How to Find Multibagger Stocks:
20 Insights from the Book ‘Superperformance Stocks
If you read Jesse Livermore’s “How to Trade in Stocks” from 1940, Nicolas Darvas’s ‘How I made 2M in the stock market” from 1960, Richard Love’s “Superperformance Stocks” from 1977, William O’Neil’s early version of “How to make money in stocks” from the 1990s or Howard Lindzon’s “The Wallstrip Edge” from 2008, you will realize that after so many years, the main thing that has changed in the market is the names of the winning stocks. Everything else important – the catalysts, the cyclicality in sentiment, has remained the same. Here are some incredible insights from Richard Love’s book ‘Superperformance Stocks’. In his eyes, a super-performance stock is one that has at least tripled within a two-year period.
The first consideration in buying stock is safety
Safety is derived more from the good timing of the purchase and less from the financial strength of the company. The stocks of the nation’s largest and strongest corporations have dropped drastically during general stock market declines. The best time to buy most stocks is when the market looks like a disaster. It is then that the risk is lowest and the potential rewards are highest.
2. All stocks are price-cyclical
For many years certain stocks have been considered to be cyclical; that is, the business of those companies rose and fell with the business cycle. It was also assumed that some industries and certain companies were noncyclical— little affected by the changes in business conditions. The attitude developed among investors that cyclical industries were to be avoided and that others, such as established growth companies, were to be favored. To a certain extent, this artificial division of companies into cyclical and noncyclical has been deceptive because although the earnings of some companies might be little affected by the business cycle the price of the stock is often as cyclical as that of companies strongly affected by the business cycle. Virtually all stocks are price-cyclical. Stocks that are not earnings-cyclical often have higher price/earnings ratios, and thus are susceptible to reactions when the primary trend of the market begins to decline. This can occur even during a period of increasing earnings.
3. A Superb Company Does Not Necessarily Have a Superb Stock
There are no sure things in the market There has been a considerable amount of investment advice over the years that has advocated buying quality. “Stick to the blue chips,” it said, “and you won’t be hurt.” But the record reveals that an investor can be hurt severely if he buys a blue chip at the wrong time. And even if he does not lose financially, he usually has gained very little, particularly considering the risks he has taken.
4. The catalysts
Super performance is triggered by many actions, such as a surprise announcement of a large increase in a company’s earnings, or the decision of one company to merge with another. But most often it is found in stocks that are rebounding from oversold conditions, such as those characteristics of bear market bottoms When stocks begin to regain strength after touching bear market lows, which are the stocks that bounce back fastest and strongest? Contrary to a belief held by some investment advisers, it is not the big, quality stocks…Rapidly increasing earnings were characteristic of most of the stocks on the list. Another notable feature is their size; these companies were all quite small – in terms of float and market cap
5. Sooner or later, all trends come to an end
Super performance price action is not consistent year after year in even the greatest growth stocks. Stock prices usually move rapidly upward for a period of months or several years. This is the super performance stage. The super performance stage might be followed by a price reaction or a sideways price movement. After a period of consolidation, which sometimes lasts for years, there might be another super performance stage.
Most stocks experience declining prices after a super performance phase has run its course. In many cases the price decline is severe. There appear to be three principal causes for the price reactions. These include weakness in the stock market in general, including the beginnings of a new bear market; the overpricing of stocks, which often results in profit-taking and a lack of new buying interest; and a drop in a stock’s earnings. However, in most of the latter instances, the stock’s price began its slide before the reported earnings began to decline. In many cases, though, the earnings decline was undoubtedly anticipated by some investors.
6. Look for small-float, small-cap companies with innovative products
Opportunities for big gains in the stock market are more likely to occur in relatively small companies than in companies with many millions of shares outstanding. Look for a small company introducing a unique product that is likely to become widely used. This is the combination that has time after time resulted in dynamic growth and volatile super-performance stock-price action.
7. Change means opportunity, and change is one thing that is certain
The introduction or planned introduction of a unique new product can have a dynamic effect on the price of the stock of a relatively small company. Many investors tend to be attracted to new, developing situations and to ignore old, established, stable situations. A large, mature company is likely to remain relatively stable in price, thus offering comparatively little opportunity for large capital gains.
