The following is an adaptation of a Starvine Way podcast episode called “100 to 1 in the Stock Market (Part 2)“:
In the investment world, achieving substantial gains often requires a combination of foresight, analytical skills, and a sense of value. In the undercelebrated book “100 to 1 in the Stock Market,” author Thomas Phelps explores the psychological and analytical aspects behind making significant gains in the stock market. In this post, we will delve into the key takeaways from Phelps’ book, focusing on the analytical factors that contribute to successful investing.
A Sense of Values and Ability to Figure the Odds
Successful investing involves more than just foresight. Phelps emphasizes the importance of having a sense of values and avoiding overpaying for potential gains. It’s not enough to predict future trends accurately; investors should also have an intuitive understanding of when a company’s valuation is cheap or expensive. Wise investors make big bets when the odds are in their favor, recognizing undervalued stocks and focusing on long-term potential rather than short-term market movements.
The Mathematics of Compounding
To achieve significant gains, Phelps highlights the power of compounding. Increasing a stock’s value 100-fold over several years requires a compound annual growth rate (CAGR) ranging from 12.2% to 36%. Long-term capital appreciation is directly tied to long-term earnings growth, and investors must estimate the chances of sustained earnings growth to identify potential multi-baggers.
Combining Factors: Multiple Expansion and Earnings Growth
Phelps emphasized the significance of having both multiple expansion and earnings growth on one’s side when making investments. Let’s explore the importance of these factors:
- Multiple Expansion: The most common reference to this term is an increase in the price-to-earnings (P/E) ratio of a stock. It occurs when investors are willing to pay a higher price for each dollar of earnings generated by the company. Multiple expansion can significantly enhance investment returns but has a one-time, linear aspect to it. If the earnings power of a company remained constant at $1 while the share price increased from $5 to $10, the stock’s P/E multiple would have expanded from 5x to 10x without there having been any change to the company’s underlying profitability. The stock has undergone what we would call a “re-rating”, which can be thought of as a change in the market’s overall perception of the company’s prospects. In this hypothetical example, an investor who bought at $5 and sold at $10 made a 100% capital gain without having to make a correct judgment on the company achieving a high rate of growth. All that was needed was a change in overall investor sentiment from bearish (negative) to neutral.
- Earnings Growth: If an asset’s earnings grow significantly, then so should the value at which it can be sold. I cannot think of any investor who would not want to own companies that are likely to continue growing their earnings per share at a brisk pace. More specifically, high quality businesses with identifiable moats that are able to re-invest earnings at decent rates of return (and for several years) will lead to compounding – assuming one has not grossly overpaid upfront.
Phelps emphasizes in his book that the identification of opportunities offering both of the above factors will set an investor up favorably for outsized returns over the long term. In other words, if investments are selected that present a low valuation and high earnings growth, the factors multiply to produce a dynamite result. In my Q4 2016 letter, I used Jarden and Coca-Cola to profile real-life examples that illustrate what can happen over a long stretch when both factors work in one’s way (Jarden), and what happens when one factor contradicts the other (Coke).
It’s All About Balance
Achieving substantial gains in the stock market requires a combination of foresight, a sense of values, and analytical skills. Thomas Phelps’ book, “100 to 1 in the Stock Market,” offers valuable insights into the psychological and analytical aspects of successful investing. By understanding the mathematics of compounding, exercising patience, and identifying opportunities with long-term growth potential, investors can increase their chances of finding the next 100-bagger. However, it’s essential to approach investments with a balanced perspective, considering both growth and value factors to make informed decisions and mitigate risks.
