Multi-baggers with growth companies 📈💸

Buy well, buy low, keep validating and hold long to growing companies to enjoy the wonders of compounding

Note: A keystone post on investing. Buy well, buy low, keep validating and hold long of growth companies has been my main strategy. I have been learning and refining my strategy; always a work in progress. Hence, I do update this post quite frequently.

Quality and valuation

There are 2 important aspects to investing especially with growth companies: quality (buy well) and valuation (buy low).

1. Buy well: Quality

Growth companies consist of a wide spectrum. They have very different rates of growth (10%, 20%, 50%, 80% or more than 100%), duration of revenue growth (How long have they been growing consistently? Is their growth accelerating or deaccelerating?), their gross and net profits (Are they making losses as they are aggressively reinvesting?) as well as their operating and free cash flows. They are different due to:

  1. The stage of development
  2. The potential and maturity of the total addressable market (TAM) and the ability of the companies to expand and capture TAM
  3. The intensity of competition and aggressiveness of the companies to enter the market to compete and capture the growth

Profit margins and returns also follow the life cycle, albeit with wide differences across firms:

A typical life cycle
The founder has a business idea and decided to create an innovative product. At this stage, they will still be investing in product development, marketing and various aspects of the business. When early adopters buy and use them, these will be shown in terms of operating metrics (such as daily/monthly average users/use).

To grow fast, they may prioritise revenue growth over profitability; raising money to improve and expand their product lines to gain an insurmountable lead over competitors. They may have low net margins or make losses as they keep reinvesting.

Growth companies especially those in the early and hyper-growth stages that are spending and growing revenue aggressively while incurring huge negative (operating and free) cash flow and losses are more difficult to ascertain and analyse for retail investors. We need to monitor their cash flow and sales and marketing spend versus customer growth and their spending (Net dollar retention rate (NDRR), Average revenue per user (ARPU), Annual retention rate (ARR)).

Will their leadership, products and brands live up to their promises to capture value in the long term with increasing operating/net margins and generate free cash flow? Can their investments succeed? They are more volatile. Their valuation can be very high during the upcycle and they will be more affected during the downcycle as the market goes risk off. As we are unsure how long and tough the economic downcycle will last, can they survive and thrive as they are still investing to grow their business that generates little or negative cash flow?

Slowly, the business must be able to generate good free cash flow that can finance its investments that can compete effectively with its competitors and maintain its market leadership. It will take time before the companies achieve operating leverage to become profitable with net profit margins increasing.

In short, it is the ability to grow revenue consistently, and maintain/increase gross and net margins to generate free cash flow for reinvestments into the business to keep building its moat and grow its business.

As companies get larger, they will grow at a slower rate. Well-managed companies can grow for many years (or decades) before they lose their competitiveness and go into decline.

Depending on the lifecycle stage that the company is in, different metrics will be important. Usually, a slower revenue growth company can have a higher net profit margin, better free cash flow and net cash position. However, there can be companies that are growing much faster in revenue and yet able to achieve a good net profit margin, free cash flow and a good cash position. The types of growth companies to invest in will depend on your preferences, comfort and conviction level.

Signs of multi-baggers

1. Consistent annual revenue growth of at least 10%Strong long-term demand demonstrating its ability to consistently create value
2. Maintain/increase gross and net margins with revenue growthAchieve operating leverage through (a) strong pricing power and (b) operational excellence (with continuous improvement culture)
that demonstrate their strong consistent ability to consistently create and capture long-term value
3. Generate increasing free cash flow (FCF to revenue) to fund their investment and growthThe litmus test of high-quality growth companies and their ability to capture long-term value is their ability to be a cash machine.
4. Maintain/improve ROE and ROIC over time Ability to create and capture value with capital consistently
5. Ability to keep doing the above points 1 to 4 consistently over the long termAbility to keep building and strengthening its moat with sustained investments consistently –> creating a flywheel effect with its ability to grow on rising returns on rising cash flow levels; the holy grail of compounding
6. Increasing net cash position (cash ratio) through debt/equity and generating free cash flow An important buffer especially during a challenging situation

Our conviction in their long-term consistency and durability in revenue growth, margins, profit growth and free cash flow are crucial as shown below.

