Finding Growth Stocks That Multiply. (Multi-bagger Study)

What are the key characteristics?

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Finding stocks for huge growth

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In today’s video we look at the in depth study completed by Stockopedia, named - The Makings Of A Multi-Bagger. The study uncovers the common characteristics of companies delivering huge growth.

The basic math of investing is compounding. Either you clock average returns and compound them for very long periods, or clock high returns and achieve the same outcome in less time, often referred to as trading.

Achieving average returns is relatively simple, You can select an index and keep investing in that for your desired horizon. If you do this for 2 to 3 decades, you can accumulate a significant amount.

Alternatively, you can also find ways to improve your average annual returns and build that corpus in less time. One such way is to find multi-baggers, which are stocks that grow multifold in short periods. Some stocks deliver returns such as 10x, 20x and 30x in short periods and can potentially alter the course of your investment portfolio even if you get only a few of them right.

Finding those multibaggers needs an active involvement. The good news is that such stocks display some traits with certainty and all you need to do is look for those traits, do some research and get on the train for reasonably long periods. More good news is that platforms like Stockopedia provide resources to help an average investor identify those multibaggers.

Stockopedia studied past multibaggers and outlined the characteristics they displayed during their advance. In this video, I summarise the findings from the study, which I believe is very useful for any DIY investor looking to compound capital at a faster pace.

Here is the list of the top 10 performers on the London Stock Exchange in the last decade. All of the shares in the list at least six bagged in the study period, with JD Sports being the outstanding performer with a 22x return. The average performance of the set was an 11.1x return.

There are some familiar and well-known consumer names in the list, from brands like JD Sports and package holiday provider Jet2, to some lesser-known acquirers like CVS Group and Judges Scientific.

One thing that needs to be established at the outset is that these multibaggers do not happen in a short period. For a stock to post multibagger gains, the underlying business has to perform for long periods and therefore the gains also come over those long periods. Hence, this game isn’t for the impatient and you need to give your investments enough time to perform.

Now, let’s look at the sectoral breakup of these multibaggers. The chart here illustrates that four of the top ten shares were in the consumer cyclical sector, three in the industrials sector, two in financials, and one in healthcare. None of the top performers came from the basic materials (mining), energy, utilities, telecoms, or technology sectors.

Now there are some interesting takeaways from this sectoral graph of winners. In a decade when the US mega-cap technology shares dominated global market returns, the UK technology sector failed to serve up any of the market’s outstanding performers. Even in the healthcare sector, dominated by exciting life sciences and biotechnology shares, the outstanding performer was CVS Group focused on the pet care and veterinary market.

The key point here is that the most returns may not necessarily be in the hottest sector in the globe. It can be hidden in unusual, ignored, and dull businesses, which you might ignore because it’s not talked about or is not as high-flying as some other sectors. So, you must not ignore a stock displaying multibagger traits just because of your hot-sector bias.

Now let’s get to the meat of the topic - shared traits of these ten multibagger stocks.

Stockopedia has classified the shared traits into three major groups - stock ranks, quantitative metrics, and qualitative traits.

Let’s look at Stockopedia’s StockRanks, which is a simple but effective stock analysis, a framework based on the empirical evidence of which factors drive stock returns over the long run. This framework analyses thousands of technical and fundamental data points on every stock daily across their Quality, Value, and Momentum characteristics. Stockopeedia brings this analysis together in a proprietary scoring methodology called StockRanks, which is used in the study as an initial shorthand for assessing the traits of each of the 10 shares at the start and end of the ten-year period.

The table here summarises the rankings for all the 10 multibaggers in the study at the start of the 10-year period.

At the start of the journey, the companies shared the following themes:

Almost all the companies would be classified as small caps, with market caps ranging from £50 million to £350 million. Therefore size matters for multibagger returns. Mid-cap and large-cap stocks are less likely to become multibaggers.

The companies ranked high on quality, with a median quality rank of 83/100. Quality rank assesses profitability, cash flow generation, margins, and key red flags to avoid bankruptcy and earnings manipulation risk.

