Listen to the deep-dive discussion – The Twin Engines of 100-Baggers (36:19 min)
The buckets define where capital goes. The lenses calibrate how much and when. But one question remains: What goes into Bucket 3?
This is the selection problem—the art and science of identifying businesses worthy of capital and time.
Bucket 4 (Amplifiers) is easier. Lottery tickets with favorable odds are being purchased. Small positions, asymmetric payoffs, acceptance that most will fail. The selection criteria are looser: optionality, convexity, exposure to the right tail.
Bucket 3 is different. These are core holdings. They will represent 50% of the portfolio. They must compound. They must endure. A mistake here is not a lost lottery ticket—it is dead weight dragging on wealth for years.
The selection process is designed to filter for one thing: businesses that compound intrinsic value over long periods of time.
The Twin Engines
Thomas Phelps, in his 1972 study of 100-baggers, identified the mathematics of extreme wealth creation. His observation was simple:
$10,000 compounding at 26% annually becomes $1,000,000 in 20 years.
But how does a stock deliver 26% annually for two decades?
It requires two engines running simultaneously:
Engine 1: Earnings Growth
The company must grow its earnings—year after year, decade after decade. This is not revenue growth (which can be bought with losses). This is profit growth, driven by expanding the business within its competitive advantage.
Engine 2: Multiple Expansion
Multiple expansion. The market must be willing to pay more for each dollar of earnings over time (multiple expansion). A stock trading at 15x earnings that re-rates to 30x earnings doubles—independent of any change in the underlying business.
The multiplication effect:
| Engine | Contribution | Example |
| Earnings grow 5x | 5x return | $1 EPS → $5 EPS |
| Multiple expands 2x | 2x return | 15x P/E → 30x P/E |
| Combined | 10x return | Both engines firing |
This is why 100-baggers are rare. They require both engines to fire—strong, sustained earnings growth AND a rising multiple—over a very long period. One engine alone produces good returns. Both engines together produce extraordinary returns.
The implication for selection:
The search is not just for “good companies.” The search is for companies where: – Earnings can grow substantially (the business has runway) – The multiple has room to expand (purchase is not at peak valuation)
This leads to a key concept which I would call: Margin of Expansion.
Margin of Expansion
Value investors speak of “margin of safety”—buying below intrinsic value to protect against errors. This is defensive.
Growth investors need something different: margin of expansion—buying where both earnings and the multiple have room to rise. This is offensive.
Margin of Expansion is the discipline that positions the investor to capture the second engine.
The entry valuation must leave room to capture a potential re-rating — this is the discipline that positions the investor to capture the second engine. A stock purchased at 40x earnings has no margin—the market has already priced in excellence. A stock purchased at 15-20x earnings retains optionality: if the business proves itself, the multiple has room to expand. This is not predicting expansion. It is positioning to capture it if it occurs.
What creates margin of expansion:
- ROE not yet extreme. A company with 20% ROE can plausibly reach 30%. A company already at 45% ROE has less room. Paradoxically, “too good” metrics can limit future upside.
- Multiple not yet stretched. A quality compounder at 18x earnings has expansion potential. The same company at 45x earnings has already priced in years of growth.
- Reinvestment runway. The company can deploy retained earnings at high rates of return. It is not yet constrained by market size, competition, or capital efficiency limits.
The trap of “obvious” quality:
Everyone knows Coca-Cola is a great business. But a great business at 35x earnings with 3% growth has limited margin of expansion. The multiple is full. The growth is mature. The dividend yield and little more may be all that’s earned. This does not make Coca-Cola a bad investment. It makes it a Stabilizer — a Bucket 3A holding that provides ballast and dividends rather than explosive growth. The error is not owning it. The error is expecting Twin Engine returns from a single-engine business.
The 100-bagger hunters—Phelps, Mayer, Akre—look for quality that is not yet fully recognized. Businesses with great economics that the market still prices as merely “good.”