Credit: BCG, Morgan Stanley Research

Mark Mahaney, a legendary analyst in his book, “Nothing But Net” wrote about the 20% revenue growth “rule”: Only about 2% of the S&P 500 have been able to consistently generate 20% top-line growth for five years, but these stocks have usually materially outperformed the market. The ability to keep growing revenue consistently can often reflect large market opportunities, relentless and successful product innovation, compelling value propositions and top-quality management teams. As a start, he suggested looking for companies that have generated 20%+ revenue growth for at least five or six quarters in a row. Past performance can sometimes be an indicator of future performance.

Check out the post: Nothing But Net by Mark Mahaney

As companies report their earnings every 3 months, we tend to focus on their quarterly performance and their ability to beat earnings expectations and raise guidance. Together with news and events happening then, these can make us too focused on the short term and neglect their longer-term performance which should be the key focus for investing in growth companies. Zoom out, companies that can grow consistently over a long period will see their share price appreciate substantially.

If a company makes a product that customers really love, they can’t get it anywhere else, they use it forever, and everyone needs or wants it, that must create a lasting environment for reinvestment back into the business at strong rates of return.

The Virtue of Patience, Doug Clinton

It is also good to focus on companies, sectors and countries/regions that we are more familiar with; where we understand how they make money, what are their competitive advantages and the possible market potential.

Quantifying qualitative factors

Companies may be promoted for various reasons. Companies may position and hype as the next great company with the next great products in the next great sector to get a higher valuation and raise more money. Mainstream and social media may hype the companies as having a competitive advantage and their CEO/founders to be larger than life. Many especially retail investors will be attracted to them and their investing thesis feeling FOMO (fear of missing out).

Validating their investing narratives
Hot sectors, hot products, hot companies ≠ High-growth, high-quality companies
Value created ≠ Value captured

Aswath Damodaran explained that the qualitative factors should be reflected in financial statements and compared to its competitors and industry averages. The company must be capable to execute its investing narrative, story and claims with the results demonstrating signs of a multi-bagger.

The ability to grow its revenue, and maintain or increase its margins and free cash flow is a good validation of the durability and sustainability of its moat and the size of the total addressable market.

Attractive sectors especially those with lower barriers to entry will attract new entrants into the sector. The sector’s growth may not be durable as expected. Companies may experience high revenue growth but suffer losses continuously — able to create value but unable to capture them. We need to determine who are the crying wolves and who are companies that are capable of riding the hot industries and secular trends.

An interview very worth listening to between the valuation guru Aswath Damodaran and William Green, 5 April 2022

The Highest Possible Returns. Period. By David Gardner

2. Buy low: Valuation

Valuation is a quantitative process of determining the fair value of an asset, investment, or firm. Valuation should be based on the companies’ expected stream of cash flows – Discounted Cash Flow analysis. Metrics such as Price to Sales and Price to Earnings are also used to determine their relative value.

As valuation is based on expectations, we need to be convinced of the quality of the company’s growth and its ability to generate consistent free cash flow vis-a-vis its market value. For companies in their early lifecycle stage, can the company achieve free cash flow?

Often, companies will pivot and innovate; expanding and deepening their product offerings to strengthen their position in the market as well as going into adjacent markets. This means reinvesting and concurrently, to continue to grow its revenue. Hence, our valuation is a function of their ability to grow faster and longer than what the market expects. The crucial question: Can they?

Buy low versus buy early; low ≠ early

There is a trade-off between buying early and buying later. When the companies have a longer operating history, we study how they handle their growing pains with each internal and external challenge. We are more confident as we have more information to judge their ability to balance ambition, aggressiveness and resiliency when presented with different operating environments.

There will be greater risks when we buy young companies and just listed with little financial performance and track records to study, hoping to ride on them earlier. We are unsure of the long-term receptiveness of their products. They are less battle-tested and not proven. They are riskier.

