Where to find "ten-bagger" stocks – the market's Holy Grail

• This article was first published in MoneyWeek magazine issue no 984 on 31 January 2020. To make sure you don't miss out in future and get to read our articles as they're published, sign up to MoneyWeek here and get your first six issues free.

A ten-bagger is the stockmarket’s Holy Grail: a company whose share price rises tenfold, or 900%. The term was coined by Peter Lynch, the legendary fund manager whose Magellan Fund was a ten-bagger and the best-performing fund in the world from 1977 to 1990, averaging growth of 29.2% per year. An investor putting $1,000 into Magellan in 1977 would have turned that stake into $28,000 by 1990.

Lynch managed to identify many ten-baggers and these made important contributions to his fund’s outperformance. It’s well worth trying to emulate him, but it isn’t as easy as he made it look. This article highlights some examples of ten-baggers, explores their key characteristics and suggests where you may be able to find new ones.

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The ten-bagger stocks that dominate the US market

The most famous recent ten-baggers have been American companies and they are some of the biggest names in the US equity market. They include Walmart (which soared from $10 in 1991 to $100 in 2018), Alphabet ($120 in 2005 to $1,200 in 2018), Microsoft ($11 in 1997 to $110 in 2019), Facebook ($20 in 2012 to $200 in 2018) and Apple ($17 in 2007 to $170 in 2017). Whereas Walmart took 27 years and Microsoft 22 years, Facebook required a mere six. That reflects a compound annual growth rate of a staggering 47%. A stock rising tenfold in nine years would notch up compound growth of slightly over 29.2% per year, the average annual growth rate of Peter Lynch’s Magellan Fund.

As with all shares, some ten-baggers fade away; some keep going, but far more slowly; and some fall back significantly but then embark on another growth spurt that eclipses the initial run. Britain’s Immunodiagnostic Systems, for instance, rose from 119p in mid-2006 to 1,200p in mid-2011, becoming a ten-bagger in just five years as the company benefited from strong interest in vitamin-D testing. However, the shares fell sharply during the rest of 2011 and have mostly been in the range of 170p-300p for the last five years.

Amazon is a good example of the third type. If you had invested $100 in Amazon at its initial public offering (IPO) in 1997, you would have bought five shares. Those became 60 through stock splits in 1998 and 1999, implying an initial price of $1.67 per share. Each share was worth $105 in April 1999 only to crash to $6 in September 2001 after the dotcom bubble. But if you had hung on then, you would have made a fortune. The shares soared past $2,000 in August 2018 – a rise of 333 times from 2001, making them 1,000-baggers from the IPO.

What ten-bagger stocks have in common

Ten-baggers are usually companies that come early to substantial growth markets and have the potential to dominate their subsectors or niches. These growth markets are typically driven by major trends in society, the growing use of mobile phones being one recent example. Ten baggers also usually have patented new technologies and/or new products or services that enable the company to take a leading position in its subsector or niche and establish an enduring competitive advantage over new entrants.

The new technologies or products may be supplemented by bolt-on acquisitions to enhance the product range and fend off competition. Smaller companies can grow very fast, but can often find it more difficult to become leaders in their market niches, so acquisitions can be crucial.

An example of a new technology or new product in a growth market was Apple’s launch of the iPhone in June 2007, which took Apple into the fast-growing market for smartphones with software and design superior to the market leader, Nokia. A much smaller British example that used related acquisitions to help cement its market-leading position is Judges Scientific.

Judges has built a business in precision instruments for scientific research and testing and now has 14 divisions providing a wide range of instruments from electron microscopy and ultra-high vacuum components to fire testing, optical fibre testing and the computer-controlled testing of soils and rocks. Judges’ shares rose tenfold between 2010 and 2013 in only three years, then dipped but went on to rise again. By late 2019 it had become a 40-bagger.

A larger UK company that has built on a trend and made many acquisitions is JD Sports Fashion. It early on spotted the trend for large numbers of non-sporting people to wear sports-related gear and that they outnumbered customers who actively participated in a sport. This powered the share price from 33p in early 2012 to 330p in late 2016. The shares reached 450p in mid-2016, dipped a bit, then rose to over 830p recently after strong Christmas trading.

