There is no way around it. Almost all of the businesses in the 100-bagger study were substantially bigger businesses at the end than when they began.
(There is an exception to this, which I’ll highlight below.)
So, you need growth—and lots of it. But not just any growth. You want value-added growth. You want “good growth.” If a company dou-bles its sales, but also doudou-bles the shares outstanding, that’s no good. You want to focus on growth in sales and earnings per share.
Likewise, if a company generates a lot of extra sales by cutting its prices and driving down its return on equity, that may not be the kind of growth you’re looking for. You want to find a business that has lots of room to expand—it’s what drives those reinvestment opportunities.
And yes, I’m being intentionally vague about whether you want sales growth or earnings growth. You’d love both. But there are also examples of 100-baggers that grew sales at a high rate but did not show much in the way of reported earnings through the high-growth phase. (Comcast and Amazon are examples we covered.)
Earnings are the reported numbers, whatever they are. Earnings power, however, reflects the ability of the stock to earn above-average rates of re-turn on capital at above-average growth rates. It’s essentially a longer-term assessment of competitive strengths.
This is a distinction Phelps makes in his book 100 to 1 in the Stock Market.
He writes, “Failure to distinguish between ephemeral earnings fluctuations and basic changes in earnings power accounts for much over trading, [and]
many lost opportunities to make 100 for one in the stock market.”
Don’t get lost following earnings per share on a quarterly basis. Even one year may not be long enough to judge. It is more important to think about earnings power. A company can report a fall in earnings, but its longer-term earnings power could be unaffected. In the same way, earn-ings may rise but the underlying earnearn-ings power may be weakening. For example, a company might have great earnings but a high percentage may come from one-off sources.
So, how do you separate the ephemeral earnings setback from the real thing? Well, there is no substitute for knowing the business you’ve in-vested in. If you don’t understand what you own, it’s impossible to make a wise choice. Let me illustrate by way of an example.
There is a business I like called General Finance (GFN). It’s a simple business. It leases containers—the kind of things you see on construction sites where people store things.
In addition to these, GFN leases
• freight containers—used by road and rail operators—which can store dry bulk goods and refrigerated goods;
• portable building containers—essentially mobile mini-offices or lunchrooms, first aid rooms, and so on—used by construction firms and natural-resource companies and even for public events;
• portable liquid tank containers—which can hold wastewater, chemicals and other liquids—used in oil and gas, environmen-tal remediation and the like; and
• mobile offices and modular buildings.
The economics of container leasing are fantastic. Payback is only a few years, but the asset has a 40-year life. So, we’re talking about high returns on capital. The industry is fragmented, and there is lots of room to grow by acquiring mom-and-pop operations. And there is a talented and proven owner-operator in Ron Valenta.
In early 2015, the stock sells off hard on earnings slowing down because of a slowdown in oil and gas sales. GFN leases containers to oil and gas customers. But really, has the earnings power of GFN been compromised in any way? Is the long-term thesis here cancelled out because of a slowdown?
The answer is no.
They still have their containers, which they can lease elsewhere. GFN has a fleet of about 37,000 storage containers. Its customer list is diverse.
GFN serves over 30,000 customers across 20 industries. These assets didn’t go anywhere.
They still generate tons of cash. There are still a lot of mom-and-pop operations out there they can continue to roll up. As Valenta put it in an interview with me,
We probably spend as much time or more time on a company once we acquire it. We have great product breadth, so we can make improvements there. We look at billing systems. Are they billing monthly or every 28 days? Do they have damage waivers?
How are they handling trucking? So we analyze the business and what can we do with it. . . . We’re not just an acquirer. What we’re really good at it is taking things and improving on them dramati-cally. We’re a very disciplined buyer. But more importantly, we’re a value creator in what we do with the asset. (emphasis added)
That hasn’t changed. All that’s changed is a temporary dip in earnings because of a cyclical change in fortunes in its customer base. There is no
new competitive threat. There was no management change. There is no new regulation or other factor that might change this business in any significant way.
This is the kind of thinking I do. As you can tell, you can only do this if you know the business well. Spend less time reading economic forecasters and stock market prognosticators, and spend more time on understand-ing what you own. If you’re not willunderstand-ing to do it, then you’re not gounderstand-ing to net a 100-bagger or anything close to it.