I recently listened to a conference call by an investment manager I hold in high regard. His investment style can be best described as “high quality”. This is in contrast to the traditional “value” manager who searches for unloved stocks the market has pushed to unjustifiably low multiples of earnings or book value. It is also in contrast to the typical “growth” manager, who is prepared to pay high multiples to buy (often less well-established) companies that are growing their revenues or earnings (better yet, both) at very high growth rates.

The high-quality manager typically invests in high-quality businesses with durable franchises that grow their revenues dependably at GDP-plus rates and, due to operational leverage, their operating profits at a slightly quicker rate than this.

This style has delivered very well for the fund’s investors due to the power of the compounding effect on earnings over sufficiently long periods. Unilever was held up as a good example of this compounding effect, and we can only agree that its past compounding power has often been underestimated.

I was, however, quite surprised when he referenced the excellent (though US-focused) book, 100-baggers, by Christopher Mayer, as justification for continuing to hold some of the businesses (such as Unilever) that have done so well for him. For those of you that are not familiar with this term, a 100-bagger is a stock that has increased 100 times from when one originally bought it. Needless to say, finding a stock that manages to do this represents the holy grail for any investor.

An example of an SA 100-bagger would be Naspers. While Koos Bekker’s investment acumen had already been demonstrated through his involvement in the founding of MultiChoice and MTN, it was Naspers’s $32m investment in Chinese internet company Tencent that catapulted it into the global “big league”. Naspers’s market cap was a “mere” R5bn when it invested in Tencent in 2001. Now its market cap is more than R1.3-trillion. 

Another example of an SA 100-bagger would be Capitec Bank. In the case of Capitec, its share price was decimated in the small banking crisis of 2002/2003 and eventually troughed at about R2 per share. Today, after its successful expansion strategy premised on zero-fee banking and lending to the formerly unbanked, Capitec’s share price is sitting at more than R8,500. Capitec’s market capitalisation recently surpassed that of Nedbank, which was founded in 1831.

There are even a couple of global companies owned by South Africans that have become 100-baggers, including Tesla, which has risen almost 100 times since its initial public offer in 2010, and the less well-known Monster Beverages, which has increased its share price a huge 1,000 times since January 1 2000.

In his book, Mayer details a number of “essential principles” that should guide one in identifying future 100-baggers:

  • The most important of these is to identify stocks that earn above-average rates of return on capital due to a “moat” or a competitive advantage.
  • The second is to ensure the business is run by highly skilled managers who have a history of treating shareholders as partners.
  • Finally, these businesses should have a sufficiently long runway for growth. As a result, smaller companies are preferred when identifying 100-baggers because it is harder for larger companies to grow at the same rate as smaller companies.

Interestingly, however, Mayer found that companies should not be “too small”. In his study of the 365 companies that were 100-baggers, the median sales level at the outset was $170m (in non-inflation adjusted terms), which still represents a fairly sizeable business.

The holdings of the large investment manager I spoke about earlier comply with all the rules above, except for the last one. Perusing the fund holdings reveals their fatal flaw: they are simply too large.

Mayer’s book is about identifying the 100-baggers of the future, not paying homage to the 100-baggers of the past. To refer to Unilever once again, for it to be a 100-bagger from here, its market cap would have to increase from its current $155bn to $15.5-trillion. As a point of reference, the combined market cap of the 10 largest companies in the world today is only $11-trillion.

It typically takes between 20 and 25 years for the companies in Mayer’s study to become 100-baggers but, short of a global inflationary shock, I would wager it will take far, far longer than 25 years for Unilever to be a 100-bagger when measured from today.

At Flagship we believe there is a place for different types of stocks in a portfolio. The largest weight should be assigned to high-quality companies that steadily compound their earnings. These companies have performed admirably for patient long-term investors. However, to find the 100-baggers of the future, you have to cast your net wider than your past winners.

• Wales is global portfolio manager at Flagship Asset Management.

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