Another UK consumer product example is Fevertree Drinks, whose novel mixers powered the shares from 210p in early-2015 to over 2,100p in mid-2017 – a ten-bagger in 2.5 years. Fevertree was over 3,800p in September 2018, but was back to under half this level recently after a profit warning.

Three key ingredients in the ten-bagger secret sauce

There are several characteristics to look for when trying to identify potential ten-baggers. None of them provide certainty, but they do increase the chances of success. The main characteristics pointing to success are excellent management; top-notch products or technology in growing markets; and a leading position in a sub-sector or niche (or the ability to achieve it).

1. Does the boss have an eye for detail?

Taking excellent management first, I was fortunate enough to interview many CEOs for the UK government’s business department. Three of them were particularly impressive. The first was James Dyson, and Dyson would certainly have been a ten-bagger had it been a listed company. The second was Simon Wolfson (now Lord Wolfson), the boss of Next. He had both a sound strategic sense and a complete grasp of detail.

At the end of the interview he asked me where my home was and we then discussed the Next store in my nearest town. He had a clear understanding of why the store was positioned where it was (close to Marks & Spencer). He was also aware of its limited size and had plans to address it. It was clear that he had an equally good understanding of all his hundreds of stores and of Next Directory’s potential. It is not surprising that Next was a ten-bagger, rising from 717p in late 2002 to 7,170p in February 2015.

The third CEO was Stephen O’Shea of Halma, a company specialising in hazard detection (offerings include pollution gauges) with a strong focus on product development, a record of making successful bolt-on acquisitions, a high return on capital (a key gauge of profitability) and a dividend that has now risen by at least 5% a year for 40 years. Halma is another ten-bagger rising from 155p in October 2008 to 1,600p in March 2019 and reaching over 2,160p in December 2019.

The second pointer to success is excellent products in growing markets. Apple’s iPhone and Google’s search engine, which rapidly came to dominate the fast-growing market for online advertising, are classic examples. Another is Intuitive Surgical, the robotic surgery specialist that has continually developed its da Vinci robot-assisted keyhole surgery system to dominate this fast-growing market.

The da Vinci system was approved by America’s Food and Drug Administration (FDA) for its first operations in 2000-2001 and by 2019 there were 5,000 da Vinci systems in hospitals worldwide. Intuitive’s shares rose from $30 in 2009 to $300 in mid-2017 and then doubled to $600 in January 2020.

When it comes to promising products, biotechnology is a fertile hunting ground for ten-baggers since FDA approval of an effective drug can drive a company’s share price higher very quickly. An example is Incyte, whose drug Jakafi was approved for myelofibrosis (an unusual type of bone-marrow cancer) in November 2011, then for polycythemia vera (a form of blood cancer) in December 2014 and finally for graft-versus-host disease, a post-transplant problem in which immune cells from the donor attack the recipient’s tissues, in 2019. Incyte’s share price was $12 in November 201, but rose to $120 in September 2015.

While companies such as Alphabet, Intuitive Surgical and Incyte used innovative technologies or products to become market leaders, retailers can do this by providing a desirable product range and appealing services to customers. In addition to JD Sports Fashion there is Primark, which expanded from 100 shops just before the year 2000 to 373 in 12 countries by 2019. Primark offers fast fashion at value prices and provides around half the sales and over three-quarters of Associated British Foods’ (ABF)profits. ABF’s share price rose from 308p in early 2000 to 3,200p in late 2014. Had Primark been a separate company it would probably have become a ten-bagger much more quickly.

2. Which ten-bagger companies will fall from grace?

There are also several quality companies vulnerable to a sudden share-price slide before or just after reaching ten-bagger status. The main problem areas are the company’s finances, the quality of its products or services, and its market position.

Financial warning signs include sizeable debt, cash flow being significantly less than profit, recognising revenue before cash is received, capitalising things that should be in the income account, excessive stock and acquisition or fair-value accounting tricks.

