You don’t want to pay stupid prices.
Let’s say you pay 50 times earnings for a company that generated
$1 in earnings last year. Think what you need to happen to make it a 100-bagger. You need earnings to go up a hundredfold and you need the price–earnings ratio to stay where it is at 50. If the price–earnings ratio falls to 25, then you need earnings to rise 200-fold.
Don’t make investing so hard.
We saw earlier in our case study of Gillette how a price–earning ratio collapse from 20 to 10 blunted the return investors got from Gillette’s earnings growth.
But on the other hand, you shouldn’t go dumpster diving if you want to turn up 100-baggers. Great stocks have a ready fan club, and many will spend most of their time near their 52-week highs, as you’d expect. It is rare to get a truly great business at dirt-cheap prices. If you spend your time trolling stocks with price–earnings ratios of five or trading at deep discounts to book value or the like, you’re hunting in the wrong fields—at least as far as 100-baggers go. You may get lucky there, of course, but the targets are richer in less austere settings.
I say lower multiples “preferred” because you can’t draw hard rules about any of this stuff. There are times when even 50 times earnings is a bargain. You have to balance the price you pay against other factors.
Remember, time is the friend of the great business. And you can pay more for a great business. Let me give you another example: Interactive Brokers (IBKR), the online broker.
Matt Goodman (the analyst who did the case study on Monster Bever-age) did an analysis of IBKR, a stock we recommended in our newsletter.
He showed how it has been applying new technology to an age-old business. Its platform is more capable than competitors and it is easily the least-cost option.
You can see this anecdotally in industry news, as Goodman points out:
• According to legendary trader Peter Brandt, talking about Inter-active Brokers, “On one trading platform and with one account I can trade the world—from US to global futures markets, US and global stock exchanges, options, forex, you name it. . . . Credit Suisse would offer me the same package for an account worth
$50 million. Ditto for Goldman and D-Bank. No other firms I know of provide this capability for accounts under $5–10 million.”
• Bank of America, JPMorgan and others are giving their hedge fund clients the boot. Some, like E-Trade, are closing global trading ac-counts. Where do these customers all go? Interactive Brokers.
• Scottrade recently added its clients to IBKR’s platform. Scotttrade is a competitor, and it’s essentially put up the white flag.
Goodman writes you can also see all of this in the numbers. He showed how growth in new accounts was actually accelerating at IBKR:
“This is information one can find in the IR section of the IBKR website,”
Goodman wrote. “I added the last column, ‘Prior month annualized.’” Key
(in 000’s)
takeaways here: While year-over-year growth seems impressive, month-over-month growth is even more impressive. And client equity is growing even faster than total accounts. That’s a huge positive trend because it means the business is attracting wealthier customers who are opening larger accounts.”
So, this is a fast-growing business. But the stock traded for about 25 times earnings in late 2014, when you backed out the excess capital it had. That is not a low multiple. So was it worth it?
Charlie Munger, vice chairman of Berkshire Hathaway said, Over the long term, it’s hard for a stock to earn a much better return than the business which underlies it earns. If the business earns 6% on capital over 40 years and you hold it for that 40 years, you’re not going to make much different than a 6% re-turn—even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you’ll end up with a fine result.
“That quote is a cornerstone of a 100-bagger philosophy,” Goodman wrote. (And it’s the second time we’ve referred to the quote in this book.)
“We’re looking for companies with very high returns on capital. That’s one of the key requirements 100-baggers must meet. And this quote proves the point. Here’s a table to breathe some life into Munger’s comment.”
You can see how dramatically different a 6 percent return is from an 18 percent return.
At the end of 20 years, a company returning 18 percent on capital winds up with a pile nearly eight times larger. The lesson: don’t miss out on the chance to acquire great businesses at fair prices, and you can clearly see why in this chart.
“One way to look at it is by using something called the PEG ratio,”
Goodman suggests. “The PEG ratio is simply the (P/E Ratio)/(Annual EPS Growth Rate). If earnings grow 20%, for example, then a P/E of 20 is justified. Anything too far above 1x could be too expensive.”
IBKR’s brokerage pretax earning growth rates for 2010–2014 were 19 percent, 35 percent, -8 percent, 33 percent and 29 percent. IBKR’s earn-ings grew 29 percent in 2014, yet the stock traded at 26 times earnearn-ings, giving us a PEG under one—unusual for such a high-quality business growing quickly in today’s market. The fact that we can get it under one is a major plus.
Again, this is an example of the kind of thinking you should work through. Just remember that the higher the multiple you pay, the higher the earnings growth rate needs to be.
To repeat once more: lower multiples preferred.