While we may invest in companies after a few years of their listings, the companies may still have many years (or decades) of potential and runway that we are actually early. They can keep expanding the total addressable market with their pivots and innovations; attract customers to use, and buy more and more often. These high-quality companies may go on to work on multiple huge total addressable markets and keep expanding (examples: Amazon, Microsoft, Google, Tesla). Hence, we are early for these companies with many optionalities with several huge total addressable markets.

Types of growth companies to invest in and their portfolio allocation will depend on the risk appetite, ability to assess their potential and longer-term performance and balance the risk-reward with appropriate portfolio allocation. Stable growth companies tend to be more predictable and consistent in their growth while faster growth companies can be more booms (multi-baggers) and busts (lose capital). Both spectrums of growth companies can be profitable investing but the evaluation, investing process and journey will be different.

Yes, they are often expensive.

Whenever investors think that a company has huge potential, it can stay expensive with financial metrics such as Price to Earnings (P/E) or Price to Sales (P/S) ratios. Many may find their valuation in a “speculative” range and price for perfection. The earnings are often deflated as they spend a lot to invest to grow and improve their competitive advantages.

Using Amazon as an example, its share price increased by 54 times or 5,406% in 22 years from the start of 1999 (USD 59.15) to the end of 2020 (USD 3256.93). Throughout the period, its PE ratio has always been at least 40 and sometimes, negative (due to losses) while maintaining a quarterly growth of mostly more than 20% year-on-year. Amazon is always expensive (overvalued). In 1995 when Amazon was just started, it was difficult to know how it could achieve its mission of becoming “an everything store”. They keep investing for future growth to fortify their moat, thus, their low net profit margin. They pursued numerous projects (such as Kindle, Echo, AWS, Amazon Fresh, Amazon Studios, Alexa, Fire phone and Fire tablets as well as building their own logistics with their own planes, warehouses and delivery network), acquired several companies (such as Souq, Twitch, Whole Foods Market, They were willing to let go of the ones that do not work. If we worked backwards from 2020 to 1999, putting actual growth rates into the valuation, Amazon was cheap in 1999. However, it is impossible to know, decades ago, that Amazon can do so extraordinarily. Slowly, we can appreciate the fruits of labour which they keep investing all these years. It is difficult to value the fighting and innovative spirit of the company — the ability to keep innovating, investing, failing and learning.

Amazon’s share price

Amazon’s share price % off the high

Amazon’s PE ratio

You can refer to for further historical analysis. For Amazon’s historical PE ratio:

Read more about Amazon to study a multi-bagger in greater detail: A case study of a mega-compounder: Amazon

Long-term compounders will always trade at a high valuation; paying for quality. Whether the high valuation is justified, time will tell as long as they keep growing, generating cashflows to further fuel their expansion and fortify their market position against competitors.

Almost universally, we overestimate what can happen in the short term and underestimate what can happen in the long term. This applies to investing as well. Great companies keep innovating, pivoting, and leveraging their ecosystems to market more products and usages that can create accelerating growth we will underestimate their potential. It is hard to quantify exponential growth and its drivers. Many technology companies can enjoy exponential growth due to Metcalfe’s law (i.e. network effect) at work. It is difficult to quantify great founders with their products to derive a target stock price over a long-term period. Just buy, validate and hold to ride on their growth momentum.

Yes, they are very volatile; a strong conviction is required to buy and hold.

Zooming out, we may not notice the volatility and think that buying and holding is easy. Being in the present and holding the position, we feel the wild swings frequently.

Because of the high valuation, the market has high expectations and its share price is very sensitive to any signs of underperformance, unexpected news and macro uncertainties. As shown above, Amazon has fallen 30% several times from the local tops. Investors need to be able to stomach large share price drops and the duration of these drops. We need strong long-term conviction else, it is very easy to be affected by the share price swings.

Buy at the dip to buy low

While we are convinced of the long-term multi-bagger potential, there will be short-term market and financial cycles that will create pullbacks and these can be huge pullbacks. These are opportunities to buy low.

