This article is about how to buy companies that will let you have a 1,000% return on investment (ROI) or more famously known as a 10-bagger, popularise by Peter Lynch. These are stocks that return RM10 for every RM1 invested. Meaning if you have a budget of RM10,000 investment, you can turn this into RM100,000.
We all know how to find good companies; high gross profit margin, high return on equity, increasing revenue, increasing net profit, increasing cash flow and low debt. These are quantifiable data and we can calculate them but the problem is that these statistics and financial performance are already in the past.
As an astute investor, what we want to see is the future growth of the business we invest in. Therefore, the main thrust of our article here is not only finding wonderful companies but also companies that can last long because companies returning a 10-bagger need the time to grow. If they grow, our investments grow too. Then the problem lies in that not all companies can last long. We all wonder why some companies can continue to grow for decades while others roll the carpet in just a few years.
Herein lies the secret of every successful investor.
Warren Buffett has quietly slide a paper under the door to us with one of his priceless wisdoms:
Yes, we must buy companies with a competitive advantage or more commonly known as an economic moat. Not only that, this economic moat of the company must be durable and last long. So what is this economic moat all about? An economic moat is inherent in a business of a company and has the ability to protect its long-term profits and market share from competitors in their industry. Just like a medieval castle, the moat serves to protect those inside the fortress and their riches from outsiders.
So imagine if you create and own a great business with very high profit margins and ever increasing net profit. You opened a 2nd branch within just 1 year. Words spread fast that your business is booming and now, copycats will enter and operate the same business as you because it is very seductively profitable. If your business has nothing to prevent these competitors from entering the market, all your profits will be taken away by more and more competitors and then leaving you and everyone earning just a market average return.
Take for example the boba milk tea business. Just 2 years ago, this was a very hot business with a very high profit margin. Hundreds of people queue for hours just to have a taste of this drink. All the business needs are brown sugar, tapioca starch, tea, milk and other low costs ingredients to make this delicious cup of sugary diabetic beverage and sells you for RM15.
Naturally, due to the attractiveness of this business model, more and more boba milk tea brands enter the market. So you see, despite how profitable your business is during the 1st year, competitors will come and snatch every penny and market share from you. The boba milk tea business has no moat at all. This is evident by the recent news shown below.
So the whole idea is to buy the right companies with a strong and durable economic moat. If the company’s business can consistently protect their high profit margins and continuously generate high return on equity, the business can continue to grow and compound its return without being interrupted and challenged by competitors in the market for many years.
Say we have a business with RM10 million in equity and we make RM2 million in net profit. That is a 20% return on equity (ROE) which is remarkable. Now this RM2 million is being put back into the business and now it has RM12 million in equity. Next year, this business generates RM2.4 million in net profit which is still a 20% ROE and if it keeps doing the same thing for 15 years, it will have grown to achieve RM154.07 million in equity! Wow!
So what this means is that when you see a company that has an ROE of 20% year after year, somebody is taking the profit at the end of the year, recycling it back into the business and uses it efficiently so the ROE can stay right where it is. And this person can only do this year after year if his business has a strong and durable economic moat. A company needs to do something well for quite some time if it is to become a 10-bagger. If the company you invested in becomes a 10-bagger, so does your investments.
A company with an economic moat can sustain high returns for longer than one without. That allows the company to reinvest those profits at higher rates than their competitors and able to compound longer than other companies. The picture below sums up perfectly about this idea.
That is why you see wonderful companies like FASTENAL is a 532-bagger, MICROSOFT is a 1,160 bagger, APPLE is a 430-bagger, AMAZON is a 1,000-bagger and the legendary BERKSHIRE HATHAWAY which is an astounding 25,100 bagger! All these companies are able to achieve such remarkable feats because all of them has some form of economic moat that is protecting their business which allows them to grow for decades.
Summarily, once you have done the work to find a good business with strong financials while being protected by a durable economic moat, all you need to do is give it time to achieve your 1,000% ROI. Time is the friend of the wonderful business, the enemy of the mediocre. Let your stocks ripen on the vines. Don’t pick them too early. Invest and hold for the long term. Don’t be impatient and find the need for “action”, the powerful feeling that you need to “do something” to achieve something. Just let time and the power of compounding work in your favour. Good luck and happy investing.
Disclaimer: All facts and opinions presented are for educational purposes only. This is not a recommendation to buy or to sell. The author involved in the writing of this message has no vested interest in the companies. Please consult a professional for expert financial or other assistance or legal advice.
This article was written by Team VIC
Team VIC is formed by experienced and well-trained individuals from Value Investing College (VIC). The team has been consistently studying the latest stocks market trend in order to focus on educating the layman on investment principles and techniques.