Bookworm: An essential ingredient in “multi-bagger” investments

Welcome to Bookworm, where I explore insights from business and investing writing that I found useful or interesting.

Each insight falls under one of three main principles that I am trying to live by in my investing endeavours.

These principles are fostering a long-term mindset, owning high quality assets, and putting process over emotion.

Today’s edition falls under the long-term mindset principle.

Hunting huge stock market winners

Peter Lynch popularised the term ten-bagger.

For those of you that haven’t read One Up On Wall Street and his other work, it means a stock that returns ten times your initial investment. Or in other words, a rather good outcome.

Chris Mayer took things even further in 100 Baggers, his (rather good) effort to bring the lessons from Thomas Phelps’ 1971 book 100-1 In The Stock Market into the modern day.

For many, the main selling point here are tips on finding shares with the potential to deliver massive long-term returns.

For me, though, the most important lessons relate to not selling investments with good long-term prospects at a poor time.

Getting comfortable with the uncomfortable

In a past Bookworm, I wrote that exceptional long-term results require an investor to accept things that most investors cannot accept.

In that case, I was referring to the reality that a portfolio of shares can’t reasonably be expected (and doesn’t need to) outperform the market every year.

Once an investor accepts that, they can stop potentially harmful efforts to optimise short-term results. They also open themselves up the possibility of a long-term edge over those who are incentivised to do exactly that.

When it comes to opening yourself up the possibility (not the guarantee) of abnormally good returns from a single stock, you need to accept that even the best long-term investments are going to have tough periods.

There are going to be times where the business – or even just the market’s perception of it – are weaker than usual.

Short-term results in the business might stumble or markets may become worried about the future. Either way, the shares take a beating.

Many investors would sell at this point in the fear of avoiding more losses. Maybe just to get the stock out of their brokerage account and out of their sight.

But taking a step back from short-term results and market signals can be wise.

“Phelps wrote that investors have been conditioned to measure stock price performance based on quarterly or annual earnings but not on business performance” writes Mayer, who goes on to revisit Phelps’ example of Pfizer shares in the 1940s and 1950s.

“Phelps showed that if you just looked at the annual financial figures for Pfizer—ignoring the news, the stock market, economic forecasts and all the rest—you would never have sold the stock. It was profitable throughout, generating good returns on equity, with earnings climbing fitfully but ever higher.”

Pfizer went on to deliver a 140 times return for investors that held the stock between 1942 and 1972.

A poor time to sell

If you remain confident in the long-term prospects and competitive position of a company that you are invested in, the only thing you are likely to achieve by selling at a challenging time like this is a poor price.

After all, companies with good long-term prospects and a strong competitive position are probably in a far better position to deliver solid returns than the vast majority of other investments out there. Especially if they are now starting from a more depressed valuation.

Also consider that if stocks are the right asset class for you in the first place, your goals should be far enough out that long-term results are the only ones that matter. Not the short-term ones you might be tempted to try and optimise.

Hunting for today’s Pfizer

The big lesson here was to avoid selling companies with good long-term prospects for short-term reasons. The flip side of that could inform how we search for buys.

Why don’t we look for solid long-term bets going through a depressed stage?

This could help us lean into one of the few edges that an individual investor can hope to enjoy over professionals: the ability to think long-term when other investors are more worried about what happens in the immediate or near future.

Funnily enough, Pfizer’s industry could be a good place to look. For a few reasons, including worries over patent cliffs and Robert Kennedy Jnr’s disdain for the industry, you don’t see many positive headlines about pharmaceuticals and biotechs right now.

In many cases, recent sales and earnings growth – two numbers that market participants obsess over – don’t look too hot either. Quite a few firms enjoyed a boost to profits during the pandemic making for tough comps in recent years.

No company embodies those headwinds more than Pfizer itself. And while our analyst Karen Anderson acknowledges its rather “flat” growth prospects, I’d make the point that Pfizer has navigated several patent cliffs and regulatory scares before.

Anderson recently downgraded Pfizer from Wide Moat to Narrow Moat, she but she still sees a lot of value in the shares. At recent prices below $25, they traded at a big discount to her Fair Value estimate of $38 per share.

Could today’s Pfizer be… Pfizer?

What if the market is right?

Buying quality companies when they are beaten down is essentially a bet that whatever problem markets are worried about is temporary. Or, like the case of ResMed and the impact of GLP-1 drugs on demand, it turns out not to have been much of a problem at all.

We’ve talked today about uncomfortable realities that you must accept as an investor.

Another of these is that sometimes you are going to be wrong on whether a company’s problems were only temporary or not that big a deal. There are a couple of saving graces here, though.

Number one, your potential downside may be smaller if you bought the shares at a price that reflected the market’s pessimism at the time. A lot of the bad outcome may already have been priced in.

You also don’t need to invest in that many successful recoveries over the long-term to do just fine at the portfolio level. The rewards of holding just a handful of great companies for the long-term from this position can offset several duds.

As Mayer and Phelps’ work makes quite clear, though, it’s important to behave in a way that doesn’t preclude you from getting the maximum benefit from those well-timed purchases.

For more on the power of buy and hold investing, read this article by my colleague Mark LaMonica.