Your Best Shot at a 10-Bagger

The following is a direct quote: "if they cant tell you what will go up 100% in a few days then motley fool are worthless and they suck at picking stocks."

I received that comment on one of my recent columns. Grammar issues aside, this type of get-rich-quick mentality scares the heck out of me.

Now don't get me wrong. I enjoy stalking monster returns. Heck, I'll even reveal your best shot at snaring a 10-bagger a little later in this piece. But first, let me warn you against an investing mistake that leads to many a zero-bagger.

The warning
My worst investing decisions have involved three common elements:

• The allure of great upside.
• The "need" to act quickly.
• The lack of proper due diligence.

My visions of huge, unrealistic profits led to hasty decision-making, which led to losses. In other words, almost every time I've tried to swing out of my shoes to hit a home run, I've struck out.

To defend yourself against the kind of greed that leads to grief, put investing returns in perspective.

My critic earlier talked about 100% returns in just a few days. Let's think through that for a minute. If you started with $10,000 and made 100% gains every week, you'd be the richest person in the world -- surpassing Bill Gates' $40 billion -- in far less than six months.

I'll go one step further. Perhaps you're thinking of the huge gains we've enjoyed over the course of the past year. If you timed it right, you could have made 100% returns on Southwest Airlines (NYSE: LUV) and Starbucks (Nasdaq: SBUX), 150% on Nordstrom (NYSE: JWN) and SunTrust Banks (NYSE: STI), or more than 300% on Mechel OAO (NYSE: MTL). But I'll show you later on why you can't expect these types of returns from these stocks in the future.

Although these are real returns some investors have achieved, they're not the sort of realistic earnings anyone can expect in their portfolio over the long term. You can't extrapolate Usain Bolt's 100-meter times to conclude that he could run a marathon in 70 minutes. Similarly, even the best investors can't generate 100% returns year after year.

What's the upper limit of reasonable?
Peter Lynch is recognized as one of the greatest investors of all time. He ran his Fidelity Magellan Fund from 1977 to 1990 -- less than 15 years, during one hell of a bull market. Even in those perfect conditions, he "only" averaged 29% annual returns.

If you're wondering about Warren Buffett, his returns are lower than Lynch's. If you got in on his company, Berkshire Hathaway, in 1965, you'd have generated average annual returns in the neighborhood of 20%.

Now because of the power of compounding for 45 years, those returns are tremendous. A $10,000 investment back then would leave you a millionaire many times over.

Believing you can do much better than the 20% to 30% long-term annual returns of Lynch and Buffett is almost surely a road to overconfidence and failure. Doing half of what they did would make you a very, very rich investor.

Your best shot at a 10-bagger
Now that we're grounded in reality, let's talk about what it takes to snag a 10-bagger in 10 years, while limiting your risk.

For a stock to be worth 10 times its buy-in price in 10 years requires a 26% annual return. As the returns of Lynch and Buffett attest, that's huge! 

Going after that kind of return, even in an individual stock, isn't for everyone. You have to have a mighty risk tolerance. That's why most people are best served allocating among index funds or ETFs, and holding for the long haul. In fact, I believe everyone this side of Buffett and Lynch should index at the core of their portfolios.

But for those of us who want to pick some individual stocks and go after a 10-bagger or two, small-cap stocks (i.e., stocks with market caps of $2 billion or less) are our best shot.

Large-cap stocks simply don't have the room to grow that their $2-billion-and-under brethren do. Large caps have their place in your portfolio, but that place isn't in the area dedicated to the 10-bagger.

To maximize your chances of achieving a 10-bagger in 10 years without throwing Hail Marys, focus on smaller companies that have:

• Strong balance sheets.
• Strong cash flows.
• Strong growth prospects.

Remember the five companies I mentioned before? The ones that have generated some high recent stock price returns? I promised to show you why they'll have a hard time replicating their past returns.

You want a "yes" in all four categories to have the best chance at a sustainable 10-bagger.

Our small-cap experts at Motley Fool Hidden Gems have recommended electrical equipment provider Jinpan International (Nasdaq: JST) and athletic apparel manufacturer Under Armour (NYSE: UA) to their members. As a "yes" in all four categories, these stocks are a good place to start your 10-bagger research. To see the Hidden Gems team's entire write-up on Jinpan, Under Armour, and the rest of their recommendations, click here for a free 30-day trial.

This article was originally published Feb. 18, 2010. It has been updated.

Anand Chokkavelu doesn't own shares of any company mentioned. Jinpan International and Under Armour are Motley Fool Hidden Gems picks. Under Armour is a Motley Fool Rule Breakers recommendation. Southwest Airlines and Starbucks are Motley Fool Stock Advisor choices. The Fool owns shares of Under Armour. The Fool has a disclosure policy.