How to Pick an 100 Bagger
Renowned value investor Mohnish Pabrai(Trades, Portfolio) recently gave a lecture for the Fall 2020 Value Investing Course at Peking University’s Guanghua School of Management. During the lecture, Pabrai shared his insights on how to spot 10 to 100-baggers, which he calls the holy grail of investing. Pabrai also held a question-and-answer session after the lecture in which he answered questions from students and sit-in audience. Below are my notes from the lecture part.
Choices for value investors
As a value investor, you can buy two kinds of businesses. The first kind of business offers you 10 to 100-bagger potential. Pabrai calls this type of business “growing pies.” You just need to buy and hold. The second type of business may offer you satisfactory returns, but it’s difficult to get more than 2 to 3 times returns from this type of businesses. They are also very tax-inefficient. This is more like cigar-butt investing.
Categories of multi-baggers
Pabrai also listed five categories of multi-baggers. The first category is what Pabrai calls the “Focused Mousetraps.” These are businesses which focus narrowly in an area with long runways. Examples of this category include Costco (NASDAQ:COST), Chipotle (NYSE:CMG) and McDonald’s (NYSE:MCD). The second category is “Outsider” companies with great capital allocators such as Berkshire Hathaway (NYSE:BRK.A) and Danaher (NYSE:DHR). The third category is what Pabrai calls the “Uber Cannibals,” which are companies with an intense focus on buying back shares. Examples of this category include Autozone (NASDAQ:AZN) and NVR (NVR).The fourth category is deeply undervalued turnarounds or public leveraged buyouts such as Fiat Chrysler (FCAU) or Rain Industries (BOM:500339). The last category is what Pabrai calls “Spawners,” which are companies that continuously “spawn” new businesses. Most internet giants, such as Amazon (NASDAQ:AMZN), Alphabet (NASDAQ:GOOGL) and Alibaba (NYSE:BABA), fit this category. It is this last category that is the fertile ground for 10 to 100-baggers.
More on “spawners”
A “spawner” is a company with a DNA of incubating new growth businesses that have huge potential. They expect failure and can tolerate it. Alphabet’s “Other Bets” business is a great example of this. So is Amazon’s Day 1 mentality. One key aspect of spawners is that they use pre-tax earnings, which is very tax-efficient and essentially a free loan from the government.
There are different types of spawners. The first type is “Adjacent Spawners” such as Starbucks (SBUX). They create new market in adjacent markets with related products. The second type is “Embryonic Spawners,” which can acquire new businesses and nurture them into much bigger businesses. Facebook (NASDAQ:FB) is an example of this. Facebook acquired Instagram, WhatsApp and Oculus VR and grew them into big businesses after acquiring them. The third type is “Cloner Spawners” such as Microsoft (MSFT). These companies don’t innovate, they just copy successful products. The fourth type is what Pabrai calls “Non-Adjacent Spawners,” which create or buy new businesses in unrelated areas.
But the best spawners are what Pabrai calls “Apex-Spawners.” These companies deploy the spawning tactics of all of the above four categories and have generated many 10 to 100- baggers.
For instance, Alphabet (NASDAQ:GOOGL) is an apex-spawner. It created new businesses such as Chrome in adjacent markets. It also bought new businesses such as YouTube and grew them into much larger businesses. It also copied successful products and created their own products such as Google+. Lastly, Alphabet got into non-adjacent markets such as Google Fiber and Waymo through reinvesting its pre-tax earnings.
Obviously more businesses are non-spawners, even many exceptional businesses such as Costco (NASDAQ:COST). These non-spawners may acquire new businesses or expand their product lines, but they are unlikely to consider entering brand new business areas. And the excess free cash flow is used to pay for dividends, buybacks or capital expenditures.
It’s not easy to screen for spawners and it takes a lot of work to identify them when they are still in early stages. Pabrai offers a few tricks to spot these stocks. For instance, you should look at the history of the business. Does it have a “spawning DNA?” Is there a great capital allocator at the top? Is the future of the business obvious? In other words, you shouldn’t need to make grandiose assumptions regarding growth.
Spawners can become multi-baggers. A business which grows 15% a year with multiple doubling will become an eight to 12-bagger in 10 years and a 40-bagger in 20 years. If you have a portfolio of five to 10 great Spawners bought at reasonable prices, you should do well.
I enjoyed Pabrai’s lecture. It’s a very interesting perspective on finding 10 and even 100-baggers. Conceptually, it makes sense. Like most things in investing, there are many factors to consider. For instance, it appears that most of the apex-spawners are internet companies. It is also a bit like venture capital and private equity investment, especially for those early-stage spawners. How do you incorporate margin of safety and circle of competence into the spawner framework? Regardless of the practical questions, I think Pabrai’s framework is very interesting.