7 Principles for Finding 10-Bagger Stocks

7 Principles for Finding 10-Bagger Stocks

David Gardner, co-founder of The Motley Fool, has a decade-plus record of thumping the market with his stock picks -- including a number of huge winners. I've been following his stock picks for more than a decade, and I've identified seven key principles for finding big winners -- stocks that can return 10 times or more their original investment.

Since 2002, David has been the co-advisor of our Stock Advisor newsletter, along with his brother, Tom. Since 2004, he has been the advisor of our Rule Breakers newsletter. Over the past five years, both newsletters have produced twice the returns of the stock market.

The key to success: huge winners (i.e., 10-baggers)
A huge driver of the tremendous performance has been David's knack for finding huge winners -- he's found nine 10-baggers in more than a decade (and that's just in our published newsletters). But how does he do it?

I decided to make a study of David's 10-bagger recommendations. Since the Fool is transparent and all our recommendations are archived, I had access to every recommendation David has made since we started a premium newsletter in 2002 (by the way, this isn't exclusive access -- members of Stock Advisor have access to all the same materials). I went through scorecard returns and recommendations going back more than 10 years.

Seven principles for finding 10-bagger stocks
In the end, I came up with seven principles for finding 10-bagger stocks -- investments that generate massive returns on your original investment. Now, some of these rules fly in the face of conventional investing wisdom. And this isn't a comprehensive investment strategy; in fact, searching for 10-baggers can be quite risky. It involves investing in a basket of early stage, perhaps "overvalued" stocks, for very long periods. And success isn't guaranteed -- 10-baggers don't happen that often. Personally, I've had multibagger stocks, but never a 10-bagger (hopefully, I will in the near future, say a decade). Even if you're successful, you'll experience a lot of volatility along the way. With that as a disclaimer, here are things you should consider when looking for 10-bagger stocks

1. Find businesses with unquantifiable greatness and a wide-open future
"Unquantifiable greatness" applies to businesses that provide products or services that customers love or need. If it disappeared, people would suffer or be highly disappointed. A great way to identify companies like this is through your personal life. What new service or product is disrupting an industry to make your life better? And it's not just about today's business. Unquantifiably great businesses have optionality -- lots of ways to win in the future.

That perfectly describes Marvel Enterprises, which David recommended in 2002. At the time, its finances were shaky, but it held an incredible treasure trove of intellectual property. Its characters, stories, and brands (e.g., Spider-Man, Iron Man, X-Men) were special, and the company had a huge opportunity to monetize its content beyond toys and comics. And over the succeeding years, it was able to generate significant profits from film licensing and production. Marvel stock was an 11-bagger by 2009 when Disney acquired the company. And for those who kept their Disney shares after the acquisition, the return has only increased -- today, those original Marvel shares purchased in 2002 are a 33-bagger.

2. Identify massive trends and look for visionary leaders
Historically, equities on average have only generated 7%-8% annual returns. Huge winners in the stock market are typically the result of major disruptions or shifts in industry dynamics, business practices, or consumer preferences. In fact, I'd argue that it's a necessary condition for a 10-bagger. Often, these disruptions are fueled by new technologies. So, it's important to identify major new trends -- real innovations, not just hype -- that will generate change in the future. And if you're able to find a huge trend, look for the visionary in the industry.

David Gardner has been early on several major trends -- e-commerce, 3-D printing, cloud computing, and so on. But probably his most successful investment, thus far, has been in e-commerce. In 1997, he invested $11,000 in Amazon.com . He identified e-commerce as a major trend and, among all the companies in the space, he considered Amazon.com to be the visionary. As you might expect, this turned out to be a huge winner -- his original investment is up more than 100 times in value.

3. Start small because it pays to get in early
There are certainly a lot of reasons to like Apple as an investment. But it's not likely to be your next five- or 10-bagger stock. With a market cap nearing $500 billion, it's simply too large. As companies become very large, and Apple is one of the world's largest, it naturally becomes more difficult to grow. At the Fool, we call this the megacap multiplier obstacle. To reach 10-bagger status, Apple would have a market cap of nearly $5 trillion. That hardly seems possible. Could Apple double or triple? Sure, but its size precludes 10-bagger status within the next few decades.

