How to spot shares with ‘multi-bagger’ potential

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Kyle is joined by fund manager Jean Roche to discuss how she attempts to find top-performing ‘multi-bagger’ stocks. While it’s rare for a company to deliver a four or fivefold return, let alone become a 10-bagger stock, Roche explains how she detects signs of a potential winner. Roche, who manages Schroder UK Mid Cap Ord (LSE:SCP), an investment trust, also reflects on firms she invested in that went on to become multi-bagger stocks.

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Kyle Caldwell, funds and investment education editor at interactive investor: Hello, and welcome to On The Money, a weekly look at how to get the best out of your savings and investments.

In this episode, we’re going to cover how investors can attempt to find companies with explosive growth prospects that could potentially achieve the rare feat of becoming a multi-bagger stock, which is when a company achieves a share price gain of at least 300% or 400%.

Some companies achieve the even rarer accolade of becoming a 10-bagger stock. As it implies, a 10-bagger describes an investment that has the ability to achieve, or has already achieved, a 10-fold increase, which is a 900% gain. The term was coined by Peter Lynch, one of the best-known investment gurus of the 20th century. The 10-bagger term is a baseball analogy.

Joining me to discuss this topic is Jean Roche, fund manager of investment trust Schroder UK Mid Cap Fund. Jean, it’s great to have you on the podcast today.

Now, Jean, as I’ve just mentioned, it is rare that a share becomes a 10-bagger, but it’s not impossible. There are various examples of companies that have become multi-baggers or 10-baggers.

In the pursuit of a potential multi-bagger, what are the key ingredients or attributes that you look for?

Jean Roche, manager of Schroder UK Mid Cap: Yes, it is rare, and that’s why I’m very proud to say that it’s actually more probable, according to our research, in the UK than it is in the US to find a multi-bagger. Let’s just say multi-bagger, and not stick rigidly with 10-baggers, so multiple times the return of your original investment.

So, our analysis, published a few years ago and refreshed last year, showed that over the previous 21 years, you had more of a chance of stumbling across a multi-bagger in the UK than in the US. Now that was obviously very irritating for some of my US colleagues when I unearthed that together with my colleague, James Goodman.

What we found when we looked at, over the last 21 years, the return of 2,200%, so that’s a 21-bagger - we decided to look at that - we saw that 3.6% of the investable set would get you to a multi-bagger in the US, but 3.8% of that investable set - so it had to have a minimum market cap of £150 million - was a multi-bagger in the UK, so therefore, a higher probability of stumbling across a multi-bagger in the UK than in the US. So, it depends on the periods you look at, but fairly consistently, we were finding that.

So, you were asking about the key ingredients or attributes that we look for. We turned that analysis on its head and looked at the attributes of those UK companies. What was it that they were doing that was managing to get them to this sort of status? So, companies such as Games Workshop Group (LSE:GAW) or Cranswick (LSE:CWK), for example, the food manufacturer.

A key finding was around issuing shares. Multi-baggers don’t really do it, and that’s what we found. They don’t issue, if they do issue shares, they don’t issue very many because issuing equity is damaging for returns more generally. And they don’t have to issue shares because they’re able to generate cash internally, and then, crucially, they use that for investments.

But, of course, they must be profitable in order to be generating that cash in the first place. So, you want these company models where they’re profitable, and all the other good things that you would expect, like strong management, in a sector where supply can’t keep up with demand, and pricing power. But the key factor to focus on, really, is generating cash, the cash returns, and then investing that.

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Kyle Caldwell: Is there a minimum threshold you’re applying to be a multi-bagger? Has it got to go up four or five times?

Jean Roche: Yes. That’s a really good question. I was discussing this with the family last night. I have two sons, both under 15, and they asked me what a multi-bagger was. I said think about it like a multi-storey car park; if it has two floors, is it a multi-storey car park? If it has three floors, could you say it was?

So, if it’s three times, maybe four times, I think that’s kind of what people have in their mind. But, also, what I did find was some of the literature says that it has to be the capital appreciation only. It doesn’t count the dividends, but I think it must count the dividends because that’s what the shareholder experiences. They can see, and then it’s whether they decide to take those dividends or reinvest them. But if you decide you’re going to reinvest them in the shares, it’s that, crucially, that gives you that exponential return over and above, and we really see that in mid-caps because they’re at this sweet spot in their growth stage. It's where you get the capital appreciation and then the dividend on top.

What do you think? I’d say it needs to be three x, four x or maybe five x. But I think it’s a healthy debate, and the multi-storey car park worked well as an argument in our house.

