How to spot the next ten bagger

PORTFOLIO POINT: Who knows where the next ten bagger will be. Here’s a clue: look at the small end of town.

The term “ten bagger” was coined by Peter Lynch in his book One Up On Wall Street when he referred to an investment that grows to 10 times its original purchase price. Recent examples on the ASX have included CSL, Fortescue and Arrow Energy.

Investors the world over are constantly seeking the next ten bagger but few know what they are looking for. But there are common traits among these companies, so those investors who know what they are have a distinct advantage.

The first thing to note is that generally speaking, these companies are coming off a low base. It’s easier for a $100 million company to become a $1 billion company than for a $10 billion company to become a $100 billion company. That’s just common sense; it also means that you have to be prepared to take on risk.

In the main, the “ten bagger” is a smaller company with huge potential. Over time, this is realised and the stock provides patient and loyal investors with handsome returns. The traps here for investors are numerous and deep.

There are plenty of fast-growing industries – aviation, IT and biotech for example – that have been graveyards for investors. You need to understand whether the company you have in your sights has a sustainable competitive advantage or not.

It's also crucial that you understand the inherent risk in this type of speculative investment and allocate your portfolio accordingly. Don't place all your hopes on one stock and diversify your holdings.

Examples of energy ten baggers

Importantly, Peter Lynch didn’t define the period in which you should expect a stock to multiply in price 10 times. Some stocks may take 10 years, others are quicker. Either is a good result for the shareholder.

For the purpose of this exercise we will define a ten bagger as a stock that has grown by a 1000% over a period of ten years. This requires a compound annual return of around 30% as a minimum. The following energy companies achieved at least that during the past five years.

-Showing promise
Company (sector)	ASX	Avg annual return (%) five years to May 31
Carnarvon Petroleum (oil & gas)	CVN	78
Arrow Energy (coal seam gas)	AOE	64
Bow Energy (oil & coal seam gas)	BOW	62
Energy World Corp (oil & gas)	EWC	61
Icon Energy (oil & coal seam gas)	ICN	47
Molopo Energy (coal seam gas)	MPO	47
Bandanna Energy (coal, oil, gas)	BND	44
Eastern Star Gas (coal seam gas)	ESG	41
New Hope Corp (coal)	NHC	37
Silex (solar, nuclear tech)	SLX	37
Northern Energy (coal)	NEC	34
Gloucester Coal (coal)	GCL	33
WorleyParsons (engineering, solar)	WOR	30

It is impossible to know whether these companies will continue to grow at these rates. There is evidence many of them have lost momentum, while others are reaching a size where this kind of growth becomes increasingly hard to achieve: WorleyParsons is now valued at around $5.5 billion.

What type of company should a ten bagger be?

Our list of previous successes suggests a need to get acquainted with the smaller end of the market. You are unlikely to find ten baggers in well-known large-cap names such as Woodside, Santos or BHP.

Based on the performance to date, do these companies have features in common that indicate potential factors or drivers to look out for in new companies?

The key theme here is energy, with the majority of these companies in oil and gas. Many of them also have an exploration focus, which is a key revaluation driver, as I’ll explain later. There are also a considerable number of coal seam gas plays, reflecting the changing face of energy in Australia.

But it also strikes me that the old-fashioned, and often-maligned coal sector appears three times in our list. This shows that companies involved in rather dull things can also make money for their shareholders when they are run well.

It reminds me of the old test from the 1970s in which investors are asked whether they would have preferred to own IBM and Standard Oil over the previous 50 years. Some investors were quick to assume that IBM’s share price had grown much faster than Standard Oil’s where in fact the opposite is true.

The lesson here is to pay an appropriate price for a stock regardless of whether the company is a well-known stalwart or a developing technology. Don’t disregard old economy stocks.

What makes a ten bagger different?

The majority of the companies on our list are resource-dependent. In this sector the ability to demonstrate and expand reserves or resources becomes a driver of value for oil, gas and coal companies.

Many of them have not yet turned a profit or shipped commercial quantities of resource so they are not being valued on their current cash flows, but rather the potential value of future cash flows based on anticipated reserves.

Silex is also being valued on the hope that its laser enrichment technology is going to pay handsome dividends down the track, and that its foray into solar panel production at Homebush Bay will also be profitable.

Takeover premiums are evident in the prices of Eastern Star Gas (ESG), Energy World (EWC) and Gloucester Coal (GCL) but does not totally explain away their high performance. Eastern Star Gas has been the subject of takeover rumours for some time; the impact of these rumours is usually fleeting.