There are many examples of companies that have dramatically fallen from grace in one of these ways. Enron (a case of massive debt and toxic assets hidden by accounting tricks) is just one large example. A British one is Burford Capital, a funder of legal action, whose shares rose from 140p in mid-2015 to 1,400p in early 2018, but then sank below 700p after investment group Muddy Waters challenged its accounting practices in mid-2019, particularly the large proportion of Burford’s profits coming from internally estimated fair-value gains.

Product or service-quality problems that are not resolved quickly and fairly for the customer are another warning sign (Whirlpool and Boeing come to mind as examples of what not to do). Consistently high quality and reliability are crucial. Another quality issue is management. Do the key directors have records of working for quality businesses and do they have large personal shareholdings in their own company to align their interests with those of their shareholders?

3. Can it fend off the competition?

The third characteristic is market position. A growing company needs to become a leader in its subsector or niche and defend that position. Many potential ten-baggers do well in the early stages, but larger companies can spot the same opportunity and can muscle into the market if the early entrant has no enduring competitive advantage.

Examples include IDH, whose shares fell when other companies moved into vitamin D testing while IDH took too long to develop and launch its automated testing system, which offered other tests too. Another example in Indivior, the drug developer, whose shares plummeted from mid-2018 to early 2019 as its key drug Suboxone was successfully challenged by a generics company. Indivior’s pipeline has no late-stage clinical trials offering early hope of promising new drugs to drive market growth.

Where to look now

Two promising sectors for ten-baggers are software and biotechnology. You are most likely to find successful biotech companies such as Incyte in America, but good software companies are found on both sides of the Atlantic. Software examples include Salesforce.com of the US, a world leader in customer relationship management (CRM) software and Craneware of the UK, which provides financial and administration software for over one third of US hospitals. Salesforce became a ten-bagger in late 2013 in just five years, while Craneware’s shares increased by ten times in just over six years.

The other fertile fields for UK investors to explore are growing retail (store or online) companies such as JD Sports or ASOS, the online fashion store, whose shares gained 900% in only three-and-a-half years in the middle of the last decade.

An alternative is the smaller company that quickly becomes a leader in its niche through a combination of organic and acquisitive growth, such as Judges Scientific. And then there are consumer product companies such as Fevertree Drinks that reached ten-bagger status in under three years. It is unlikely that you will be able to spot many new ten-baggers in their very earliest stages, but there is always scope for high returns when it comes to small stocks. It is also important to diversify your portfolio with potential ten-baggers from several different sectors.

Poised for a 900% gain?

Companies worth a look can often be identified by noting similarities to firms that have already become ten-baggers. For example, SDI Group (Aim: SDI), which specialises in scientific digital imaging, has some similarities to Judges Scientific. Its niche market is scientific instruments for healthcare, astronomy, consumer manufacturing and art conservation. Like Judges it grows both organically and by acquisition; its market capitalisation is only £89m. The share price more than doubled in 2019.

In software, Darktrace is a leader in artificial intelligence-based (AI) cybersecurity and BenevolentAI is using AI to identify novel therapeutic drugs. Unfortunately, both are not yet listed but are the sort of outfit worth keeping an eye on for possible listings. Among listed software companies, CyberArk Software (Nasdaq: CYBR), a cybersecurity specialist, and SailPoint Technologies Holdings (NYSE: SAIL) an identity software firm, look worthy of further research. The same applies to Everbridge (Nasdaq: EVBG), which helps companies establish communication systems in disasters such as earthquakes, although Everbridge is not yet profitable.

In biotechnology, Acadia Pharmaceuticals (Nasdaq: ACAD), which tackles central nervous system diseases and Karyopharm Therapeutics (Nasdaq: KPTI), an oncology company, are both examples of US early-stage biotechs with one marketed product and several late-stage clinical trials. Acadia has four late-stage clinical trials with three of these being additional indications for its marketed drug Nuplazid. Karyopharm has seven late-stage clinical trials for the treatment of various cancers. Apellis Pharmaceuticals (Nasdaq: APLS) has no marketed drugs, but several late-stage clinical trials, including phase-three trials for a rare form of anaemia and another for an eye condition that leads to blindness. For all these biotechs, late-stage clinical trial failures are a risk. Good hunting.