Two Clues to Finding the Next '100 Bagger' Stock

Editor's note: Yesterday, investing expert Chris Mayer explained why companies that reinvest their profits and earn a high return on equity vastly outperform typical dividend-paying stocks.

But that isn't the only path to finding the market's next huge winner.

In today's Masters Series essay – originally published in the January 6 edition of Bill Bonner's Diary – Chris discusses the two traits most of the best-performing stocks have in common...

Two Clues to Finding the Next '100 Bagger' Stock
By Chris Mayer, editor, Chris Mayer's Focus

There are two factors that almost every "100 bagger" stock has in common.

A couple of years ago, I published a study of 100 baggers – stocks that returned 100-to-1 – over a 50-year span. And the importance of these "twin engines" turned up again and again.

The best way to show you how the twin engines work is with an example...

Let's say we have a stock that earns $1 per share and trades for 20 times company earnings. That would make the stock $20.

Now, five years later, earnings have tripled to $3 per share.

If the stock still trades for 20 times earnings, then you'll have tripled your money, as the stock would trade for $60 per share.

That's a nice result. And it shows you the power of the first engine: earnings growth.

But the second engine I look for is a low multiple on those earnings.

Let's say you find a similar stock trading for just 10 times earnings. The stock is $10 and earns $1 per share.

Now, five years later, earnings have tripled to $3 per share.

But, the cat is out of the bag. The market has come to appreciate the power of its business model, and the stock trades for 20 times earnings.

Now the stock is $60, as in the prior example... and you're up sixfold.

But it can work against you if you don't have both engines working.

Say you pay 50 times earnings for a stock and earnings triple over five years. If the price-earnings ratio falls to 15 times, you lose money. Think about that: You could own a stock where earnings tripled... and lose money if that's the only engine running.

Understanding the twin-engine concept is one thing, but finding stocks that have them is another. It is not easy to find them, but these stocks do exist.

In 1982, Aflac was a small insurance company with $585 million in sales. Twenty years later, sales were up to $10.2 billion. That's a 17-fold increase. Earnings per share did better – and went from $0.04 to $1.30. But the stock was up 100-fold.

How so?

Well, the market valued earnings at just 10 times in 1982. But 10 years later, people thought much better of the stock. It traded for almost 30 times earnings. The twin engines again.

Gillette is another example. The safety-razor company grew its sales 11% per year. Earnings grew 15% per year. But it took more than these numbers to make it a 100 bagger. At the start of its run in the late 1960s, the stock traded for just 10 times earnings. By 1995, it traded for nearly 30 times earnings. The stock returned more than $300 for every $1 invested.

Perhaps the most extreme example of the twin engines at work is the MTY Food Group (TSX: MTY)...

The fast-food franchisor's stock went up 100 times from 2003 to 2013. That's just 10 years. Sales went up 7.8 times. Earnings went up 12.4 times. But the stock was up 100 times... because in 2003, you could've bought the stock for 3.5 times earnings. And in 2013, it traded for 26 times earnings. (A tip of the cap to Chip Maloney at the MicroCapClub for the example.)

That's the power of the twin engines. Focus on finding stocks that have both the ability to grow... and the potential for a higher revaluation.

The table below has five stocks with low price-to-earnings ratios compared with their estimated earnings-growth rates for the next five years:

Of the five stocks listed, Fiat Chrysler (FCAU) is especially interesting. The company is controlled by Exor Holdings, an Italian "Berkshire Hathaway." Fiat's CEO, Sergio Marchionne, turned the struggling company around in mid-2000, and is well along in his turnaround of the now-combined Fiat Chrysler Group. The stock trades for just six times next year's earnings, despite a forecasted earnings per share growth rate of 15% in 2017 and 20% in 2018.

The second stock we think is worthy of closer inspection is Verisign (VRSN). Verisign is one of the few highly profitable legal monopolies. It essentially owns the Internet. For every $10 spent per year to register an Internet domain, Verisign takes a big cut – anywhere between $7 and $8. The company generates a tremendous amount of cash and should grow for years and years to come.

Even at 20 times earnings, we still think it's a cheap stock. And Berkshire Hathaway is its largest shareholder. More than 12% of this $8 billion company is owned by Warren Buffett. Over time, this investment should pay off.

That said, each of the five companies I listed has the twin engines I look for in an investment. I recommend checking them out.

Sincerely,

Chris Mayer

Editor's note: This weekend, Chris hosted a free online training event to show viewers how to build a concentrated portfolio of companies with the "twin engines" that could make them huge winners in the years to come. If you missed the event, that's OK. It's not too late. You can still learn about all of Chris' portfolio-building strategies right here.