8. Growth, Growth, Growth
Any investor looking for large capital gains in the stock market should look for companies that are in the growth stage of the life cycle. These are usually companies that have been established for a few years; they have been in existence long enough so that their chances of survival are pretty good. But they are usually fairly small companies, with comparatively few shares of common stock issued, usually under ten million. The percentage growth of sales and earnings, and also the stock’s price, can usually be much more rapid for a five-million-share company than for a hundred-and-fifty-million-share company, particularly if an appealing new product is being manufactured and large companies do not have the advantage of patents and established distribution channels for that particular product.
9. A good story can only get you so far In choosing growth-stage companies, it is necessary to be very selective. Stock prices can be pushed up quickly because of a good promotion or story that usually describes impressive plans for future development. But in the long-run stock prices are based on earning power. So the story has to begin to come true or else disillusioned investors will begin to sell their stock and drive down the price. As long as the story is coming true through satisfactorily increasing earnings, most investors will continue to hold their stock. Separating fact from fancy is the big job of investors who are searching for growth, and for super performance price action based on growth.
10. Look for sudden earnings explosion
It will take a while for the market to discount it properly Earnings explosions are often of great significance because they call attention to newly developed earning power. Recently I ran across a small clipping I had torn from a local newspaper in the summer of 1963. The clipping reads: “Xerox Corporation in 6 months ended June 30 earned $10,327,031 or $2.66 a share vs. $5,658,165 or $1.74 in 1962 period.” That is an example of an earnings explosion: a large sudden increase in the profitability of a company. The earnings explosion occurred just after Xerox introduced its new copiers, and the earnings increase was directly traceable to revenues from the new copiers.
11. Rumors are also catalysts
One of the strongest forces propelling the price increase was the rumor, later confirmed, of a large increase in earnings. In this case, the earnings for the 1963 fiscal year were more than quadruple the earnings for fiscal 1962. Of even greater importance than reported earnings, however, was the expectation in the minds of speculators that future earnings would be even larger. Syntex at that time was one of two companies pioneering the development of birth control pills. Investors could anticipate a very large market and increased earnings for the future. Thus, the expectation of large future earnings caused a buyers’ stampede for the stock.
12. Market is forward-looking
Expectations Matter Higher Earnings Are Usually Anticipated But how about earnings that are uncomplicated by manipulation, that are higher simply because the company had a much more profitable year? Let’s suppose the earnings are reported and they have doubled. The stock should go up in price, right? No, not necessarily. Not if a dozen mutual fund managers had expected earnings to triple, not merely double. They would be disappointed and might decide to sell. Other investors who had predicted the earnings increase might decide to sell on the news. Reports of large increases in earnings have their biggest impact when they come as a surprise. When that happens, almost everyone has an opportunity to participate in the resulting rise. Being able to interpret the effect that an earnings report will have on the market is very important. And even more significant is the light it might cast on the company’s prospects for continued future profits. Earning power, real and potential, is the most important feature to look for.
13. Multiples Expansion –
Most super performance price moves are caused not by developments such as increased earnings, but rather by the overreaction of investors to those developments. The overreaction can be measured quite accurately by comparing the increase in the price to the increase in earnings—that is, by the expansion in the P/E ratio. Some of the biggest stock market profits are made by going along with the crowd while it pushes the price of a stock higher and higher in nonstop optimism.
14. Momentum and the fear of missing out –
Sometimes the quickest profits are obtained during these periods of optimism in very active stocks that everyone seems to be aware of and many people are trading. But with this type of stock it is important to be in the action early. Cautious investors often delay their purchase until they are absolutely certain that they are right in buying a stock. It is often at this point that the stock, which has been going up in price for some time, is due for a reaction. Do not be too late in joining the action; it is also important not to overstay a position that has turned stale or has started to decline. Be alert for turns or changes in investor psychology. For your own protection, it is discreet to use stop-loss orders if the price of a stock has risen rapidly.