Smaller stocks are simply more likely to hit multibagger status. If I look at the 10-bagger positions that David has recommended in Stock Advisor, all were on the small side -- well under $10 billion in market cap. In fact, most were well below $2 billion in market cap and half were below $1 billion.

The largest 10-bagger recommended, in terms of initial market cap, was Amazon.com in 2002, at around $6 billion. Of course, David also recommended Amazon.com in 1997 under $1 billion in market cap. When David initially recommended it in 2004, priceline.com only had a $700 million market cap -- today it's at $57 billion. Netflix was recommended four times between 2004 and 2006, well below $2 billion in market cap at the time. Marvel, recommended twice in 2002, was the smallest -- only $170 million in market cap when initially recommended.

4. Spread your bets across many companies
Owning more companies gives you the benefit of diversification. Furthermore, finding those truly great businesses that will deliver 10-bagger returns isn't easy. Very few businesses or stocks will deliver 10-bagger returns, and you'll increase your chances of finding them by spreading your bets. It's sort of like venture capital investing. Venture capitalists invest in a basket of high-potential companies with hopes that a few massive winners will more than offset the inevitable losers.

Since 2002, David has recommended nine positions (all published in Stock Advisor and Rule Breakers) that have increased more than 10 times in value. That's an amazing feat, but it came from continuous search and investment. David made more than 360 recommendations during that time. If he had taken fewer positions (fewer bets), it's unlikely that he'd have found so many big winners.

5. Longer holding periods result in larger gains
A big winner -- like a 10-bagger -- doesn't happen in a quarter, a year, or even five years (most of the time). If you want the really big gains, you need to be prepared to hold for a long time. David's top five highest-returning stocks in Stock Advisor have, on average, returned 30-times their original investment. But it didn't happen overnight. Those five positions were all recommended between 2002 and 2004, putting the average holding period around a decade. And David's biggest all-time winner -- a 100-bagger on Amazon.com -- took 16 years. Watch David and Tom discuss the 100-bagger in Amazon.

6. Let winners run and keep your money on the table
It's a well-known bias that investors tend to be overeager to sell winners and "lock in" the gains -- called the disposition effect in behavioral finance literature. There's an old Wall Street saying: "Bulls make money, bears make money; pigs get slaughtered." The implication is that you need to regularly take profits on your winners.

And, frankly, it's fine, in certain circumstances. If a single stock has become such a big part of your portfolio that you're uncomfortable or if you lose faith in the business, it's fine to trim or sell out. But resist the urge to mindlessly sell winners. If you're interested in 10-bagger returns, you need to stay in the game and let your winners run.

Here's an example from Stock Advisor: David recommended Priceline.com in 2004. After six years of holding, it was an eight-bagger. He could have closed the position to "lock in the gain." But the business was doing well, so he decided to stay invested. Over the next three years, the stock increased again by nearly six times in value. At present, it is approaching 50-bagger status, largely because David chose to let it run.

7. Don't anchor on superficial valuation measures or on past prices
It's a basic truth that a business is worth the sum of its future cash flows and, by definition, your investment returns are a function of the price you pay for the business. This basic principle, while completely sound, leads a lot of investors astray, particularly with early stage and fast-growing companies. Investors obsess on unreliable forecasts or P/E ratios and miss the big picture.

When David recommended Netflix in October 2004, it was worth nearly $1 billion with negative earnings. It would have been easy to look at the financials and say it was "overvalued" while ignoring its fast growth, smart management, and big market opportunity, which are harder to quantify (and don't show up in the historical financials). David recommended the stock regardless, and it's a now 20-bagger on the Stock Advisor scorecard. And David added to the position twice in 2006 (at higher) prices. Those positions are now 12- and 14-baggers.

Foolish bottom line
Finding huge winners, like 10-baggers, is tremendously difficult and risky. But if you find a basket of early stage innovators, it's likely a big winner will emerge. If you can hold that winner or even add to it, over a long period, it should do wonders for your portfolio.

More Foolish insight
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The article 7 Principles for Finding 10-Bagger Stocks originally appeared on Fool.com.

Brendan Mathews owns shares of Apple and Amazon.com. The Motley Fool recommends and owns shares of Amazon.com, Apple, Netflix, priceline.com, and Walt Disney. Try any of our Foolish newsletter services free for 30 days. We Fools don't 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.

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