As we have already discussed, size is a factor. The smaller the company, the less likely it is to have garnered institutional support. Many of the companies we’ve listed would have been largely ignored by large broking houses, researchers and analysts five years ago.

Their market capitalization has grown as they have been discovered by analysts, with interest and exposure increasing as their share prices, resource upgrades and other milestones were duly reported. By the time they appear on the radar of mainstream commentators they have often already experienced their best growth.

Candidates for the next ten bagger

Given the factors we have already discussed, we have created the following list of potential ten baggers. Our selection to energy companies with market capitalisations lower than $1 billion and included a mix of renewable, alternatives, coal, oil and gas for diversity.

Dyesol (DYE). Market cap $132 million. Produces and licenses solar dyes for use in building materials such as glass and roofing, effectively turning whole buildings into photovoltaic cells. Continues to hit positive milestones especially with international partnerships that show great promise. Somewhat under the radar of the major broking houses.

Ceramic Fuel Cells (CFU). Market cap $175 million. Makes fuel cells that can turn gas connected households and businesses into miniature power generation sites. The company receives a lot of interest from overseas, especially from Europe. Like Dyesol it has been ignored somewhat locally. Significant differences in the energy utility market between Australia and Europe has added to lack of understanding of their strategy.

Infigen (IFN). Market cap $652 million. Until recently Australia’s only pure wind play. The remnants of troubled and debt-laden Babcock & Brown Wind Partners, the company has recently been awarded government funding, via a joint venture with other companies under the Solar Flagships Program. The company still has some debt issues but its foray into solar as well as wind’s first mover advantage with the RET (Renewable Energy Target) and a future ETS likely re-valuation drivers. A potential target for a larger utility like AGL Energy or Origin wanting bolt-on renewable exposure.

Green Earth Energy (GER). One of the smaller cap geothermal plays capitalised at only $7 million. The company has been successful in achieving $35 million worth of funding arrangements from both state and federal governments, and operates in the lower-risk hot sedimentary aquifer (HSA) area compared to the higher risk fractured rock technology of larger companies like Geodynamics.

Galaxy Resources (GXY). Market cap $194 million. Not instantly recognisable as an energy play, Galaxy is a lithium producer that is tied into the growing market for lithium-based batteries for the potentially explosive growth in the electric car market. Further, the ownership structure of the company’s resources through its partnership with a Chinese company has led to an announcement that the project could be exempt from the proposed Resource Super Profits Tax (RSPT). The market has chosen to ignore this announcement so far.

Rey Resources (REY). Market cap $28 million. A widely ignored and potentially undervalued West Australian coal miner with an interest in supplying the Indian thermal coal market. The company has some unique diversification benefits such as shorter sea route access to India compared to eastern seaboard coal miners, and a more stable thermal coal market that is not as reliant on growth-dependent Chinese steel production.

Amadeus Energy (AMU). Market cap $57 million. A small cash flow producing oil and gas company sits on an attractive market price to book ratio of 0.40. The company is also attractively valued on an enterprise value to 2P (Proven and probable) reserves basis. Most of its peers trade at around $20 per barrel of reserves, while Amadeus sits on around half of that. Based on enterprise value to earnings, the company is valued at four times compared to 15 times for the oil & gas sector. The company is not broadly covered by analysts but those who do are positive on the stock’s potential re-rating.

Oil & gas value plays. Other smaller oil and gas plays that sit on price to book ratios (p/b) below 1 and which could shoot skyward should they upgrade their resources or make promising finds include:

• Innamincka Petroleum (INP). Market, cap $20 million, p/b 0.64.
• Oilex (OEX). Market cap, $19 million, p/b 0.39.
• Marion Energy (MAE). Market cap, $16 million, p/b 0.1.
• Lakes Oil (LKO): Market cap $33 million, p/b 0.53.
• AED Oil (AED): Market cap $106 million, p/b 0.47.
• Meo Australia (MEO): Market cap $143 million, p/b 0.91.

Survivorship bias is always going to play a part when you look back at companies that succeed because those that don’t won’t show up in the performer tables. Understand that not even the experts get the calls right all the time. But if you ensure a portion of your portfolio is exposed to smaller energy companies that are quietly putting runs on the board, or can expand their resources for very little cost, then you may discover your very own ten bagger.

Frank Gomez writes for The Australian Energy Report, where this article first appeared.