You can refer to this article: A Trading Set-up: Bottom-fishing

Trade the volatility: Ride the secular trends, trade the shorter cycles

Some investors who are experienced traders may trade a portion of their positions on shorter time horizons of cyclical and tactical cycles instead of holding the entire position throughout the long-term secular trends with lots of wild swings along the way.

Choose your ride: Not for everyone

Everyone loves the returns of the multi-baggers but not everyone is ready to put in the efforts to find, analyse, identify these multi-baggers and validate them continuously to stay convinced. Also, they are volatile. Growth companies are not as stable as established companies.

Evaluation of growth stocks will be more judgemental and subjective. How durable and sustainable is their growth? Can their margins and free cash flow maintain/improve over time? Will their (aggressive) reinvestment improve their competitiveness? Can their past be a good predictor of their future? There are lots of growing pains and challenges as the company scale and out win its competitors and imitators. They are usually valued higher. The greater the growth the market expects, the more sensitive its share price will be to macro events and earnings releases and hence, greater volatility.

Investing in growth companies takes much more time to analyse and requires prudent allocation into the portfolio. Investors must also remain flexible that their investing thesis can be wrong and be willing to cut. The key is to identify several high potentials and be able to add winners and trim losers.

Most typical investors tend to rely solely on financial reports to evaluate the quality of companies. They will evaluate them based on a standard checklist such as their growth and returns on equity, book value, debt level, cash flow and consistency in these metrics over a period and they must fulfil as many criteria to consider investible.

Different growth stocks can be different. They do not tick most of the boxes on many investors’ checklists looking for more established companies. Investing in early-stage companies which have just started to generate revenue is more akin to venture capitalist investing. The financial performances of more aggressive growth companies do look ugly financially too as they keep investing to expand to grow; resulting in low net margins/losses and minimal/negative free cash flow.

Make your portfolio reflect your best vision for our future.

David Gardner, Motley Fool

Tails drive everything. Only a handful of companies will become long-term growth companies that attribute most of our returns. Not all growth companies we identified will succeed. We need to study them in detail and set our investing criteria tight, we can be wrong and be able to cut losses of poor-quality companies.

3. Keep validating and hold long

Investing is where you find a few great companies and then sit on your ass.

Charlie Munger

Validate and hold

Hold ≠ Buy and do nothing
Hold = Buy and continually verify

To reiterate, not every company wins and/or wins all the time. Many may not live up to expectations. Hence, after the initial investment into the selected growth stocks, investors need to continuously study the companies to ensure that their businesses continue to be great, executing what they have planned; able to withstand and thrive with each obstacle. We need to ensure the investment thesis continues to be valid.

Continuous validation helps to reinforce our conviction through research and analysis (not market hearsay) to objectively evaluate how events and incidents affect the companies, whether their strategies are effective and whether the market has gotten them wrong. Ignore mainstream news; they usually create FUD (fear, uncertainty and doubt) and greed with FOMO (fear of missing out). Else, we will be continuously vacillating between greed and fear, between euphoria and disgust. It is also better to add and hold the winners during pullbacks and crashes when everyone’s conviction got shaken and their share prices become oversold; buy when people are fearful.

The great investing myth (2): Buy and hold

Jeff Bezos’ Letter to Amazon’s shareholders is a good read. It showed the decoupling of the share price (as the dot com bubble burst affecting every dot com company) and what Amazon was doing.

It will get uncomfortable especially when the companies are still in early-stage and still proving themselves. Many invest in blue chips, income stocks, buzzword/trend-following stocks or what’s in hype right now. Be prepared to have dubious look and be scorned when discussing your growth stocks portfolio with friends.

Not every stock will be a winner, but the winners will far outweigh the losers. Time will differentiate the winners from the losers. Keep adding to your winners over time. As shown in the diagram below by Brian Feroldi, our portfolio in terms of market value should improve with time as we have more performing companies; more multi-baggers and fewer losers — we are on the right track.