The next trait is valuation. With a median rank of 77/100, the shares typically began their journey amongst the least expensive quarter of stocks in the market. This gave their P/E Ratios plenty of room to grow as the market woke up to each company’s quality.

Lastly, the company has to have momentum in its favor - both price and earnings momentum. With a median rank of 78/100, the stocks appeared to have strong price and earnings momentum.

The stock scanner we have in our group also share the same principles when it comes to Quality and Momentum metrics, both highly correlated to growth.

Now, let’s look at how these parameters changed at the end of the period for all these companies. Here is the table summarising StockRanks for the same stocks in 2023.

The median market cap has grown more than 10x to almost £1.8 billion. None of the companies are now small caps. Most are midcaps and some like JD Sports, Games Workshop and

Jet2 have graduated to be large caps.

The Value Rank of the group has dropped from 77 to 23. The market woke up to these shares and bid them up to a premium valuation. The share’s valuations rose from the cheapest quarter of the market to the most expensive quarter. The market pays up for consistent quality.

The Quality Rank of the set increased from 83 to 88. These companies have managed to improve their profitability as their operations grew. This is truly the trait of outstanding companies.

The graph here captures the journey of these stocks in the last 10 years. The Value Rank dropped considerably, as the shares moved from cheaper valuations to expensive valuations, while the Quality remained extremely high.

Stockopedia classifies the traits of shares into a set of eight different classifications called the “StockRank Styles”. It is notable that typically these shares have journeyed from a fingerprint of the “Small-Cap Super Stock” classification to the “Mid-Cap High Flyer” classification. High Flyers are regarded as “growth” stocks that fund managers want to own, but they began as good quality, but out-of-favour, value stocks. The market changed its perception of these shares over time.

Let’s now do a deep dive into the fundamentals of these top performers.

The set displayed High Profitability and sustained a median Return on Capital Employed of 16% throughout the study period. This allowed them to reinvest their profits at high rates of return, back into their operations. Scalable operations meant room for massive growth.

The set also displayed growing margins with the companies growing their operating margins from 4.5% to 12.5% through the study. Operating leverage helped these companies grow their operating profits faster than sales by scaling up their enterprises. Net margins also grew until the Pandemic and declined thereafter, possibly due to higher tax and interest burdens.

The companies sparingly used Debt as many of these companies were free cashflow generators, requiring minimal borrowings. The overall net debt-to-equity ratio began at -15%, growing only to 17% at the end of the study. Debt grew from 2020 as companies

dealt with the impact of the pandemic.

The set also did not see any meaningful shareholder dilution. These companies averaged only 0.58% of share dilution annually, most likely for staff incentive schemes. There was no strong evidence of share issuance, so shareholders did not suffer from significant dilution.

The companies also saw strong Sales and Earnings Growth. Sales growth was maintained at very high levels, and trailing earnings per share growth was 20% annually.

Another important factor in their multibagger returns was Expanding PE Ratios. Share prices are driven both by earnings growth but also an expansion in the price the market pays for

those earnings - the Price / Earnings Ratio. The set of super performers began their journeys on median PE Ratios of 14x, ending at 23x. This “earnings multiple expansion” supercharged their returns.

The companies also saw expanding Price to Tangible Book Values. Multibaggers often are capital-light businesses. As the market began appreciating the value of their intangible assets - the brands, intellectual property, and goodwill in the businesses - they put a higher price on the net- asset value. The median P/TB increased from 4x to as high as 18x along the journey.

The stocks were good Dividend Yielders. Surprisingly, all ten of the stocks paid dividends on the initial date. The yields were higher at the start but averaged under 1.5% through the journey.

Unsurprisingly, these stocks were outperforming the FTSE All Share by 12% on a 6-month basis, and 24% over a 1-year basis. It was consistent share price performance that led to compounding gains. Buying multi-baggers is challenging as often the best time to buy is when the share price has already been beating the market, counter intuitive to some.