Kyle Caldwell: You mentioned Games Workshop and Cranswick. 10, 15 years ago, these would have been less-familiar names with investors. So, do investors need to look outside the bigger names in the FTSE 100 to try and identify companies with potentially greater growth prospects?

Jean Roche: Yeah. It’s intuitive, really, isn’t it? If you start with a £10 billion company, let’s say, for it to be a 10-bagger, if we go back to just 10-baggers versus a £10,000 or a £1 million market cap company, if you start with that smaller company, then it’s more likely that you can increase by that multiple. So, that’s a good place to start, if we accept that normally £10 billion companies are not going to 10x.

So, if they get multiple expansion, how do they get multiple expansion? Because more people start to know the name. As it starts to prove itself, more people get interested in it. It’s under researched in the beginning, so that’s where the opportunity lies.

Obviously, small and mid-caps tend to be less well known and particularly less well known by international investors. So, as international investors start to get on board, and often we find that’s the sweet spot, you see the first couple of American investors appear on the register.

I remember back in the day, I covered ASOS (LSE:ASC), 20 years ago, and in its time that was a multi-bagger over a certain period. When the first phone calls started to come from, say, West Coast hedge funds about the stock, then you start thinking, well, now you might see the multiple expansion.

So, if you get together with the top line, the revenue growing, together with the margin expansion, together with the multiple expansion. So, say the top line doubles, the margin doubles, the multiple doubles, you’ve got an eight-bagger there. It depends on the amount of time you think that might happen.

I think that’s the real kicker, when you start to get the multiple expansion because more people start to know it.

Kyle Caldwell: Are there certain sectors or industries that you would highlight that have potentially higher-growth opportunities?

Jean Roche: Yeah. Well, it’s counter-intuitive in some cases. Some, take Cranswick, for example, you wouldn’t think food manufacturing would be your ultimate multi-bagger hunting ground because you would think high return on equity sectors, high return on invested capital, low capital intensity.

Well, of course, Cranswick, which does pork products and chicken, generates lots of cash internally, tick the box, doesn’t issue shares, but a high level of capital investment is required there, but they actually make that investment, and then they get the return on that, and then they’re also able to return cash on top of that to shareholders in the form of dividends. So, that’s a sector where you wouldn’t expect to find it, and that’s a stock that’s a 200-bagger-plus, so very interesting.

That’s maybe an anomaly. You wouldn’t traditionally look in that sector. You’d look in sectors like IT, industrials, consumer discretionary, healthcare, financials, typically. So, they would also be lower capital investment required generally and double-digit profit margins typically.

But you can find them in all sorts of sectors, and that’s the interesting [thing] and there’s joy in researching these things when you get that glorious, excellent management team on top of the right sector and the lack of supply of whatever it is they’re doing.

In the case of Cranswick, you’ve got the lack of people being able to do something complex, which is food manufacturing and handling raw meat, and being able to do that well in a consistent way.

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Kyle Caldwell: Could you highlight examples within Schroder UK Mid Cap Fund of multi-baggers over the years?

Jean Roche: I thought you’d never ask! But, yeah, I’ve already mentioned Games Workshop and Cranswick, but when we’ve done the analysis, all the others that have popped up on our screen that have been multi-baggers, we can look at in an alphabetical way, if you like.

So, we would have had Ashtead Group (LSE:AHT), which is equipment rental, which obviously sadly has gone to the US now. Computacenter (LSE:CCC), generating very high levels of cash, paying it back in dividends and special, and then reinvesting that cash. You’ve got Diploma (LSE:DPLM) now in the FTSE 100.

Grainger (LSE:GRI) as well, not a multi-bagger if you cut the data currently, but when we did it two years ago, it was, and that rents out accommodation to people, high-quality accommodation, private rental sector, and, as you know, there’s a shortage of accommodation in the UK and a strong management team there. Savills (LSE:SVS) as well.

So, they’re household, or at least broadly recognisable names, but one of the things is they arrived. They became multi-baggers, but what you then need to do is look for your next multi-bagger, which is why it’s quite a useful discipline, and we do that in the trust that I run called Schroder UK MidCap PLC.

The philosophy within the team, together with Andy Brough and James Goodman, is that we sell a mid-cap when it goes into the FTSE 100 for these strategies, and then we look for, ideally, the next multi-bagger at the lower end of the market cap spectrum, which is hopefully not very well known.

Going back to what we said earlier about starting small, a lot of the multi-baggers, if you get some of the printed lists of stocks in the 1990s, the small-caps, you’ll see some of those multi-bagger names.

Croda International (LSE:CRDA), for example, is a chemicals company not currently doing that well, but that was flagging very strongly as a multi-bagger a couple of years ago. It’s had a more difficult time recently, but you would have seen some of these twinkling away in the small-cap. So, that’s why it’s really great in the team that we have a small-cap angle as well.

