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TRADER'S NOTEBOOK


The Search For The 10-Bagger Begins

03/23/06 12:10:21 PM PST
by Thomas Maskell

These promising stocks are elusive but not particularly rare.

Ever since Peter Lynch coined the phrase "10-bagger," investors have been searching for these elusive little gems. Defined as stocks that increase in price 10-fold, 10-baggers are elusive but not that rare. In any given year, you can find a few of them. If you lengthen your time horizon to two or three years, you can find hundreds of them. Of course, when I say you can find them, I mean you can find them after the fact. Finding them before the fact -- well, that's why we're here.

DIGGING FOR 10-BAGGERS
In a perfectly rational market, there would be no such thing as a 10-bagger. According to the magicians of manipulation, the market sees all and knows all. All available information is built into the price. Even some information that isn't available is stuffed into that price. So how can there be stocks that rocket from $1 to $10, or $10 to $100 over the course of a couple of months or a couple of years? There are two possible answers. First, there are hundreds of companies increasing their sales and profits 10-fold, or second, the stock market isn't rational. A quick look at the fundamentals of most companies leads me to think the second answer is the best bet.

If the market isn't rational, how can a rational investor ever hope to spot an emerging 10-bagger? That's a tough one. But you can answer that question by looking at them to see if they share any traits. To do that, you will need a stock-screening tool like the one found at www.Reuters.com. Screening helps you identify a list of stocks that have risen in price by 100% or more in the past year. These are doubles, and while not all doubles are 10-baggers, all 10-baggers are doubles. So it's a good starting point.

I chose a one-year price increase horizon because that is the longest horizon available at Reuters. If your stock-screening tool identifies price increases spanning longer than one year, you will be able to skip the next step, which is to determine which of these doubles are potential or actual 10-baggers. A 10-bagger usually requires two or three years to mature, but it must at least double in each of three consecutive years. Thus, a one-year price screen only provides a clue to its existence. The screen may be highlighting the beginning, the end, or the middle of its move. You will have to broaden your time horizon to get a clearer picture of which doubles are truly 10-baggers.

To broaden the time horizon and narrow the field, I use www.BigCharts.com, another free service. Big Charts provides stock price charts for the majority of the companies you will uncover in your initial screen. Linked to these charts provided by Big Charts are select technical and fundamental data. Among the technical indicators are volume, the moving average convergence/divergence (MACD), the relative strength index (RSI), money flows, on-balance volume, and so forth. For the fundamentalist, there are rolling earnings per share (EPS), price/earnings ratios, and dividend yields. These are provided for time horizons ranging from one day to 10 years.

NARROWING IT DOWN FURTHER
To give you an example, using the Reuters screening tool, I uncovered 588 stocks that had doubled in the past 52 weeks. How many of those stocks are or will become 10-baggers? Big Charts will help me determine that, but looking through 588 stock charts is a daunting task. You will want to narrow the list by eliminating some stocks before you begin your chart search.

First, it's best to establish some list demographics. This will help you with your elimination criteria. For instance, the total number of stocks listed in the database is 8,915. The date of the screen was March 8, 2006. The 588 stocks featured by the screen are 6.6% of a total market. That is 588 stocks from a market whose major indexes were relatively flat. That is a very significant percentage of the total.

To help shorten the list, two descriptors may provide candidates for elimination: industry and trade exchange. The list doesn't show any industry preference. There are 79 different industries represented on the list. Since there are 190 industries in the database, it means that 6.6% of the stocks represent 42% of the industries. They are a very diverse group and span both low- and high-tech industries.

The list does indicate a significant concentration with respect to the exchanges. The OTC and NASDAQ have the lion's share of the doubles. Together, they account for more than 84% of the companies listed. By itself, the OTC represents 54% of those listed. The American Stock Exchange is better represented than the New York Stock Exchange, but neither achieves double-digit status.

There are a few more interesting demographics. For instance, the launch price of these doubles range from zero dollars per share (stocks priced below $0.01 are listed as zero) to $194.53 a share with a median beginning share price of $0.82. Another interesting observation is the degree to which these stocks increased in price. More than 100 of them were five-baggers within the 52-week time frame, with 57 of those stocks becoming 10-baggers within the year. The beginning price of these high-flyers ranged between $0.00 and $6.15 with a median launch price of $0.01.

