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TRADER'S NOTEBOOK


Search For The 10-Bagger Fundamentals

07/03/07 04:53:06 PM PST
by Thomas Maskell

Though they may not be particularly rare, these elusive stocks hold promise nonetheless.

Recently, I received an email from a Technical Analysis of STOCKS & COMMODITIES reader inquiring if he had missed the follow-up articles in my series on searching for 10-baggers. I had to tell him that he had not missed them because I had not written them, having been distracted by a more pressing writing deadline. However, I promised to use his email as inspiration, which brings us to our subject today: finding 10-baggers using the techniques of fundamental analysis.

REVIEW
Figure 1 illustrates a typical 10-bagger. It is defined as a stock that increases in price 10-fold within a three-year period. Thus, it doubles in price every year over that period. Of course, 10-baggers aren't always typical; some may explode to 10-bag status in mere months, while others may lumber past the three-year time limit. Still others may go beyond 10-bag status to become 20-, 30-, and even 50-baggers. But they all follow the basic pattern shown but not necessarily the same time frame or maximum price.

Also illustrated in Figure 1 is the basic dilemma of stock investing (or trading or speculating): the problem of perspective. When we analyze a stock, we are looking backward. When we buy a stock, we need to look forward. When we analyze, we are working with facts, relationships, trends, and history. When we buy, we are peering into a dark room hoping that the light from behind us will illuminate the room in front of us.


FIGURE 1: A TYPICAL 10-BAGGER. Here you see a chart of a stock that increases in price 10-fold within a three-year period.

Thus, investors must generate two sets of loosely connected data. The first set is historical. Its main purpose is to educate the investor as to how well a company (and its management) has met previous challenges and capitalized on past opportunities. The second set is predictive. Its main purpose is to determine how the company will handle future challenges and opportunities. The first dataset (the cause) will lead you to a good company. The second dataset (the support) will lead you to a good investment. We shall explore both.

THE FUNDAMENTALS
Investing is quite different from trading and speculating. Traders are game players, while speculators are gamblers. Traders and speculators buy stocks, while investors are business people; they buy companies.

There are three basic investment strategies: dividend, value, and growth. Of these, only dividend is a pure investment strategy. The other two are a blend of investing, trading, and a dash of speculation. But dividends have no application to 10-baggers, since 10-baggers rarely pay a dividend. Our investment approach to 10-baggers will rely heavily on the rules governing growth and value investing.

Another aspect of our fundamental analysis is confidence. By that, I don't mean bravado; I mean statistical confidence. The more statistical confidence you have, the less risk you have. They are at opposite ends of a continuum. The objective of any stock analysis should be to increase our confidence that the course we choose will be profitable. In our fundamental analysis, we will do this by comparing our selected stocks to the market as a whole.

LOOKING BACK (CAUSE)
The past and present are defined in Figure 1 as the area to the left of the move point. That is the point at which we must buy. It is like an entrance to a dark room. Beyond that entrance is the unknown. So let's compare what we know about 10-baggers at or before their move. Hopefully, their past performance will uncover some trends that carry forward into that darkroom.

Since most investors will agree that earnings drive the market, Figure 2 compares the earnings per share (EPS) of 30 recent 10-baggers to that of the overall market. About 75% of the 10-baggers have a negative EPS compared to just 10% of the overall market. Further, only 3% of all 10-baggers have an EPS over $1. The market has about 55% in the over $1 EPS range. If earnings history is our guide, 10-baggers are a poor investment.


FIGURE 2: EARNINGS PER SHARE (EPS) DISTRIBUTION. Approximately 75% of the 10-baggers have a negative EPS compared to just 10% of the overall market.

But history must be viewed over time in the search for trends and extrapolations. Figure 3 looks at the EPS of our 10-baggers before and at their price move — that is, the known data. Unfortunately, it simply confirms what we learned in Figure 2. In fact, as a group, the 10-bagger's earnings looked better a year before their move. Their median EPS was slightly better (-0.12 versus -0.13), and more of them were positive (35% versus 25%). If there was any EPS trend at the move, it was downward. Apparently, EPS trends would not help us spot these 10-baggers.


FIGURE 3: 10-BAGGER EPS. As a group the 10-baggers' earnings looked better a year prior to the move. The results here indicate that EPS trends wouldn't help to spot the 10-baggers.

In the absence of earnings, investors often look to sales to establish a valuation. The most useful sales valuation metric is the price to sales ratio (PS). In Figure 4, the PS of our 10-baggers is compared to the PS of the overall market. It is clear from Figure 4 that 60% and more of our 10-baggers come from just 22% of the market. We have found our first distinguishing fundamental metric. By narrowing our search to stocks with a PS of under 0.50, our confidence is increased from 0.4% to 1.1%. Not very high, but much better than a random pick.


