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What kind of investing strategy a young person must follow in order to achieve financial freedom?

Growth investing, buying shares of companies that are positioned to rapidly increase their profits, or earnings, is probably the most popular investing strategy. There are good reasons for that.

Most companies' stocks are valued as a multiple of their earnings; therefore, when a company's earnings grow, its stock value tends to follow suit.

A high growth firm will grow its earnings at an accelerated rate compared with others. Assuming Firm A earns 10 sen a share a year and it pays no dividend. Further assume that it can reinvest all its earnings into the business with the same rate of return. Assuming its earnings grows at CAGR of 10% a year. In 5 years, its earnings per share (EPS) will grow to 16.1 sen.

EPS (year 5) for Firm A =10 sen * (1+10%) ^5 = 16.1 sen

Assuming there is another company, Firm B with the same initial EPS of 10 sen but an compounded annual growth rate, CAGR, in earning of 30%. After 5 years, EPS of Firm B will be 37.1 sen,

EPS (year 5) for Firm B =10 sen * (1+30%) ^5 = 37.1 sen

Figure 1 below depicts the expected growth of earnings for Firm A and B in the next 5 years.

This EPS after 5 years for Firm B is more than double that of firm A. Hence, should not the present share price of Firm B worth more than that of Firm A? Of course.

Growth, the prime engine of stock price appreciation

Assuming one is willing to pay a price of 12 times the earnings of a company with expected growth rate of 10%, he will be willing to pay RM1.20 to invest in Firm A today.

Price A = PE ratio * earnings = 12 * 10 sen = RM1.20

And another investor may be willing to pay RM2.00, or 20 times earnings for a high growth company, Firm B with 30% CAGR,

Price B = 20 * 10 sen = RM2.00

Now assuming that in 5 years’ time, both Firm A and B will be selling at the same valuation multiples of 12 and 20 times respectively, their fair prices in 5 years are computed as below,

Fair price of Firm A = 12 * 16.1 = RM1.93

Fair price for Firm B = 20 * 37.1 = RM7.43

Return for investing in Firm A in 5 years = 1.93 - 1.20 = RM0.73

Or = 0.73 / 1.20 = 61%

Return for investing in Firm B in 5 years = 7.43 - 2.00 = RM5.43

Or = 5.43 / 2.00 = 271%

Paying a higher price for a higher growth company (CAGR 30%), Firm B yields 4.5 times return than a lower growth company, Firm A (CAGR 10%) in the next 5 years.

Expansion of PE valuation, the twin engine

If the earnings of Firm B can grow by 30% for the next 5 years, its PE ratio valuation is likely to expand. Let us assume that the terminal PE ratio after 5 years expands to 50.

Fair price of Firm B = 60 * 37.1 = RM22.28

Return for investing in Firm B in 5 years = 22.28 – 2.00 = 20.28

Or = 20.28 / 2.00 = 1014%

That is a 10-Baggers stock in 5 years, a stock which becomes 10 times its initial value!

Isn’t that fantastic, achieving a return of more than 1000% investing in a stock in just 5 years?

What about catching a 100-Baggers? Is that possible?

The case of Top Glove

Top Glove was first public listed sometime in March 2001 in the Second Board of KLSE. The adjusted price then was just 4 sen. At the closing price of RM24.70 today on 23 July 2020, and with a span of about 20 years, it is a 617-Baggers! Thanks to the Covid-19 debacle. Below is the share price movement of Top Glove in the last 20 years.

In fact, Top Glove became a 100-Baggers way before this Covid-19 thingy. It was already a 100-Baggers at the end of year 2017.

There are and had been a few other 100-Baggers in KLSE, besides Glove companies. Which are those companies, and what are their characteristics?