So, we look at things coming up from small cap and then wait for them to move into mid-cap, and we invest in them then in our mid-cap funds. Then we’ll move on from them when they make it into the FTSE 100, hopefully.

Kyle Caldwell: You’ve mentioned your sell discipline. If a company enters the FTSE 100, you’d sell. Prior to that, if a company’s having a good run up in share price, how do you decide whether to take some profits or keep on running it as a winner?

Jean Roche: Yes. I think that’s one of the key disciplines, remembering to sell, not falling in love with a share. But, of course, what we find is we didn’t buy the position all at once, we went into it slowly. We didn’t suddenly put 4% into the fund because, often, these stocks move to become 3%, 4%, 4.5% positions in the fund, so it makes sense to top-slice.

We look at PEG ratios (price/earnings to growth ratio) particularly. So, when the price/earnings (PE) divided by the three-year forward growth forecast in earnings per share is looking a bit out of whack with where it’s been previously perhaps, that might be time to do a bit of top-slicing.

And as I mentioned, 99 times out of a 100, if it goes into the FTSE 100, we’ll sell it all. Actually, by then, having to slightly contradict what I just said, because it’s going into the FTSE 100, it probably has good enough liquidity at that point that you can actually sell it all. Whereas when you were buying it in the early days, hopefully right down in the bottom of the mid 250 opportunity set, it wouldn’t have been possible to buy that position all at once. So, you can actually sell quite quickly when it’s being promoted.

It's widely anticipated in many cases as well, but probably before then, you’d have been selling down, top-slicing it.

Kyle Caldwell: So, if a mid-sized company becomes a large company, then it’s the FTSE 100, your decision to sell, that’s an internal decision? I ask because I do know that other funds and investment trusts, smaller company funds, I’ve often seen certain holdings enter the FTSE 100, and then they’re still in the top 10 holdings.

Jean Roche: Yes. They can occasionally keep going. One company where we have given an example in the past is, say, for example, Frasers Group (LSE:FRAS), which would have gone into the FTSE 100 at £8.50, and then come out of there and traded around down as low as below £3.

It has often been the right thing to do, and the company formerly known as Royal Mail, then IDS, now obviously has been taken out. That one got promoted into the FTSE 100 twice and fell out twice, and both times it was actually a good trade to do, to buy it when it fell out and sell it when it went back in.

So, generally, we find that it also forces us to look for new ideas down in that small-cap sweet spot part, and it might be you end up buying two new ideas to replace that one idea that went out through the sunroof, shall we say, and we’re always waiting, very happy to have another look if something that’s got promoted comes back to say hi in the mid 250 again.

Sometimes stocks keep on going, and I’m sure there’ll be people who’d say ‘I’d hold on to them’. I think, as you would expect, that’s a live debate, and if you have a little look, you’ll probably see a few Games Workshop shares still lingering, which is now in the FTSE 100, of course, in this fund. So, I did say 99 out of a 100.

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Kyle Caldwell: I wanted to next turn my attention to your portfolio at the moment. Could you highlight where your finding the best opportunities are present? Are there any sectors that you would pick out or types of companies that you have in the investment trust? And could you run through some recent portfolio activity over the past couple of months?

Jean Roche: Yeah. So, I should probably mention, and I think it’s been highlighted before, where we see inexpensive technology stocks. So, they’re disguised as defence stocks, but they’re, actually, in our view, inexpensive technology stocks, and that’s where we have been fairly over-indexed recently.

We had Babcock International Group (LSE:BAB) that got promoted into the FTSE 100, so we don’t have that anymore. But at one point, 12% of the fund was in defence, and actually, I went to DSEI yesterday, which is the biggest defence showcase in Europe, and that’s ongoing, out at the Excel Centre right now.

But you can really see that in an environment where growth is low and, of course, the UK has higher growth than many other G7 countries right now, but in an environment where generally growth is hard to come by, that is a sector where we are going to see growth. Of course, it’s important to lean into certain stories within that. You’ll see positions like Chemring Group (LSE:CHG) in the portfolio, we also hold QinetiQ Group (LSE:QQ.), which generates a lot of cash too.

You can also see in IT services as well inexpensive technology stock. I’d class Kainos Group (LSE:KNOS) as one of those, and they do workday services and solutions. There, we had the CEO come back into the business, and we’ve really seen the fruits of that as it moves to recovery. So, in that inexpensive tech stocks bucket, that’s where I’d put some of the defence names and some of the IT services.