Fighter mentality and playing the infinite game

It is not the strongest of the species that survives, not the most intelligent that survives. It is the one that is the most adaptable to change.

Charles Darwin

The best companies play the infinite game (as opposed to a finite game). It is not about becoming a market leader or achieving a certain valuation, rather, it is to keep the game going. The infinite players focus less on what happened and put more effort into figuring out what is possible.

Amazon’s 1997 Letter to Shareholders which has been attached to all subsequent Annual Reports is worth reading. It explained its long-term, strategic and bold investment approach in its relentless focus on customers and revenue growth than short-term profitability that it has held true to this day.

There is no status quo. Companies must continuously innovate, improve and re-invent themselves leveraging on market situations to strengthen their market leadership and move towards their vision.

Markets will react if the product is good and believe there is an opportunity/threat. Companies will copy to develop cheaper, better and/or faster offerings. Others may create competitive pressures such as blocking distribution channels and price dumping. Also, the operating environment can change unexpectedly and beyond any control such as economic crises, political tension, and pandemic.

Bad companies are destroyed by crisis, good companies survive them, great companies are improved by them.

Andy Grove

The key is how the companies pursue their vision and thrive in a constantly competitive and evolving market environment in the long term. The best time to evaluate companies is when they are having problems and how they overcome them. Observe how these extraordinary leaders will improve their competitive leads with each crisis.

Everybody has a plan until they get punched in the mouth.

Mike Tyson

The best companies can iterate fast and stay resilient. It is about the leadership and organisational culture that give them the speed and ability to experiment, fail, learn, succeed and the cycle continues. The road to success is never smooth sailing.

Tough times never last, but tough people do. The ultimate measure of a man is not where he stands in moments of comfort and convenience, but where he stands at times of challenge and controversy.

Martin Luther King, Jr., Civil rights leader and minister

“A smooth sea never made a skilled sailor.”

Franklin D. Roosevelt

It is good to read the life stories of founders/CEOs and their en route to their success (from business case studies, interviews and biographies). Many went through multiple personal and professional challenges to overcome against the much larger incumbents to succeed and more. It is a startup David versus the well-established industry giant Goliath. Logically, the probability of success is very low. These founders are highly visionary, with a strong conviction that they have a unique proposition that the market needs and an immense fighter mentality (grit, willpower and discipline) despite being outnumbered and out-gunned in every aspect. Notable examples are (a) Tesla against traditional (ICE) automakers such as Ford, General Motors, BMW, Mercedes and Toyota; (b) Netflix against Blockbuster, against linear TV channels and now against other non-linear TV providers such as Disney; (c) Amazon against bookstores (Barnes & Noble, Borders) and slowly, into every retail category such as fashion, toys, household essentials, electrical appliances, gadgets, clothing, sports apparel and equipment.

We cannot value and quantify the fighting spirit, tenacity and determination in the financial valuation. Do not underestimate the underdogs. History is filled with extraordinary companies led by extraordinary leaders creating new and great S-curves with their innovative products.

It is always good to buy great companies at a good bargain during crises and huge corrections. They will be sold out of fear by traders and noobs. Knowing that they will survive and thrive, we will be handsomely rewarded as stock prices go up to reflect their calibre later.

Companies such as Amazon, Facebook and Apple, Google which have been growing consistently for many years are capable of defining, developing and extending their S-curves into various product categories and geographical markets as well as developing new S-curves (digital products such as books, music and videos, Amazon Web Services).

What should investors do when markets are crashing??!!

Just start; start small and slow

Volatility has to be experienced to understand so it is good to start small and slowly with a few companies; each with a small initial allocation.

It will not be an easy ride. It can be difficult at times. There are companies whose promises turn out to be false, resulting in losses. There will be periods of huge pull-backs as much as 60% (2007 to 2008 Global Financial Crisis; 2020 Covid-19). Some will pull through each internal and external challenge and crisis, and some may lag and fail. Because of high growth expectations, it will be volatile that swing our emotions if not careful. Hence, we have to assess our risk appetite and comfort level.

