave them alone.

Sam: If you take a look at the Wall Street Journal or turn on CNBC, the first thing you see is someone saying we're more than seven and a half years into this bull market. The bull market is growing old. Some people – Porter included – are calling for a big pullback and the start of a bear market. Does the strategy you use in Focus work in both bull and bear markets?

Chris: Yes, because we aren't relying on market forecasts. If you look back through history, there are multiple 100-baggers you could have bought every year in bull or bear markets.

But bull and bear markets do influence the number of opportunities out there. Right now, there are fewer opportunities than there would be if we had a market correction. In a lot of ways, I welcome a pullback in prices.

Regardless, the idea is to invest irrespective of what the markets are doing. If the market suffers a severe correction, these stocks will probably go down. In the history of 100-baggers, one of the key things that prevents people from making 100 times their money is that they panic every time their stocks fall and they end up selling.

Some of these 100-baggers had tremendous drawdowns that you had to suffer through. In my book, 100-Baggers, I talk about Monster Beverage (MNST), which returned 100-fold in just 10 years. But in that 10-year period, you had to suffer through a 40% decline, a 30% decline, and several 20%-plus declines. If you had just focused on the business and ignored movements in the share price, you would never have sold the stock because it was growing its earnings and sales at a high rate every year, and had a high return on capital.