There was also a consistent trend of professional analysts upgrading their earnings estimates for the coming year. Aside from a huge miss during the pandemic, it was not unusual to see estimates upgraded by 5-10% each quarter through the study period.

The table earmarks the occasions when the posted earnings were ahead and below expectations. These companies were eight times more likely to announce news “ahead of expectations” than “below expectations”. Regularly, their share prices would spike after a positive announcement. Taking profits in these scenarios would have been extremely costly.

Let’s now take a look at the qualitative traits of multibagger stocks.

The most important qualitative aspect of potential multibaggers is that they have simple scalable business models. Of the ten multi-baggers in the study, very few offer products or

services that are especially exciting. Instead, the most common shared trait is the simple,

scaleable nature of their business models.

For example, two retailers in the bucket, JD Sports and Games Workshop sell relatively

simple products via multiple channels which can be easily replicated and scaled. And then

there are the businesses that were able to expand thanks to demand in multiple locations.

Safestore serves local areas by acquiring and growing its number of storage facilities, CVS Group serves local pet care needs by buying veterinary services. YouGov, Jet2 and 4imprint

are also incredibly simple business models operating in markets where demand allows for

strong growth.

For these businesses to be able to scale unencumbered by competition, they also required a competitive advantage. This is something Warren Buffet calls an ‘economic moat’.

The moat can be of various types - an easily identifiable brand or switching costs which make it inconvenient for customers to switch to competitors. Some businesses are protected thanks to economies of scale or superior processing power. Others benefit from network effects, where a growing number of users make the service provided by the company more valuable.

This table shows various kinds of moats these companies possessed during their rapid advance.

Another important qualitative trait is Management’s sensible capital allocation. As this table shows, all but two of the companies in the list has had the same chairman or chief executive throughout the ten years and any company that has had a change of chief executive during the decade has promoted someone internally. What’s more, five of the companies are still led by a founder.

For several of these companies, stable management meant investment in earnings-enhancing

acquisitions. JD Sports, Judges Scientific, Renew Holdings, CVS Group, YouGov and

Safestore have acquired small businesses along the way that enhanced and accelerated

their earnings growth.

Summing it all up, to help simplify this process and set you on a path to potentially transformative returns, Stockopedia has distilled its research into an actionable checklist. Split into quantitative and qualitative characteristics, this checklist aims to be your compass in navigating the dynamic world of hunting for multi-baggers. Please note that it’s highly unlikely that any one stock will qualify for all these rules, so please use them as a guide, rather than as prescriptive must-haves.

Here is the Quantitative Traits checklist

Look for a StockRank  score greater than 82 and Greater than 85/90 on a breakout.

Search for "Small Caps" – a Market Cap ranging from £50m to £350m.

Look for Strong Profitability - ROCE > 10%. Quality Rank > 75. Growing Operating margins.

Check for Low Debt with Net Gearing < 30%.

Check for High Free Cashflow.

Look for Moderate Valuation, P/E with room to grow with a Forecast P/E less than 15 and earnings yield of less than 3%.

Look for Strong Growth - current and future - at least above 10%.

Look for Share price strength. 1-year Relative Strength greater than 0% and ideally > 10%.

Avoid excessive share price dilution. Look for Share dilution less than 2%.

Here is the Qualitative Traits checklist

Look for simple, scaleable businesses in favorable industries - e.g. Media, Retail, Software rather than hard asset firms.

Prefer businesses with a proven operating model.

Look for brands, niches, network effects, or other powers.

Look for Smart Capital Allocation - earnings-enhancing acquisitions.

Look for Something New - new management/acquisitions/products can catalyze improvement. Look for Positive Surprises - Earnings ahead of expectations.

Lastly, finding multibaggers is a skill that anyone can acquire with practice, the real test of an investor is waiting it out for returns. The multibagger returns come with several dips and corrections that appear to be serious at the time but don’t matter in the long run. The real test is going through the pain without making emotional mistakes.

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