A Fool's Guide to Multibaggers

Peter Lynch gave investors a language of their own when he wrote in his classic One Up on Wall Street:

In Wall Street parlance, a "tenbagger" is a stock in which you've made ten times your money. I suspect this highly technical term has been borrowed from baseball, which only goes up to a fourbagger, or a home run.

It seems that the term "bagger" -- be it a three-bagger, a 10-bagger, or a 40-bagger -- has created a movement. All investors are searching for the elusive multibagger, hoping to find the type of stock that can wash away investment mistakes or get us to retirement five years faster.

Great! Sign me up!
And now for reality: Searching for multibaggers can feel a bit like trying to catch lightning in a bottle. The easiest route, it would seem, is to search for a 10-cent biopharma-whooza-whats-it trading over the counter and hope it will ride up to a buck.

Don't take that dangerous path. While, as Lynch says, "You may have thought that a tenbagger can only happen with some wild penny stock in some weird company like Braino Biofeedback or Cosmic R and D," that's not the case.

High-growth penny stocks may provide multibaggers every once in a while, but not without subjecting investors to enormous risk of capital loss. There's a better way.

Step 1: The Fall
Something happens at a company with good economics, and market expectations turn negative.

Maybe it's an earnings miss, or a misstep in the marketplace, or a change in leadership, or a litigation settlement. Whatever the reason, a company faces turmoil, and the stock market, which doesn't like problems, starts selling off the stock. Funds and institutions that need short-term performance (for job security, quarterly bonuses, etc.) dump the poor performer. Individual investors, fearful of being sunk, get out too.

The price nosedives; value investors get excited.

Step 2: The Turn
The company picks itself up, dusts itself off, and gets back to business. Investors begin to realize the market has made a mistake.

Basically, the market corrects itself. Investors realize that the price of the stock is out of whack with the company's value, and they start buying. This buying causes the price to rise.

It's tempting to jump ship at this point, take your returns, and move onto the next stock. But remember, this isn't a $0.94 nanotechnology stock. The company has solid economics, by which I mean a solid leadership team, a competitive advantage, and future growth prospects.

So while the trick is to buy after "The Fall" when others are selling, the trick is also to hold during "The Turn" as the stock price rises -- as long as its intrinsic value is increasing along with the price. While that can be difficult, we miss multibaggers by selling too soon.

Step 3: The Ride
The company, because of its favorable economics, performs well. The market's expectations have gone from sour to sweet, and investors bid up the price.

The reason you want to hold a stock past "The Turn" is because when a company that is creating value comes back into the market's good graces, it can trade at a premium to its performance. Remember: We're talking about a formerly down-and-out stock that has come back from its lows. It has momentum. Short-term-minded institutional investors -- who think in the short term because they have to answer questions to fund shareholders who think in the short term -- jump on board.

And that's where the big returns come. "The Ride" is where value investors take advantage of the market to put a multibagger in their portfolios.

Think IBM and its 1,000% rise over the past decade.

Some proof
In searching for examples, I came across these three companies whose stock fell during 1995 and proceeded to rise over the next 10 years (from January 1996 through December 2005).

All three of these companies were fast growers in the early 1990s. Unfortunately, their growth hit speed bumps in 1995. Declining sales caused investors to change their expectations from positive to negative, and the share prices fell.

Fortunately, all of these companies have good business models and were able to turn things around. IGT continued to supply new, digital games to its casino customers. Panera continued to supply good food and attractive price points. And American Eagle continued to turn out fashions for its young customers. Investors who bought during the troubled times and held during the turnaround have been richly rewarded as market expectations changed back to positive.

It happens over and over
Are you worried that you missed these opportunities and that there won't be any more? Don't be. This cycle repeats itself in the market all the time. Here are some more examples from 1998, 2000, and 2002, respectively.

Again, we have three companies with good economics. And at some point, the market's expectations changed. Taking advantage of those shifts in expectations led to amazing gains.

Three keys to managing the steps
You know as well as I do that hindsight is 20/20. But we can let these companies guide us going forward. The keys to earning multibaggers through value investing are:

1. Know the business -- If we can't describe what the business does and why it has an advantage, we shouldn't invest. Without knowledge of the business and how it works to create value, we're speculating on a stock rather than investing in a business.
2. Have courage in our convictions -- Things almost always get worse before they get better. But if we understand the business, we can draw strength from that knowledge.
3. Let the market work for us over time -- The longer you stay invested, the more likely you come out ahead. As Burton Malkiel noted, the market's random path is generally upward. By buying to hold, you let the market go to work for you.

The Foolish bottom line
While the process for finding multibaggers can be simplified, it does require hard work and patience. If you'd like some help finding good companies that the market has soured on, consider joining our Inside Value newsletter free for 30 days. Each month, lead analyst Philip Durell recommends two stocks that may have what it takes to become multibaggers. While he doesn't guarantee results, his long-term recommendations are already beating the market by nearly four percentage points in just two years.

You can find multibaggers without investing in penny stocks. Click here to let us help you do it.

Fool David Meier does not own shares in any of the companies mentioned. eBay is a Stock Advisor recommendation. The Motley Fool has adisclosure policy.