To turn a modest sum of money like £1,000 into £10,000 from investing in shares, you need to be a good investor. It’s possible to achieve a 1,000% return if you’re prepared to wait a very long time with an ETF or a portfolio of dividend-paying shares.
However, to increase the odds of ten-bagging, then the smaller end of the market is probably the place to look. That’s because, as many growth investors point out, elephants don’t gallop.
The benefits of smaller shares
When I talk about smaller shares I’m not talking penny stocks — those are a whole other ball game and come with big risks. If you suffer a 50% loss on an investment you need to make 100% to just breakeven. You can check out the maths yourself if you don’t believe me. It gets worse as your losses increase. This is why I avoid penny stocks and instead am looking to invest for the long term.
This is about investing in high-quality stocks that happen to have low market capitalisations. Probably because they are small, growing businesses, or they have been previously mismanaged.
The benefits of smaller-cap shares are numerous, but among the most important is greater inefficiency in the market. Because, institutional investors do less research on smaller-cap companies, there are more opportunities to buy undervalued shares. On top of that, small caps find it easier to double in size. It’s easier to grow from being worth £50m to £100m, for example, than it is to go from £10bn to £20bn.
Thirdly, smaller companies can generally be more agile, less bureaucratic, and in many cases will have founders retaining significant shareholdings. This often makes them more entrepreneurial.
Investing in shares: making returns from smaller-cap companies
Bearing in mind all these advantages, I’d check for profitable companies on AIM as a starting point. Many of these companies are actually very high quality. The trick though is to find ones that are undervalued. One way is to find those with low price-to-earnings ratios and low price/earnings-to-growth ratios, favoured by growth investors like Jim Slater. In many ways the later is more important as the former might screen out too many high quality companies.
Car seller Motorpoint is an example of a share that I think has the potential to rapidly grow. It has a PEG of around 0.4 and earns a respectable return on capital employed of 16%. Its industry has faced some problems, but its fundamentals seem strong.
With a market cap just over £250m, it’s certainly not a behemoth. It’s a ship that can be turned around. When lockdowns end, I expect it could be well placed to pick up from pent-up consumer demand, which will drive sales.
So, at the end of the day, growth investing isn’t without its challenges. However, I believe trying to find undervalued growth shares is the way to go for me.
Andy Ross owns no share mentioned. The Motley Fool UK has recommended Motorpoint. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.