How to spot the next multi-bagger microcap

The lightning bolt of Afterpay might never strike again, but that shouldn't stop investors from seeking less dramatic multi-bagger businesses, says Merewether Capital founder Luke Winchester.

In this video, Winchester delves into exponential growth stocks — how they are made and how to find them early.

Rapid growth within a business is the main thing. "But then what really drives those big multi-bagger moves is when the multiple the market is paying for the business expands as well," he says.

Winchester also explains some of the special characteristics of microcaps and the strategies he uses to invest safely in the sector.

One factor is the thirst for capital injection. "These are businesses that rarely grow in a straight line, particularly at the profit level, because they have to reinvest back into themselves," he says.

A superficial reading of the numbers might scare off more timid investors afraid of lumpy profitability, but Winchester has found value where the underlying drivers of growth are solid.

Edited transcript

What are the common characteristics of multi-baggers?

The main one is obviously growth in the underlying business. You'll very rarely see a multi-bagger without that.

What you really want to find is that growth coming through, I guess, in three levers, which is the top-line revenue growth, but that's also filtering through to margin expansion, which means the profits are growing faster.

But then what really drives those big multi-bagger moves is when the multiple the market is paying for the business expands as well.

If you can find a business that might be growing its top line by 10 to 15% growing its profits by 25 to 30, but then the multiple that business trades on goes from 15 to 20, that's where you see the big multibaggers come over time.

That's where my value lens comes back in. I'm looking for obviously good businesses that are ticking those fundamental boxes.

But if you can buy them intrinsically cheaper than you think the market will pay as that business executes, that's where you see that real multi-bagger effect as the growth trickles down and compounds at each level.

Can you assume that a high-performing microcap will keep outperforming or do you look deeper?

I'm definitely looking deeper to understand other drivers of growth and how long can they be sustained.

For Growth companies, and where you're projecting years into the future, my rule of thumb is to avoid looking too far into the future. Two to three years is where most people can get an accurate forecast. Beyond that, you're probably crystal-ball gazing, particularly for a microcap, because these are volatile businesses.

These are businesses that rarely grow in a straight line, particularly at the profit level, because they have to reinvest back into themselves.

And while they're small and the profit numbers are small at an absolute level, that reinvestment can be a large chunk of their profit.

As an example, if a business is earning a couple of million dollars a year net profit but they want to put on five new sales staff, it's probably going to take a $500,000 bottom-line hit.

A larger business can sustain that quite easily, but for a smaller business, that looks like quite lumpy profit margins.

That's where you look to an analysis of the business and the growth drivers they're seeing. You look at the underlying business rather than those reported numbers. And you often get the opportunity from the market in circumstances like that as well.

The market may just be looking at the reported numbers or what is the bottom line. And if you can get the edge that will recover over time, or the business ceases to go through an investment phase, you know the market will eventually come back to that growth story and then the share price can often do quite well.

How long does it typically take to see a stock become a multi-bagger?

I'm always looking about two to three years out, and that timeframe gets you a fantastic return if you can compound that over time.

Afterpay is the post child of that multibagger effect. The adoption of the product was so quick, and the share price and the business itself just exploded. That's a once in a lifetime stock for people.

When I see people talk about the next Afterpay, or even the next Xero, which is a slower burn, I take a step back. They genuinely are once in a lifetime stocks for people if you did get in early and hold all the way.

My multi-baggers are probably much more boring than an Afterpay. It's not that explosive growth. It's not 10 bags in a few years. But it's sustainable growth.

And those numbers I said before, where you can turn 10, 15% top-line growth into a real multi-bag, or if you can get the margin expansion underneath, but then also you're buying it cheap enough where you know the market will re-rate that multiple higher, it's the same as compounding over time.

You'd be surprised how far what looks like modest top-line growth can go with a business that can really leverage it. And if you can buy it cheap enough, then the market gets a bit excited.

My multi-baggers, unfortunately, haven't been the likes of Afterpay. But you can still find such companies when you look over a reasonable time period.

Looking to invest in microcaps?

The Merewether Capital Inception Fund invests in small and microcap companies listed on the ASX, with the ability to invest in pre-IPO opportunities. It employs a long-only, high conviction strategy (10-25 positions) with a focus on profitable growing companies with skilled and aligned management teams. The Merewether Capital Inception Fund is open to wholesale investors only. Contact Merewether Capital here.