A fundamental principle of value investing is to never lose money. Value investors achieve this by buying incredibly cheap stocks. But buying cheaply doesn't simply reduce the risk of losing money; it also allows for huge returns. Consider MFC Bancorp, which has the potential to become a 10-bagger for me.
A "Bootylicious" bargain
Think back to the summer of 2001. "Lady Marmalade" and "Bootylicious" were at the top of the charts. Three of the four horsemen of the tech bubble, Cisco Systems (NASDAQ:CSCO), Yahoo! (NASDAQ:YHOO), and Amazon.com (NASDAQ:AMZN), had been renamed Pestilence, Famine, and Death as their stocks collapsed to less than $20. And a merchant bank named MFC Bancorp was quietly growing.
MFC provided businesses with advice about mergers and acquisitions, reorganization, and raising capital. Occasionally, when MFC saw a particularly attractive opportunity, it would invest for its own account. This strategy led to MFC acquiring significant positions in diverse businesses.
It wasn't a high-profile business, but it was profitable and growing. The company had demonstrated 25% year-over-year earnings growth and returns on equity in the low 20% range -- an indication of a superior business. The company's tangible book value was $16, while its diluted earnings were $1.85.
With those numbers, one would have thought that the stock should be trading for more than $20. But shares were $8 and change -- half of book value, with a price-to-earnings ratio (P/E) of 4.5. The stock was offering a huge margin of safety, so I bought.
The waiting game
One of the biggest virtues an investor can have is patience, and MFC tested mine. For two years, the business continued to grow, with its book value reaching $21 and earnings hitting $2.35. Yet the stock's performance didn't quite keep up with fundamentals. After two years, the stock had returned 0%.
Now, that's not quite the return I was looking for. It was disconcerting, but not worrisome. MFC had increased in value. Its business still seemed solid. Sometimes good investments don't skyrocket overnight. Or even for months.
The market finally began paying attention to MFC in the second half of 2003. Perhaps it was the stock's sub-4 P/E. Perhaps it was MFC spinning off several businesses -- businesses that, in aggregate, would be worth as much as I'd paid for the stock originally. Or perhaps it was that MFC had a presence in China, which was booming.
Eventually, MFC's management realized that its KHD Humboldt subsidiary -- focused on selling equipment and engineering services to companies such as Cemex (NYSE:CX) and Lafarge (NYSE:LR) -- had become bigger than the rest of the company combined. So MFC renamed itself KHD Humboldt Wedag (NYSE:KHD) and spun off the financial business.
Today, KHD is still going strong, with its order backlog growing by 100% year over year. The stock still doesn't seem expensive, even though it's now trading north of $60, putting it within spitting distance of becoming a 10-bagger.
The Foolish bottom line
There are three important things to be learned here. First, a stock doesn't have to be sexy to make you huge profits. In fact, sexy can be bad -- Apple (NASDAQ:AAPL) is sexy, but it's unlikely to be a 10-bagger over the next decade because the stock's so richly valued already. Second, patience is sometimes necessary. I made nothing for two years, but even with those two years, I have a 40% compounded annual return.
Finally, MFC would not have had these excellent returns had it not been severely undervalued when I bought it. The value of the business has increased, but not as much as the stock has. The cheap price gave me the huge upside.
If you're looking for other high-potential stocks like KHD was a few years back, our Inside Value newsletter focuses on the best undervalued stocks on the market. You can read all our top recommendations with a free trial.
Fool contributor Richard Gibbons knows less about cement engineering than a merchant banker does. He owns shares of KHD. KHD and Cemex are Motley Fool Global Gains recommendations. Cemex, Yahoo!, and Amazon are Stock Advisor recommendations. The Motley Fool has a disclosure policy.