The screen also provides some fundamental demographics. Most long-term investors would certainly argue that growth in a company's operational performance would be reflected in the growth of its stock's performance. A quick perusal of our list gives 10-bag hunters reason to doubt that. Of those stocks, 32% had a declining EPS during the year. Equally intriguing, 83% of them had three-year annual EPS growth rates that were listed as "NA" -- an indication that usually means these are newly listed companies. We will have to dig deeper to confirm that.

The sales growth is equally baffling. Of these companies, 25% had negative trailing 12-month growth rates. This statistic carried over to the three-year annual sales growth rate, with 27% being negative. EPS and sales growth are apparently not magic indicators. Fundamentalists, take note!

In stock analysis, a picture is worth a thousand words -- or, in this case, a thousand entries on a spreadsheet. But I'm not interested in blindly clicking through 588 stock charts on a computer screen. I need to narrow this list to something more meaningful. My first elimination criterion will be as practical as it is logical. The first stocks I will eliminate are those that won't make me any money. After all, that is the purpose of this search.

To make this first elimination, some simple math is in order. If we assume a 10-bagger and a trading cost of $25 per thousand shares, it is reasonable to eliminate any stock with a beginning price of $0.01 or less. The logic is simple. The cost to get into and out of the stock would be $0.05 a share. Add to that the cost of the stock and subtract it from the final price ($0.10 - ($0.05+$0.01) = $0.04), and your 10-bagger has turned into a four-bagger. Not bad, but not worth the risk. With this one calculation, we have eliminated 136 stocks -- 23% of the total.

You can use any elimination criterion that makes sense to you or reflects your risk profile. For instance, if you are like me and find the OTC to be somewhat untrustworthy, dropping OTC stocks from the list will eliminate 54% of the candidates. Other possible elimination criteria are industries (you may not like some), shares outstanding (drop the biggest numbers), or sectors (eschew the "old economy").

The key here is to eliminate based on criteria that are not causal. The search for a 10-bagger is a search for cause (and support) and effect. The effect is a 10-fold increase in price. The cause (and support) is the performance of the company or the madness of mobs or the manipulation of markets. Our hope in this venture is to determine why these stocks launched -- performance, madness, or manipulation? Keeping this in mind, it is unlikely that the exchange caused the price increase. In addition, given that more than 79 industries are represented in the list, industry is also an unlikely causal indicator. Other noncausal indicators include sectors and shares outstanding.

What I am going to do is eliminate all stocks with current prices below $0.10, all OTC stocks and all American depositary receipts. This will leave a total of 254 stocks in 55 different industries and listed on the three major exchanges (Figure 1). Now I have a list that is small enough to begin charting with.

Not only is the list smaller, but its character is different. For instance, only 24% of these stocks had trailing 12-month (TTM) EPS declines (versus 32% for the original 588). Sales growth was even more dramatic, with only 9.8% showing TTM negative rates (versus 25%). However, it is clear by the screens and the subsequent eliminations that the market is willing to bid up the price of stocks with declining fundamentals. What do they see that we don't? Maybe the charts will tell us.

Next time, I'll look more closely at the charts. However, if you want a head start, you can peruse the 254 charts listed in Figure 1 at your leisure. I start with a five-year weekly chart with volume, P/E, and rolling EPS indicators. Focus on the period just before the stock makes its move. Remember that you are seeking cause and support. What caused the stock to move? And what kept it moving?

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Figure 1: FIVE-YEAR WEEKLY. These charts can give you a head start on looking for 10-baggers.

Thomas Maskell is an amateur investor with a large risk aversion and a small nest-egg. In addition, he has a degree in engineering and a master's degree in business administration, which means he knows just enough to be dangerous but not enough to be rich.



Thomas Maskell

Thomas Maskell is a frequent S&C contributor whose recent book, The Complete Guide to Investing During Retirement, provides an excellent primer on investing, trading and speculation in the stock market. It is available nationwide. To comment on this article or his book, contact him at Retireestocks@aol.com or visit his blog at retireestocks.blogspot.com.

E-mail address: Retireestocks@aol.com


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