FIGURE 4: PRICE-TO-SALES (PS) RATIO. More than 60% of the 10-baggers come from 22% of the market. By searching for stocks with a PS under 0.5, confidence is increased from 0.4 to 1.1.

We can do a similar analysis for several other fundamental metrics and achieve similar results. For instance, analyzing price yields a confidence level of 0.86%, twice as high as a random pick. You can also double your confidence with a P/E comparison. But confidence levels of 1% are not very encouraging, and while it may be possible to improve those results using multiple variables, I have neither the time nor the space to explore that here. So we will look to the other critical aspect of fundamental analysis — potential.

LOOKING FORWARD (SUPPORT)
To my knowledge, no one has a crystal ball. The best we can do is spot past or current trends, but a trend cannot continue into the future without support, and the support we seek depends on potential. In fact, the past is prologue only if it reveals potential. So let's explore potential from a fundamentalist's perspective.

Potential depends on two factors: capacity and leverage — in essence, the capacity of a company to become profitable and its ability to magnify that profitability through leverage. A company with excess capacity and ample leverage has tremendous potential.

Capacity is a function of sales and assets: How many units can we produce in a factory versus how many they are currently producing? A good fundamental measure of it is the sales-to-asset ratio (S/A). Figure 5 compares the S/A of the overall market to our 10-baggers.


FIGURE 5: VARIOUS CAPACITY AND LEVERAGE METRICS FOR THE MARKET AND 10-BAGGERS. Here you see a comparison of the sales to asset ratio (SA) of the overall market to the 10-baggers. The 10-baggers seem to mirror the market to the high side, which is a positive indicator.

Leverage allows the company to magnify or extract the maximum profit from a given increase in sales. There are several kinds of leverage at work in a company. They include operating leverage, financial leverage, and various other synergies such as economies of scale and learning curves. We will focus on operating and financial leverage.

Gross profit (GP) is one form of operating leverage. It represents the potential profit available from each additional sales dollar: the higher the GP, the higher the potential. For instance, a company with a net income of 1% and a GP of 35% would grow its profits 3,500% if it doubled sales and held administrative and marketing costs constant. That's the power of leverage. Figure 5 also compares the GP of the overall market and our 10-baggers.

A company can also magnify their profits through financial leverage. A good metric for assessing financial leverage is shares outstanding (SO). The fewer SO a company has in relationship to their sales, the greater the profit those sales will deliver per share. This is somewhat related to PS, but there is enough difference that it is worth looking at on its own. Figure 5 does that.

The S/A is a double-edged sword in that a low number represents excess capacity that could be used to grow the company. But a low S/A could also imply that the management is not efficiently utilizing the assets, which is a negative. The S/A data in Figure 5 suggests that our 10-baggers are at least as efficient as the market as a whole, and they have the capacity to grow sales. There are many more aspects that underlie S/A, but the fact that our 10-baggers mirror the market to the high side can be viewed as a positive indicator for now.

In fact, all the data in Figure 5 suggests that 10-baggers, from start to finish, tend to reflect the overall market when it come to S/A, GP, and SO. There is no significant difference on which to build a high confidence projection, but it does indicate those 10-baggers are not stepchildren — overlooked or unloved stocks. In essence, they are not "value" investments.

THE SAD CONCLUSION
What you can derive from the data presented here is that there is nothing in the past performance of these companies that would allow us to spot them before their move. They are not value plays, which leaves growth as our only viable investment strategy. But as Figure 6 illustrates, even growth is of little help to us. The median growth of our 10-baggers was only 2.98% before their move, well below the median for the overall market. The 10-baggers didn't outperform the market until after their price move was made. In most cases, the stock moves six to 12 months before the company moves. There is simply no fundamental reason to buy these stocks — no cause. Sadly, the only conclusion you might make based on the dismal growth rate of these companies is that they are frogs waiting to be kissed.


FIGURE 6: ANNUAL SALES GROWTH RATES. The median growth rate for the 10-baggers was only 2.98% before their move. Essentially, there is nothing in growth rates that would lead us to believe that the stocks of these companies are about to experience a 10-bagger rally.

Yet over the life of their move (three years), these stocks more than doubled the growth of the market. They do not blossom without support. Within one year of their move they are outperforming the market and, like their price, by the end of their run they are growing 10 times faster than their premove growth rate. But there is nothing in that premove growth number (2.98%) that would lead us to believe these companies were about to launch. To the fundamentalist, the room remains dark and uninviting.

Thus, fundamentals can tell us a move is under way, but it can't tell us a move is about to happen. But the move did not just happen. Somebody knows something. Perhaps the traders have the answer, but that will have to wait until next time.

SUGGESTED READING
Maskell, Thomas [2006]. "The Search For The 10-Bagger Begins," Working-Money.com, March 23.
_____ [2006]. "The Anatomy Of The 10-Bagger," Working-Money.com, September 5.



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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