How to Get a 66 Bagger
Kyle is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Question: How do you turn $1,000 into $66,200
Answer: Find companies that can consistently grow earnings by 15% a year for the next 30 years that are trading at a reasonable price.
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In 1919 Coca-Cola (NYSE: KO) went public at $40 a share. Many thought the stock was expensive at the time, and the following year the stock tumbled and fell to half its IPO price at $19 a share. Had you have bought a share when it IPO’d, had the fortitude to stick with it despite its major decline, reinvested all dividends, and been lucky enough to still be alive today, that one share would now be worth almost $10 million.
Even at a relatively high PE ratio companies can still be cheap if their growth rate is high enough. If a company trades at 20 times earnings, earns one dollar a year and is able to consistently grow earnings by 15% a year, then that same company will earn $66.20 within 30 years. If the company is still trading at its same multiple that one share will have grown from a value of $20 to $1,324.23… and that’s not even including any dividends!
The secret to Coke’s success has been steady, consistent growth over a long period of time.
Why the Growth Needs to be Consistent
Financial writers Jim Collins, and Mortin T. Hansen did an analysis of multiple companies in their book Great by Choice to see what made companies great in spite of challenging circumstances. Two of the companies the authors analyzed were Stryker and USSC. Between the years 1977 and 2002 both companies grew very quickly, but the average growth rate of USSC was 45% per year, while Stryker (NYSE: SYK) was at 25%. However, over this period of time, shares of Stryker outpaced USSC significantly, growing by over 350 times. USSC on the other hand underperformed the market and was forced to succumb to a takeover by Tyco International in 1998. The reason for this discrepancy between earnings growth and share price growth had to do with the volatility of their earnings growth. Stryker’s earnings had a standard deviation of 15 percentage points, while USSC’s was 116 percentage points.
To see why this matters, compare the following two theoretical charts. Both charts have average growth of 10% a year, however chart A has volatile growth, while chart B maintains a consistent growth rate of 10%. Additionally both charts assume that $100 was invested and compounds over a period of four years.
Chart A – Starting amount $100
|
Year 0 |
|
$100 |
|
Year 1 |
40% |
$140 |
|
Year 2 |
-30% |
$98 |
|
Year 3 |
60% |
$156.80 |
|
Year 4 |
-30% |
$109.76 |
Chart B – Starting amount $100
|
Year 0 |
|
$100 |
|
Year 1 |
10% |
$110 |
|
Year 2 |
10% |
$121 |
|
Year 3 |
10% |
$133.10 |
|
Year 4 |
10% |
$146.41 |
It is clear by these two charts that consistent earnings growth is important and it becomes clear why Stryker outperformed USSC.
Unfortunately Stryker no longer offers the same incredible growth rate that it once offered and so investors are now forced to look elsewhere to find consistent growth. Fortunately the market presents many opportunities for these types of companies. In fact, one investor is famed for buying companies that consistently grow earnings year over year for many years.
Warren Buffett buys businesses that have a durable competitive advantage, and can grow earnings consistently every year. His holding company Berkshire Hathaway (NYSE: BRK-B) has grown its own book value by 19.8% per year since 1965. This is because he invests in companies like Coca-Cola.
Over the past 46 years from 1965 to 2011 Berkshire Hathaway has seen its book value per share grow by a CAGR of 19.8% year, and shares have absolutely exploded since its IPO as a result of this.
Growth…. But at What Price?
Even the best companies can be bad buys if their stock price is trading too high. It is important to find good bargains in the market.
One ratio that is often used is the PEG ratio. If a company trades under 1.00 it is generally considered underpriced, if it trades over 2 it is generally considered overpriced, and a PEG ratio of 1.0 to 2.0 is generally considered to be in the Goldilocks zone of market efficiency. While the PEG ratio is a good starting point for most investors and buying stocks with a low PEG ratio has historically outperformed the broad market, it is important to remember that the PEG ratio is only one of many measurements used to value a stock.
A Consistently Growing Company that May Become a Buy
Yum Brands (NYSE: YUM) owns several fast food chains including Taco Bell, and KFC. The company has grown earnings per share consistently for the last 10 years with a CAGR of 11.3%. Over this period the company has not had a single year of EPS decline.
If you assume that the company will continue to grow at a rate of 11.3% per year (analysts estimate the company will grow by 13.63% per year for the next five years), and you add in their dividend of 1.7%, the company is left with a growth rate of 13%. At a price to earnings multiple of 21.8, the company looks overvalued with a PEG ratio of 1.62. If the stock goes down from here it may present a buying opportunity for investors.
A Consistently Growing Company that is a Buy Today
While Yum might not be a good investment today, Fairfax Financial (NASDAQOTH: FRFHF.PK) offers a tremendous buying opportunity at today’s prices.
Fairfax Financial is an insurance/holding company similar to Berkshire Hathaway. The company owns insurance firms, and then uses the float from their underwriting to finance the purchase of other securities. The company’s growth rate in book value has been slightly higher than Berkshire Hathaway at 24.7% compounded annually, and though it is fairly consistent, it is not quite as consistent as Berkshire’s growth. As a holding company, book value is a more important metric for determining valuation than earnings
The company is currently trading at only 1.09 times book, which is unbelievably cheap. Historically, the company has traded at 1.6 times its book value. Assuming that Fairfax maintains its growth rate, the company should expect to have its market cap eclipse its book value by early next year.
Conclusion
Companies that can grow earnings consistently year over year are usually good stocks to look at as investments. These are exactly the types of stocks that have made both Peter Lynch and Warren Buffett incredibly successful investors. If investors can find stocks that grow consistently year over year they will most likely be successful at investing as long as the stocks they buy aren’t incredibly overvalued.
Visit the Author's Personal Blog to find more companies that offer good investment opportunities.
Kyle owns shares of Fairfax Financial. The Motley Fool owns shares of Berkshire Hathaway and The Coca-Cola Company. Motley Fool newsletter services recommend Berkshire Hathaway, Stryker, The Coca-Cola Company, and Yum! Brands. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.
