How we scored a near-200% gain from a stock hidden in plain sight

Every week, there is a stock out there hitting its 52-week low.

In other words, there is no shortage of cheap stocks. These are not hard to find.

But low prices alone do not make a stock worth buying.

Ideally, the company behind that stock should exhibit all the desirable traits that we want in a good business.

Growth for the win

Previous members of the Motley Fool Singapore's Stock Advisor Gold service will be familiar with our most successful US stock pick, Mastercard.

Our favoured approach, while running the service, was centred around growth investing.

And Mastercard represented all the positive traits that we seek in a growth stock.

We picked Mastercard in July 2016 and kept our recommendation unchanged all the way until the service closed in October 2019. During this timeframe, Mastercard delivered a total return, including dividends, of 194.6 per cent.

Let me explain how we identified Mastercard as a stock pick so that you can do it on your own.

1. That's good, but will it continue?

As growth investors, we are not looking for businesses that are broken.

We are looking for businesses that are already firing on all cylinders.

Typically, these companies already have a working business model with visionary leaders or seasoned executives at the helm. Such businesses often exhibit consistent levels of profitability and the proven ability to grow faster than its industry.

But what happened in the past might not always carry over into the future.

The trick, of course, is to figure out whether the good performance can continue.

Said another way, we have to determine if the company can protect its business from competitors.

Mastercard's role, as a business, is to connect banks with one another.

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When you buy something from a store using your credit card, Mastercard connects your credit card's bank to the store's bank. The company earns revenue by taking a small cut of the transaction made between these two banks.

This network of bank connections becomes valuable when it is wide-spread and available everywhere.

That was certainly true when we picked Mastercard.

In 2015, Mastercard had 1.56 billion branded cards in circulation which were accepted at over 40 million merchants. There were also 25,000 banks in the company's massive network.

Such a network is hard to build and even harder to match, we reasoned.

To use an example, if you are a new store owner looking to accept credit card payments in your premises, which provider would you choose?

The question, of course, answers itself.

2. Size is relative

Some believe that the best way to score big returns is by picking small, unknown companies.

In the case of Mastercard, these assertions would prove to be untrue.

By the time we picked Mastercard, the company had a market cap of over US$100 billion (S$143 billion). And with well over a billion cards in circulation, the credit card company was hardly small or unknown.

However, size is relative.

We recognised that Mastercard's addressable market is much, much bigger.

Magnitudes larger, in fact.

You see, most of the world is still using cash as a medium of exchange, 85 per cent to be exact.

In short, there was plenty of room for Mastercard to continue its growth as merchants and consumers alike shifted towards digital payments.

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So, as big as Mastercard was, we saw the possibility for the company to continue its growth, putting it in a sweet spot.

With the benefit of time, we can now say that our view proved to be correct.

By 2019, Mastercard's card circulation expanded to almost 2.2 billion, up from 1.56 billion in 2015. Within those four years, the amount of gross dollar volume processes grew from US$4.7 trillion to US$6.5 trillion.

The network's growth led to strong revenue and profit growth.

Since July 2015, the month of our recommendation, company revenue grew 71 per cent while profit soared by almost 120 per cent.

In sum, the stellar performance from Mastercard backed up the stock gains that investors enjoyed from simply holding its stock.

Such companies are worth paying up for.

3. Paying up for quality

As investors, it is in our nature to seek low valuations for the stock we want to buy.

In the investing world, much ink has been spilled on valuation techniques, all in a bid to determine the right value to pay for a stock.

The approach makes a lot of sense.

You are simply trying to pay less for the value that you see.

However, I would like to provide a counter argument when it comes to growth stocks.

For me, the value that we hope to see in the future is rarely accurate.

We can do all the math that we want, but in the end, our projections have to come true for the value to appear.

If our estimates don't pan out, then our valuation efforts would be in vain.

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In that context, I submit that the probability of a company fulfilling its future promise should play an outsized role in whichever valuation approach that you take.

In fact, I think finding a company with a high probability of growth is a more important factor compared to the cheapness of the stock.

Going back to our example of Mastercard, its shares were trading at a price-to-earnings (PE) ratio of 28 times in July 2015.

On an absolute basis, it looked expensive.

However, we recognised that the stock has historically traded around 26 times earnings since 2011, making the current valuation only a touch more expensive than its average range.

When you put all the points above together, we saw a high-quality company with room to run, all while the stock was trading at an average valuation.

To use an analogy, it's like seeing a great bottle of wine selling at a reasonable price.

For the growth investor, that spells opportunity and we are glad that we picked Mastercard as a recommendation back in mid-2016.

Get Smart: Breaking the rules

The lessons above are not something we discovered on the fly.

The tell-tale signs above are a product of our experience investing in the US stock market for well over a decade.

These traits are not unique to Mastercard either.

We used the same growth philosophy in picking Apple and Amazon, both of which have gone on to increase by over 100 per cent each.

In short, we believe in our approach and stand by our observations.

This article was first published in The Smart Investor. All content is displayed for general information purposes only and does not constitute professional financial advice.