How to find the next 10 bagger (Part VIII)

Source: Telstra presentation

In this series of articles, I am taking a look at the history of some of the ASX’s best performing stocks. In particular, I hope to address the following questions.

  1. What did these companies look like at the start of their rise?
  2. Is it possible to identify tomorrow’s 10 baggers?

Telco retailer Vita Group Limited (ASX: VTG) had a market capitalisation of $31.3 million five years ago compared to $733.9 million today. Its share price has risen more than 20 fold over this time and the company has generated a further 150% of shareholder returns in the form of dividends.

In the light of Vita’s excellent 2016 results released yesterday, we can examine how much of this outperformance is due to business performance compared to market repricing.

Back in 2011, Vita delivered earnings before interest, tax, depreciation and amortisation (EBITDA) of $18.5 million for the year. However, the result included $9.6 million of trailing commissions relating to an old agreement with Telstra and so these ought to be excluded to understand underlying profitability at the time.

Based on underlying EBITDA Vita was trading on an enterprise value-to-EBITDA multiple of 4.3 in August 2011 compared to 11.7 today. Roughly speaking, the stock’s 20-fold price rise can be attributed to it becoming three times more expensive combined with a seven times growth in profit per share. This illustrates the power of combining a cheap price with a quality business, although the low purchase price was less significant than the company’s subsequent performance.

Still, multiple expansion is responsible for a large chunk of shareholder returns in the case of Vita and other examples in this series. I generally take a multi-year low as my hypothetical buy price which typically coincides with poor market, industry or company specific sentiment and hence represents a low earnings multiple. In contrast, today most of these stocks are trading at demanding prices thanks partly to the low interest rate environment, but also due to strong business performance.

It could be argued that the repricing of Vita stock over the last five years was due partly to a rising market affecting all stocks and that today prices look expensive across the board. If so, perhaps Vita’s current share price actually overstates the true value of the company. Therefore, the true value of buying Vita cheaply in 2011 is less than implied by the subsequent multiple expansion increasing the relative importance of quality over price in this case.

So if quality is the key factor then how did Vita manage to increase underlying EBITDA seven times in five years with little recourse to additional capital? Much has been made of the company’s customer focused culture which is a great source of pride for CEO, founder and largest shareholder Maxine Horne.

However, the deal with Telstra struck back in 2009 also seems significant as it led to Vita replacing its Fone Zone stores with the far more profitable Telstra branded outlets over the following years. In my view, Vita’s use of the powerful Telstra brand has been a huge benefit to the company and is a major driver behind its recent success. Given Maxine Horne founded the company, it seems likely that Vita’s celebrated culture was in place long before this deal was struck and yet for many years the company struggled.

Of course there are likely to be many other potential factors for Vita’s extraordinary performance. These include the general growth in the mobile phone market over recent years and other aspects of the 2009 Telstra deal, such as the shift from a trailing commission structure to higher upfront payments.

Whilst Vita’s culture is undoubtedly a key component of the company’s impressive recent history, it was only when it was combined with Telstra’s powerful brand that it began to yield results. Regardless, it is hard to imagine Vita thriving without the dedication of founder Maxine Horne and her passion for exceptional customer service.

Buying stocks like Vita in 2011 is exactly how one man turned $10,000 into over $8 million. Find out more about how he did it and how you can start down the path towards financial independence. Simply click here to learn more.

Motley Fool contributor Matt Brazier has no position in any stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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