From the pen of Karin Iten…

Dear Investment Academy Reader,

Even the most level-headed of investors dream of buying a share that makes them really rich in a hurry. The good news is there are strategies to improve your chances of doing so.

Peter Lynch came up with the “ten-bagger” concept in his book One Up On Wall Street, and others have elaborated on it since.

Here we look at some ways to find stocks that can potentially turn R1,000 into R10,000.

The investment approach

Hunting for ten-baggers is high-risk and you should only dedicate a small chunk of your overall portfolio to it – you could invest as little as R5,000 a share. You want to aim for about 10-12 shares, preferably in different sectors, so you spread your risk.

That’s straightforward enough – but how do you choose your stocks?

Investors Chronicle’s David Stevenson recommends looking for shares that have seen strong share-price growth – which suggests the company, too, is growing fast.

Ideally, you want a firm whose growth puts it in the top quartile for the market. But while this shows the share has momentum, it doesn’t tell you anything about the underlying business – so you also need to do some quality checks.

Three quality checks you must do no matter what…

Firstly, the firm’s products must be in demand – look for 25% or more top-line sales growth in the past year.

Secondly, those sales must be profitable – you want consistent net profit margins (profit after tax as a proportion of sales) of 10%-15%, along with a return on total capital employed (operating profit divided by long-term balance-sheet debt and shareholders’ funds combined) of at least 10% for the past two years.

The next step is to look for a decent trend in earnings, not just the share price – a good guide is whether the company achieved earnings per share growth (net profits divided by the number of ordinary shares in issue) of at least 10% per year and ideally closer to 20% for the last 12 months. But you don’t want to overpay for this growth – a price to earnings growth (PEG) ratio of less than one is a useful rule of thumb.

Other good indicators include directors owning at least 10% of the company. There’s nothing like shared ownership to focus the management team’s attention on the same goal as yours – raising the share price.

Also remember that “cash is king” – take a look at the cash flow statement and see whether operating cash flow (near the top) covers capital expenditure and also any ordinary dividends further down. This is important because too many small businesses grow quickly but then go bust having forgotten about the mundane, but critical, tasks of collecting and managing cash.

What to buy

You could also look for small companies that may not fit all the criteria above, but have huge potential. For details on the best small companies on the JSE, why not take a look at the latest Greg Lecoq’s Red Hot Penny Shares has to offer.
 
Here’s to your financial freedom!

Karin Iten,
for the Investment Academy