15. Market is a giant mood ring –
Just as there are times to go along with the bullish enthusiasm of the crowd, there are also times to leave, to stand aside. The time to sell is when the bullish drive is beginning to lose its momentum, to turn stale. Price super performance phases do not last indefinitely. Most of them last only a couple of years, then the stock reacts into a downtrend or sideways price action. The prevailing mood of investors changes, often slowly, from bullish optimism to doubt and apprehension, to bearish pessimism, and finally to panic as the decline accelerates. As with unbounded optimism, never underestimate the power of negative thinking. Fear and pessimism become so overwhelming at times that even the strongest, most bullish-looking stocks are caught up in the selling deluge. The speculative mood of investors appears to move in waves of pessimism and optimism that are based on actual economic or political conditions but which greatly amplify those conditions.
16. The P/E ratio reflects the enthusiastic optimism or gloomy pessimism of investors –
More important than your mood is your sensitivity to whether the crowd is optimistic or pessimistic. The rewards are few if you are optimistic while the crowd is selling in waves of pessimism. The crowd may be wrong, but you cannot fight the crowd by yourself. If you try to buck the stampede, you will be trampled. If you buy a stock too early during a period of highly emotional selling, you will soon discover that you have a loss, and perhaps a large one. The time to be contrary, to sell or to pick up bargains, is after an emotional binge of mass optimism or pessimism has lost momentum and a reversal is imminent. Soon others will realize that the future is not as bleak or as rosy as it had appeared. P/E ratios expand to higher multiples when the future looks very good; they contract to lower multiples when the future looks bleak or uncertain. P/E’s are sensitive measurements of mass psychology. The evidence indicates, therefore, that investor psychology is just the opposite of what it should be for successful investment since P/E ratios have been high at the end of super performance moves. But it is after a stock price has moved upward for two or three years that caution and a low P/E ratio are called for since it is at this time that a price reaction is most likely to occur. And even the very best stocks have price reactions.
17. Value is subjective –
Price is what the market is willing to pay you now. A piece of property is worth as much as someone is willing to pay you for it. So it is with common stock. Find stocks for which you think someone will be willing to pay you a higher price at some time in the future. This approach is applicable to any type of investment—in a diamond, a painting, a bushel of corn or wheat, a house, a piece of land, or a share of common stock. The market price of the item reflects the psychological factors—the extremes of optimism and pessimism—that can cause the value of an item to vary widely, sometimes in just a few hours or days. When the market value of an item is plummeting, it reveals that the fear many people have of lower values for their property is stronger than their hopes for higher prices.
18 - There often appears to be little relationship between the price of a stock and its inherent value –
Stocks that are overpriced relative to their inherent value often have severe price declines sooner or later, but many of them remain in an overpriced state for years before the price reaction occurs. In a similar way, some stocks of companies in unglamorous industries are frequently depressed in price, as compared with stocks in general. Throughout the late 1960s and early 1970s when most stock prices and the market averages were soaring, the steel industry stocks remained depressed. The mere fact that a stock is depressed in price relative to its inherent value does not necessarily mean that an adjustment will be made and that the stock’s price will rise. The stock can remain depressed for many, many years. Finding “value” is not enough, by itself, to assure that a specific investment is good. The book values of stocks are relatively stable in comparison with their large fluctuations in market price.
19. The Art of taking profits –
Timing the sale is more difficult than timing the purchase because stocks reach their bear market lows simultaneously, but their bull market highs are attained independently. Following the stock averages and selling when the primary trend turns down is often unsatisfactory since numerous stocks reach their peaks prior to the peaks in the averages. The price and volume trend for each stock must be studied independently and action taken accordingly.
20. Short Selling –
Profits in the stock market can usually be made faster by selling stocks short than by buying them.The reason is that price declines are usually much steeper than price rises, which occur more gradually, over a longer period of time, and are usually accompanied by a healthy amount of pessimism that gradually lessens the longer the price rise continues. Price declines, on the other hand, contain an element of panic that increases as stock prices plunge lower.