This article represents my whole investing career. I wrote this article as a guide for my own investing. Something that I could reference again and again as I research stocks.
I will likely keep updating this evergreen article to be ever more useful and findable. The reason for that is this might be the most important article you read today and I want to make sure you see it.
In this article, I will show you how I look for and find stocks that can deliver financial freedom to those who invest in them. We are going to look at high-level concepts, but my hope is that you get immense value from this article.
The Magic of Compounding Over Time
Albert Einstein called compounding the 8th wonder of the world. Why? Because it’s a fact! Compounding is the basis of investing in the stock market.
You can compare any investment by its CAGR which stands for compound annual growth rate. It is the average annual growth rate of an investment for a period spanning multiple years.
Thus, if I had investment A that had a 26% CAGR over 3 years, I would know that I roughly doubled my investment after those 3 years. Then I could compare that to investment B that maybe only had a 10% CAGR over the same 3 years. Every year, each investment compounds the initial investment to the tune of their CAGR and snowballs that year over year.
For long term investors, CAGR is an important metric that ultimately condenses everything that we will talk about in this article to a normalized return over a set period of time.
If you want an AMAZING CAGR calculator, Stock Analysis has one here for free so check it out with your own investments - CAGR Calculator.
When you hear these super investors returning a high annual return for 10-20 years straight, it is compounding that is responsible in generating such huge wealth after that timeframe. Their money is building upon itself year after year.
Durable Moats and Competitive Advantage
Warren Buffett popularized the term “economic moat“ where he compares a great business to a fortified castle with a moat around it. The idea is that the business can fend off competitors using said moat and thereby protect revenues and margins.
There are several kinds of moats that a business can have though if you think about it for any length of time. A company like KO 0.00%↑ has a brand and patent moat; they have literally patented their brand and recipe.
Still others may have a technological moat and one of the best examples of this today is ASML 0.00%↑. ASML 0.00%↑ manufactures the EUV (extreme ultraviolet) machines that can print the nano-scale circuit patterns onto silicon wafers used ubiquitously in the semiconductor industry for AI.
These machines cost hundreds of millions of dollars each and are so complicated that ASML 0.00%↑ basically is a monopoly. The idea is the same though: fight off competitors by some means to protect your product pricing power and thereby increasing revenues which trickles down to your profit - how much money you keep.
The longer a business can keep their moat undisturbed and strong, the longer the castle (the business) can thrive and compound.
The Twin Engines of Growth
I wrote about one of my favorite investing books, 100 Baggers: Stocks That Return 100-to-1 And How To Find Them by Chris Mayer, in one of my Substack notes. In it, he talks about the ‘twin engines of growth‘, which he describes as revenue/earnings growth AND multiple expansion (the price multiple that everyone is willing to assign the stock).
Why do you need both?
Well it may be obvious that you want to invest in growing companies; those that are showing increasing sales and the ability to keep more of what they earn. This provides shareholders ample reason to buy and hold the stock - capital return, reinvestment, debt reduction to name a few reasons.
But why multiple expansion? An increasing multiple makes it that much easier for a stock to reach a much bigger return than a company with a stagnant multiple with the same growth. It also indicates that you should try to get a stock BEFORE the multiple expands, that is to say, you want a stock that has a low multiple and high growth. This is easier said than done because as soon as a good business starts rolling, the cat’s out of the bag.
Chris mentions MTY Foods as an example which started with a 3.5x multiple which is basically a 3.5 P/E ratio. Their earnings rose 12.4x in a decade but their P/E ratio went from 3.5 to 27. So you can see the power of the multiple or P/E expansion on a stock’s returns.
Concentration Versus Quantity
No matter what you invest in, you have to make it worth your while. There is no point in investing $1 and getting a 10x and having nothing to show for all the time spent researching and analyzing that 10x investment.
That’s why I’m a firm believer in concentrated positions whether you invest in individual stocks, ETFs, mutual funds, gold, crypto or anything else. You have to put your conviction AND wallet on the line (within reason of course). There are plenty of positions I own today that I wish I had invested more capital in when the risk/reward was much more desirable.
Many famous and successful super investors, investors who manage portfolios over $100m, are proponents of concentrated portfolios. Look at the holdings of Mohnish Pabrai or Bill Ackman as examples to this approach (I linked their Dataroma portfolios). These are billionaires fund managers using concentration as a tool in their investment philosophy.
Founder CEO-Run Businesses
What does a company like META 0.00%↑ or TSLA 0.00%↑ have that maybe another company does not? The CEO is the founder of the business. These CEO’s have the ultimate skin in the game in running their businesses and definitely want to see them succeed more so than an external CEO.
Somebody who has poured their blood, sweat and tears into a project knows this is true. Usually these founders have a lot of shares of the stock as part of their pay packages and compensation. It is incumbent on them to run their companies like a business but also to actually believe and achieve their goals.
Elon Musk recently stated of the SPCX 0.00%↑ website that their mission is as follows:
"You want to wake up in the morning and think the future is going to be great - and that's what being a spacefaring civilization is all about. It's about believing in the future and thinking that the future will be better than the past. And I can't think of anything more exciting than going out there and being among the stars."
-Elon Musk
By having skin in the game, these founders may invest more in research and development and make better acquisitions than an outside CEO coming in to manage ‘just another company‘. Even getting a company to join the S&P 500 or Nasdaq requires a great deal of commitment and skill on the part of management.
Intelligent Capital Allocation
Good capital allocation is the demarcation between a company with good fundamentals and a company that has that good fundamentals AND actual value to give back to shareholders. You want to invest in the latter. Capital allocation can come in many different forms:
Share repurchases when the stock is undervalued
Dividends that are well covered by cash and operating income
Business reinvestment for R&D, debt repayment, PPE, etc.
M&A that will be a growth factor for the new entity
Some of the biggest returns came from stocks that were ‘cannibals‘ of their own shares. Look at AZO 0.00%↑ or even AMR 0.00%↑ in my own portfolio which bought back their shares rapidly just a few years ago. These share buybacks do a few things. They reduce the outstanding share count ostensibly, but behind the scenes they increase EPS because the denominator is being reduced.
Mohnish Pabrai exemplified share buybacks in his presentations and showed the magic of them. Below, he shows how share buybacks change the return of a stock with everything else being kept the same. You can get returns that are orders of magnitude higher in a stock that is getting their shares repurchased aggressively.
In addition, as part owner of these businesses, you as the shareholder get a larger percentage of the business as the pie shrinks. Cash flows are sent to a shrinking base, and as long as the business is not disrupted, those cash flows to shareholders become larger and larger.
Serial acquirers are also notable; companies like Constellation are revered for their ability to acquire software companies that are net positive to their financials and keeping their margins high. Through these high quality acquisitions, Constellation has managed to keep growing all without retiring any shares.
I could go on and on with examples for these concepts that have changed my investing outlook. Since I will update this article from time to time in the future, I will leave it here with you, the reader.
I look forward to your comments on this article and if you have suggestions, please let me know and consider subscribing to my Substack if you haven’t done so!
As always, none of my content is financial advice. Please do your own due diligence when investing your own money.