Editor’s Note: Chris Mayer is one of the best stock pickers in the game. He’s the only analyst Bill has committed to follow with $5 million of his own family money.
This week in the Diary, we talked about three special “100 baggers” (Southwest Airlines, L Brands, and H&R Block). These companies returned more than 100x 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 few basic 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, an airline, and a 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 14x 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’s Note: For the last week, thousands of Diary readers tuned in to learn an investment strategy Chris calls “the biggest breakthrough of my career.”
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