Understanding Multiple Expansion
While it’s important to be prudent and reasonable with growth expectations, it’s also good to remember that smallcap stocks can produce phenomenal gains.
We’re talking about the homeruns that turn $10,000 into $1 million, producing the kind of windfall that changes lives and creates investing legends. And while there are many factors that go into what makes this happen, the most crucial point—the pang of regret we’ve all felt when hearing about these stocks—is finding them before everyone else.
There are many excellent resources that can get you started on this journey. This includes a great book by Chris Mayer, titled 100 Baggers: Stocks that Return 100-to-1 and How to Find Them. Our approach includes a lot of the aspects Mayer talks about, expanding on them with our own proven and unique style.
Finding a rapidly growing company early is an important part of what’s needed for a multi bagger, but another critical element to multi-baggers is multiple expansion. This is where the value, or multiple, prescribed to a business, be it price to earnings, EV/earnings, price to sales, etc, expands as the company continues to grow in size. And it’s about understanding what drives this multiple expansion. For instance, when you see a stock’s value going from 5 to 20 times earnings, this represents a 4 x of the multiple. If fundamentals haven’t changed, this means, for whatever reason, people have valued it 4 times higher. But if fundamentals have changed (e.g., earnings tripled), and the multiple has expanded from 5 times earnings to 20 times, this combination of earnings growth and multiple expansion means the stock’s value increased by 12 times! This happens more often than you may think but you must know where to find these opportunities.
Multiple expansion is obviously something you want to happen, as it increases the value of your investment, but what causes it?
First, and most obvious—a small valuation increases the likelihood of multiple expansion. If, for example, a stock is trading at 5 times earnings, there is a much higher chance it will experience multiple expansion than a stock trading at 50 times earnings. However, this assumes strong fundamentals, which we note below.
At the same time, don’t assume that a company trading at a high multiple has less growth potential than one trading at a low. We’ve covered this interesting psychological barrier in Cruising the 52-Week Highs, noting that you want to look for companies that are hitting new highs as they are, most likely, experiencing rapid growth—for a good reason.
There are many complicated calculations to justify this approach, including the Price/Earnings-to-Growth (PEG) Ratio, which notes that the faster a company is growing the more this should impact its multiple.
But if you start with the perspective of looking for a low valuation with signs of growth, you’ll be off to a strong start. This leads to the next step: confirming strong fundamentals, which boils down to two key areas.
Revenue and Earnings Growth
As we’ve highlighted previously, revenue and earnings growth tell us that a company is on the right track.
Revenue growth simply means that something’s working, whether it’s increased sales, more customers, product growth and more. But while any sign of revenue growth is a good thing, we recommend looking for strong year-over-year growth of at least 25% per share.
Just as important, high revenue growth with earnings (profit) growth increases the chances that a company, and its growth, is self-sustaining. Achieving profitability often means that a company may be trading at a premium to other slow growing companies, but as mentioned above this is because there’s strong growth momentum behind it and will increase in value faster.
And that momentum is what brings larger investors into the picture, as the market cap moves from a miniscule amount to an investible asset. Fast growing companies are more desirable, and as they grow, they attract more, and larger, investors. You see where this is going: smart smallcap retail enters first, followed by larger institutions, and then, with some luck, everyone else.
We’ve seen this happen many times in the past. For instance, Boyd Group, Constellation Software, Monster Beverage, Xpel, and even recently with one of our current nanocap favourites Inventronics.
BOYD Group Services (TSX: BYD)
Constellation Software (TSX: CSU)
Monster Beverage (NASDAQ: MNST)
Xpel (NASDAQ: XPEL)
Inventronics (TSX:V: IVX)
While not as crucial as revenue and earnings growth, looking at ignored and underappreciated sectors is also a smart move. The saying goes that the leaders of the last bull market are not the leaders of the next one—and there are many signs pointing to this being the case.
While tech is currently out of favour, we are seeing growing interest in the companies that make the boring things nobody thinks about—in other words, the blue collar trade. Think cardboard boxes, rubber products, metal contraptions, and things that hurt if you drop them on your foot. Also, companies that make products for the electrical grid and telecommunications equipment are seeing very solid strength.
Not only are many of these companies trading at extremely low multiples, but they are also mostly local, reflecting the growing trend to de-risk the global supply chain and bring crucial products and services back onshore.
With this knowledge in hand, you’re in a great position to act and find undervalued smallcaps with exceptional potential.
Negative sentiment is still running strong, reflecting global uncertainty and the corresponding cheap money rug-pull that has hammered outrageously valued companies (taking down the market as a whole). While many sectors are well off the highs experienced several years back, we’re also seeing a trend reversal where smallcaps are presenting strong value, with enormous potential for multiple expansion.
In fact, the current situation may be one we look back at as a dream scenario. You can buy companies experiencing high growth at amazing prices, some of which are trading at or below net value. The secret is to embrace the negative sentiment, move counter to emotions and look for the high-growth, low-value companies that are toiling in obscurity.
If you stick to this methodology, your chances of finding the next 100-bagger are greatly increased. It does happen—particularly in the smallcap space—and it often starts with the kinds of conditions we are seeing right now. These companies are too small for sophisticated investors and institutions, but perfect for smallcap investors. And eventually, the big players recognize their growth, triggering a market cap hurdle that triggers multiple expansion.
They are Google before Google, small and unknown, but not always for long.