I am extremely grateful to Michael for providing this Guest Blog and making my life easier this week, which has also enabled me to make very good progress on the Stock blog I am working on. I am sure most Readers will already know of Michael as these days he is a huge celebrity in the Private Investing and Trading world with regular articles in Investors Chronicle and SharePad etc.
Michael has a Website and if you go to the ‘Weekly Performance’ page on WD1 you should find an image of his FREE eBook and if you click on that you will be taken to his site. The book is well worth reading and of course I am biased because I was involved in the latter stages of proof-reading and tweaking it. You can find him on Twitter as @shiftingshares.
So big THANKS to Michael for letting me share this with WD Readers and I hope you all enjoy it.
Over the years I’ve had my fair share of multi-bagger stocks (and my fair share of selling multi-bagger stocks too early too). Some of these came quickly, with a lot of short-term hype and anticipation putting a rocket under the stock price, and some of these have been quality businesses that have quietly gone about their business and slowly been re-rated by the market as management continued to execute.
We all know that we are often too quick to cut our winners and instead add to our losers (a habit Peter Lynch called “watering the weeds”) but history has shown us that often our best bet is to stick with the winners and even add to them. This goes against our natural instincts, as investors we are often risk averse with our winners and risk averse with our losses, but sticking with and even doubling down with winning stocks can be seriously good for your wealth.
One of the problems of holding multi-baggers then is the conviction needed to hold when times get tough. Of course, it’s easy to look back in hindsight and think “If only we’d held Apple for a decade” – but those who have held from the IPO have been through the stomach-churning decline of a drawdown of 80%. Twice! If you’re honest with yourself, could you handle that? It’s likely that the answer is “no”. Which is precisely why very few of us ever experience these investment dreams of achieving a 100-bagger. It takes pain; the pain of the gain, and as with everything in life, just a little bit of luck. Nobody could have predicted that Apple would reinvent themselves with the iPod and the iPhone. Many had them down as dead and buried, and it wasn’t without good reason.
So if we want to find and own these types of stocks, the stocks we all day dream about, how should we go about it?
Play the high stakes game – all in
Firstly, we need to be willing to lose 100% of our money. All of it. Every single penny. There really is no other way – if we cave in at the first hurdle, we may end up missing out. Netflix has made a lot of people a lot of money, but it didn’t just go up in a straight line. Netflix has lost over a quarter of its market value in one day four times. That stock too had a stretch of several months where it lost 80% of its value. Nobody can ever be blamed for banking profits and cutting losses, but to achieve monster returns then we must be willing to risk our capital in a way that most investors never will.
The Coffee Can
Many of you will be familiar with the ‘coffee can’ concept. It’s the idea that back in the days of the Wild West, you’d put your most valuable possessions into the coffee can, and hide it somewhere safe. It would be out of sight, and out of mind – unless needed.
We can apply that same concept to delivering monster returns and multi-bagger stocks. Once we find a stock we like, and we want to see it through, we put it into the coffee can and see what happens. It’s likely that in the longevity of time, some of these stocks will go bust. Some of them will tread water with large peaks and troughs, and maybe one of them will go on to deliver continued growth which will be appreciated in the share price.
We should not be willing to buy any old junk and put it in our coffee can. If we are going to risk 100% of our capital in that position, we want to be sure we stand a good chance of it going the distance.
Coffee Can selection
Whereas usually I believe it is prudent to look at management when investing, for the coffee can approach I would flip this upside down. Management are going to come and go; they don’t last forever. To quote Peter Lynch again – “invest in a business an idiot can run, because someday one will”.
It’s important to look at the industry, how big it can grow, and how big the company we’re investing in can grow. If the industry itself is declining then unless something occurs to arrest that decline, we’re going to be on the back foot from the off. Macrotrends are important – it would’ve been no good buying into a hot new photography film stock when the market was increasingly switching over to digital.
Finding Multi-baggers in the UK
The coffee can approach is not the only way to capture huge multi-bagger returns. We can do so without risking 100% of our capital and look for certain metrics of previous stock market winners.
One of the hallmarks of fantastic companies in the UK is that they generally have high levels of Return on Capital Employed (ROCE). This is the returns on the money the company invests in itself, and high ROCE levels mean high returns which can then be further reinvested into the business. The ability to quickly compound capital delivers fast and meaningful growth where capital is deployed efficiently.
Another quality of a good company is a company that does not have to invest heavily in fixed assets. That’s not to say that good companies don’t have large fixed assets, but tangible assets often need repairing or refurbishing. A retailer or restaurant is great when the punters are flocking in as profits are operationally geared, but those same businesses can find themselves laden with assets that still need paying for or maintenance capex to be spent when times get tougher.
Finally, management should be entrepreneurial. Most investors don’t place much emphasis on management ownership but most of us would rather our management teams went beyond the distance to land the client rather than just punching the clock every day at 5pm. We can analyse this by looking at their equity ownership. Furthermore, we should see where this came from. Management putting their own hard-earned cash back into the business gives them the owner’s eye rather than turning up to a job to get paid. If the Management are simply picking up Share Options that they have not had to pay for then are they really all that committed?
The beauty of the UK market
One of the advantages of the UK stock market is that we have plenty of companies to choose from – many of which are under-researched and overlooked. By looking for simple metrics and sifting quality from the rough, we can identify potential long-term winners that have a large runway for growth.
A good way to capture these returns is by taking a small position, as this gets us invested in the story, and as management execute we can commit more capital to the position. Investing is very much like poker - as the hands turn up in our favour we can raise our stake. One crucial advantage of investing is that we don’t need to play every hand! Wait for the stocks to show themselves and then we can play.
The reality of the Coffee Can
The reality is the Coffee Can approach is a bit silly. Whilst I’m all for people long term investing, I don’t think that investors should just turn a blind eye to risk management in the form of drawdowns. Yes, I’m a trader – so I would say that – but what’s the point in being up 1,000% and not taking a single penny off the table? Why would you risk all of your initial capital outlay and all of the profit? At least by banking a quarter you have thus guaranteed a profit and withdrawn the principal capital.
You have, in effect, and I really am careful to say this, granted yourself a ‘free roll’. I hate the words free roll, because it gives the impression that it’s risk-free, when it’s not. Profit IS real money – but it’s only real when you’ve banked it.
What I mean to say is that you can reduce exposure, and still have a chance at nailing a massive multi-bagger. You are essentially trading most of your profit in the hope that the stock will go on to achieve monster returns. And if it doesn’t, you withdrew your principal capital and a bit more.
But even then, that is silly. The reality is most of the stocks on the LSE do not have a long-term shelf life. Most of AIM is garbage, and if you want to do a coffee can approach on AIM well good luck – within ten years you’ve probably lost all of your money. It’s not a stock market, it’s a market of stocks. And most of these stocks you don’t want to be in the market for.
I truly think the best way to make long term money on investing is to find ten quality companies, that have high returns on equity and capital employed, that have a growing industry, and are backed by entrepreneurial management. Split your capital 10% in each, and run a 30% stop. Some of these are going to get hit. Some of them will continue to go up, to a point where you can begin to start top-slicing. This de-risks the position and ensures that no matter what happens money has been taken off the table and profit has been banked.
History has shown that quality wins over the long term, and speculating on garbage does not (not in the long term, anyway).
So, if it’s that easy – why don’t most people do it?
You tell me.
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