In terms of recent activity, adding to that name, Kainos, for example. Recently, activity is then pushed by, for example, bids. As you know, there’s been a huge amount of bid activity in mid-cap land just really highlighting the fact that the US strategics, the US financials, are getting really interested because they really see the value inherent in these UK companies where multiples have been driven down by flows out of funds, really.

So, we’ve had a bid for Spectris (LSE:SXS), the scientific instruments company, at nearly 90% premium to the resting price, and also for Just Group (LSE:JUST), the bulk purchase annuity specialist.

So then, as you would expect, we’re looking for replacement ideas for those, so maybe adding to existing positions in world-class industrials such as Bodycote (LSE:BOY), which does high-pressure engineering where it presses pieces of metal down harder to make them work better for longer and have higher fidelity in machinery. I hope you’re not an engineer, you could probably explain it better than me if you are!

And so, what we might be doing is adding to some of those existing positions in industrials. And then looking for a Just Group…a replacement in the insurance arena, so replacing that industrials exposure with further industrials exposure and then replacing Just Group to have that bid as well with replacement ideas in the same sector.

Three or four months ago if we’d been sitting here, I probably would have said I was leaning more into UK names. I would say now probably more into international names, because some of the UK names did run a bit. We’ve seen some warning signs, some sectors starting to look a little bit more shaky on the domestic side, and you have to be very careful with, for example, which part of the consumer discretionary you lean into, so which consumer you’re exposing yourself to.

For example, Currys (LSE:CURY) have had a really good run of it, but they are exposed to the AI super-cycle in that they’ve got the highest market share of AI-enabled laptops in UK. Do you have one yet?

Kyle Caldwell: I don’t actually, no.

Jean Roche: Argh. You’ve got to get one. You may have heard some of their ads, they’re very amusing ads. I don’t know if they’re being targeted at me particularly, but they have some very good marketing out at the moment, and you’ve had the competition just fall by the wayside.

Gone are the days where you’d go to John Lewis and get them to explain your new TV to you. That just doesn’t happen anymore, so it’s wide open for Currys. They also let my boys play on all their gaming, sit in the gaming chairs and play with all their various tech kit. So, I think the store experience is strong there as well, and people are buying, refreshing that kitchen equipment, consumer tech. Having bought new stuff in 2020 during Covid, after five years of eating your lunch over a laptop, it’s not very nice, so maybe you want to buy another one.

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Kyle Caldwell: Finally, could you provide an outlook for the area of the market that you invest in? I was hoping you could name one reason to be cheerful and one reason to be fearful.

Jean Roche: You’re limiting me to one of each? OK! So just to recap the area of the market that I invest in, so we focus on the mid 250, which is the 250 companies below the FTSE 100, excluding investment trusts. So, that’s an index which then gets you to about 170 companies. So, that’s the area that I’m very focused on.

Reasons to be fearful? The Daily Mail and others will cover many, many reasons why you can be fearful, but the main reason to be fearful is fear of overpaying for a stock because that is what destroys returns, and that’s the key.

Actually, going back to the multi-baggers, as I should have said earlier, the price you get in at, there are very much timing disciplines with getting the multi-bagger equation right, so that initial valuation point. So, the fear of overpaying, I think PEG works well for that; what am I paying for this growth?

Because it might be a great story, but the valuation isn’t going to go to the sky. So, what keeps me cheerful? I need to say this quickly, as one sentence, so you won’t notice that I have a few. So, knowing individual stocks gives me great pleasure. You know, I think I talked about Currys a fair bit, for example.

Knowing management teams, having a fierce attention to accounting detail alongside the team. There’s a lot of CFAs and accounting people on our desk, and I think that’s what makes me cheerful because I can always find a data release with some positives, you know?

For example, we’re one of the fastest-growing nations in the G7 by 0.1% or something, but you’ll always find another piece of data to contradict that. That’s why you classically see those arguments in governments where one politician says one thing, for example, unemployment’s come down and unemployment’s gone up under the Labour government. Well, you could actually argue the other way around as well depending on how you cut the data.

So, we’re winning the least ugly competition with France, again, but I’m not going to cling to that. It’s about the individual stocks. And so what makes me cheerful is meeting management teams, alone or with colleagues, doing the work, and then getting it right. Getting it at the right price is the cherry on top.

Kyle Caldwell: So that’s all we have time for today. My thanks to Jean, and thank you for listening to this episode of On the Money. If you enjoyed it, please follow the show in your podcast app and do spread the word. If you get a chance, please leave us a review or a rating in your podcast app too. We love to hear from you.

You can get in touch by emailing OTM@ii.co.uk. In the meantime, you can find more information and practical pointers on how to get the most out of your investments on the interactive investor website. I’ll see you next week.