The Multibagger Trap: Why a “Perfect” Stock Is Never Enough

Ever felt the adrenaline rush after finding the “perfect” stock?

That feeling is your biggest enemy.

In the previous post, I shared how to search for quality businesses to invest in. While that is a critical first step, the next three are just as important to turn your investment into a potential multibagger. They are:

• Start with small positions and buy in tranches.
• Purchase businesses at a cheap price.
• Be patient and wait.

Let’s begin by discussing how to protect yourself from the downside.

Start with small positions and buy in tranches

There are always blindspots.

No matter how careful, you will always overlook certain aspects during your analysis. This is especially so if you aren’t familiar with the industry that the company operates in.

Even if you are meticulous and have checked every corner, you can’t change the fact that businesses always operate in uncertain environments. And despite the managements’ well-intention, things might not work out as expected.

There are many examples out there, but this misadventure by Shopify (NASDAQ: SHOP) left a deep impression.

Fulfilment network dream turned nightmare

Shopify’s business model has always been appealing because it’s scalable and a sticky one once a customer decides to use its platform.

Covid-19 pandemic was catalytic in accelerating Shopify’s growth from 2020 to 2022. However, its bold move in acquiring Deliverr in 2022 proved to be a costly mistake.

While the intent to provide fast, reliable and affordable fulfilment for its merchants is good, the acquisition represented a fundamental shift from Shopify’s traditional “asset-light, software-first” business model to a capital-intensive, physical logistics operation.

Consequently, not only did this cause a drag on Shopify’s financial performance, it also distracted Shopify’s core software business.

The market is merciless.

While this acquisition wasn’t the reason for the plunge in its share price in the late 2021, the acquisition in 2022 confirmed the market’s fears about the company’s capital-intensive strategy, delivering a final blow to its stock performance that year.

The aftermath was that Shopify’s share price lingered less than half of its peak price for a long period of time.

It took a few quarters of strong financial performance, after its sale of Deliverr in mid-2023, before its share price went north bound again.

It’s a messy world

Beyond the business itself, the world we live in is messy. The market that we are investing in is a cauldron of short-term traders and long-term investors, reacting differently to various macro-economics news.

Think about it in this way.

You are a distance runner out for a run on a track. But, the track is shared with sprinters and cheerleaders, and there is a soccer game on the field. You would never know when you’d bump into others or get hit by a ball!

While many advise you to “ignore the noise”, in reality, the market’s messiness is unavoidable.

This is why buying in tranches isn’t a sign of a lack of confidence, but rather a prudent strategy to manage the unexpected and use volatility to your advantage.

It gives you room to reassess your thesis and buy more at a better price if a quality business goes on sale.

Purchase businesses at a cheap price

No matter how good a business is, you don’t want to overpay for a stake in it. Else, while the company might continue to do well, your investment will not.

How do you then decide if the price is cheap enough?

To determine if a stock is cheap or expensive, the most comprehensive method is to find its intrinsic value (IV) using the Discounted Cash Flow (DCF) method.

In theory, the intrinsic value is the present-day value of all the cash a company is expected to generate in the future.

While there are many online DCF calculators available, relying on them can give you a false sense of security. You might incorrectly assume that if the current stock price is below the calculated IV, the stock is automatically cheap.

The problem is that DCF models are highly sensitive to the inputs you provide. A slight change in any of the following projections can lead to a drastically different intrinsic value:

• Projected growth rate for the next 5 to 10 years.
• Terminal growth rate, which estimates growth beyond the explicit forecast period.
• Discount rate, also known as the required rate of return, which accounts for the time value of money and risk.

This means you can easily overestimate or underestimate the IV of the stock.

As such, I am no fan of this method.

Instead, I typically just take a look at the stock’s price-to-earnings (PE), relative to its historical values, industry average, and its growth rate. For a better reflection of the company’s actual financial health, you can replace earnings with free cash flow.

Among the relative valuation mentioned, I prefer to use the price earnings-to-growth (PEG) ratio, as it provides a quick gauge if the stock’s PE is justified by its growth prospect.

As a rule of thumb, a PEG ratio below 1.0 is considered undervalued.

However, just like DCF, this depends on the estimation of the company’s growth rate, which might change over time.

Context also matters.

For instance, a company that experienced a one-off growth and valued at a PEG of 0.8 appeared cheap, but isn’t. A slow-growth, stable utility company might be fairly valued at a PEG of 2.0, while a hyper-growth tech company could be a bargain at a PEG of 1.5.

What this means is you should not just based your decision just on any single metric. You should combine that with your qualitative assessment of the business to arrive at a final decision.

Let me share a personal example.

Despite a PEG that was way above 3, and forward PE of 50x, I increased my stake in Intuitive Surgical (NASDAQ: ISRG) at US$476 in August.

Was I crazy to pay so much for Intuitive?

Maybe, but hear me out.

I was impressed by Intuitive’s robust and measured roll out of its latest da Vinci 5 machines.

This signals sustained future growth, primarily driven by its expanding installed base and recurring revenue stream, which makes up over 80% of total sales.

And guess what?

Despite the perceived lofty valuation, its current PE is lower than its historical average PE of over 60x across various time frames.

Hence, I think Intuitive deserved to trade at a premium.

I could be crazily wrong, and that’s why I went back to the second principle and increased my stake only by a small amount.

Be patient and wait

The big money is not in the buying and selling but in the waiting.
– Charlie Munger

Inaction is the simplest but often the toughest step. A business’s potential isn’t realised overnight; it demands patience. Consider these long horizons:

• It took iFAST Corporation (SGX: AIY) three years just to turn its Global Bank into a profitable entity.
• The Hour Glass (SGX:AGS) waited seven years before finally executing its major expansion into Australia in 2020.
• Arista Networks (NYSE: ANET) required six years to deliver a 10-bagger return.

If you are truly investing for the long term, you must be ready to play the patient game.

Worth the effort?

First, you need to search for potential, then you need to check valuation, and finally be patient for the growth story to unfold.

But is all that work worth it if you only get one 10-bagger after six years?

Should you just invest in a World or US ETF instead?

Stay tuned for the final post in this series to answer these questions.