Have an open and growth mindset; strong opinions, loosely held

Many new business ideas are innovative and disruptive; very different from the status quo. Our immediate reaction would be: Will this work? Will people buy and use it? Is there a market for this? Will the companies succeed and be able to grow with the market? Will they fail?

It may work and it may not work. We need to develop an open mindset to new business ideas and investigate. Instead of being negative/doubtful or infatuated with disruptions at first instance, we need to be objective and curious to spend time studying and investigating the founder / CEO, company and product offering as well as their financials to determine whether the company and new services have a good chance to succeed.

Not all disruptions will succeed. Not all growth companies will succeed. We need to have a growth mindset to be positive and forward-thinking so that we can learn and embrace mistakes as a learning opportunity to keep improving our home runs. Investing can be learned, developed and nurtured over time. There is no need to be too harsh with oneself with mistakes; avoid anchoring, learn to let go and move on.

It is not about being right.
Be open-minded and humble. Have conviction with flexibility. Be prepared to change and pivot.

Wonders of compounding: Time in the market > timing the market

There are no overnight miracles.

Compounding interest is the eighth wonder of the world. He who understands it earns it. He who doesn’t, pays it.

Albert Einstein

It takes years for companies to turn vision and strategies into reality. Its ability to execute and grow consistently in various circumstances for a long time will turn its stock into a multi-bagger; rewarding the shareholders handsomely. Hold tight to these great companies and let the compounding runs wild.

Patience is a competitive advantage.

Patience is a form of wisdom. It demonstrates that we understand and accept the fact that sometimes things much unfold in their own time.

Jon Kabat-Zinn

The first rule of compounding: Never interrupt it unnecessarily.

Charlie Munger

How to start: A cheat sheet to jump-start

A good start is to study how great companies are being started, struggled and persisted to success, and the biographies of great founders.

A few great books:

  • Nothing But Net by Mark Mahaney; check out my summary of the book
  • Amazon Unbound: Jeff Bezos and the Invention of a Global Empire by Brad Stone 
  • Lessons from the Titans: What Companies in the New Economy Can Learn from the Great Industrial Giants to Drive Sustainable Success by Scott Davis, Carter Copeland, Rob Wertheimer 

Another is how investors evaluated and felt that the companies would be great, found their convictions, and invested. Jason DeBolt invested in Tesla early and began to invest more as his conviction got stronger. Dave Lee’s interview with Jason DeBolt on his investing journey with Tesla is worth watching: Retired at 39 Years Old With $12 Million in TSLA — w/ Jason DeBolt (Ep. 235).

An investment advisory service is a good way to learn about investing in growth companies. Motley Fool is my favourite and a good way to start is their Stock Advisor service. They are growth investors. They have lots of resources for investors to learn about growth investing, the mindset and deep dives into stocks. You can refer to my article for details: A cheat sheet to jump-start your profitable investing journey

I have a section of the blog dedicated to my studies on multi-baggers; do check them out.

We can also learn from great investors such as Warren Buffett, Peter Lynch, Philip Fisher and William O’Neil.

Investors’ competitive advantage: Time

Our advantage as investors is time:

  1. Time spent to study the companies, their founders, products/services and the markets they are serving; be hardworking
  2. Time to hold and let these growth companies execute their plans while we keep validating the investing thesis to reinforce our conviction; be patient

The earlier we start to invest, the more time we will have to put the power of compound returns to work, and the more money we will have in the end. To be successful in investing, the key is to have (1) conviction and yet remain flexible to change, (2) hold as much of the conviction stocks as possible and (3) be able to hold for the long term.

Do read this article by David Gardner, Motley Fool: The Greatest Secret of All.

Big new ideas take years to develop. People make fun of you along the way. Stick with it.

Chris Dixon

Like great companies that take years to achieve their greatness, growth investing takes time to learn, make losses, keep learning, keep iterating, and improve. Yes, it does require hard work, tenacity and determination (i.e. a fighter’s spirit) to succeed.

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