The ROE-Growth Matrix
Before diagnosing trajectories, it helps to map companies on a simple two-dimensional framework: ROE (profitability) and Growth (reinvestment opportunity). Each position represents where a company sits today.
| High Growth | Low Growth | |
| High ROE | Quadrant 1: The Compounder
Description: The ideal position—strong profitability and significant reinvestment opportunities. Characteristics: Strong moat, expanding markets, efficient capital use, high reinvestment rate. Strategy: Hold for the long term. Consider adding as the company executes its growth strategy. Examples: Early Google, Shopify (early years) |
Quadrant 2: The Cash Cow
Description: Mature company with high profitability but limited reinvestment. “Sustaining Innovators.” Characteristics: High cash generation, stable margins, prioritizes dividends/buybacks, strong brand, limited expansion runway. Strategy: Assess capital return mechanisms. Consider potential for future growth through acquisitions or new product lines. Examples: Coca-Cola, Procter & Gamble |
| Low ROE | Quadrant 3: The Candidate
Description: Growth exists but profitability is low due to early-stage scaling or inefficiencies. Candidates to Quadrant 1. Characteristics: High reinvestment needs, margins under pressure, potential for significant improvement in profitability. Strategy: Evaluate catalysts for improving ROE (scale, operational improvements, strengthening moat). Monitor closely. Examples: Tesla (early years), early-stage SaaS |
Quadrant 4: The Trap
Description: The least favorable position—poor profitability and limited growth potential. Characteristics: Weak competitive positioning, reliance on external financing, declining industry, lack of innovation. Strategy: Avoid unless clear turnaround catalyst with high probability of success. Examples: Struggling legacy businesses in declining industries |
The key insight: Quadrant 3 is where future 100-baggers hide before they become obvious. These companies have the growth but not yet the profitability. If operational leverage kicks in—if margins expand as scale builds—they migrate to Quadrant 1. The asymmetry is enormous: buy at Quadrant 3 prices, hold through the transition, own a Quadrant 1 compounder.
But Quadrant 3 is also dangerous. Many never graduate. They burn cash chasing growth that never materializes into profit. The filter: look for evidence that unit economics improve as scale increases.
Illustrative Table: ROE Dynamics by Position
| Position (Quadrant) | Sales (Yr 1–5) | Earnings (Yr 1–5) | Equity (Yr 1–5) | ROE (Yr 1–5) |
| Q1: High ROE + High Growth | 115, 132, 152, 175, 201 | 17.3, 21.1, 25.9, 31.5, 38.3 | 100, 117, 138, 164, 196 | 17.3%, 18.0%, 18.7%, 19.2%, 19.6% |
| Q2: High ROE + Low Growth | 115, 121, 127, 133, 140 | 15.0, 17.3, 18.9, 20.0, 21.0 | 100, 115, 132, 151, 171 | 15.0%, 15.0%, 14.3%, 13.2%, 12.3% |
| Q3: Low ROE + High Growth | 105, 116, 127, 140, 154 | 5.0, 6.4, 7.7, 9.2, 11.0 | 100, 105, 112, 119, 128 | 5.0%, 6.1%, 6.9%, 7.7%, 8.6% |
| Q4: Low ROE + Low Growth | 105, 110, 116, 122, 128 | 5.0, 5.5, 5.8, 6.1, 6.4 | 100, 105, 111, 117, 123 | 5.0%, 5.2%, 5.2%, 5.2%, 5.2% |
Assumptions: Starting ROE 15% (High) or 5% (Low). Growth rate 15% (High) or 5% (Low). Reinvestment rate equals growth rate. No dividends.
What the numbers reveal:
- Quadrant 1: ROE increases over time (17% → 20%). The flywheel accelerates.
- Quadrant 2: ROE declines over time (15% → 12%). Equity accumulates faster than earnings can grow.
- Quadrant 3: ROE improves over time (5% → 9%). The candidate is graduating.
- Quadrant 4: ROE stagnates (~5%). No escape velocity.
The Six Trajectories
The Matrix shows where a company sits today. The Six Trajectories diagnose where it is going—whether the flywheel is accelerating, stalling, or reversing. Two trajectories lead to wealth creation. Four lead to traps.
| Trajectory | Quadrant | Characteristics | Bucket | Verdict |
| 1. Aligned Compounder | Q1 | Stable ROE (15-20%), revenue and earnings grow in tandem | 3B | Ideal. The flywheel is intact. Buy and hold. Costco |
| 2. Efficient Compounder | Q2 | High ROE (20%+), slower growth (3-5%), mature phase | 3A | Solid. Reliable, but limited upside. Good for stabilizer role. Coca-Cola |
| 3. Efficiency Maximizer | Q2 | Flat revenue, earnings grow via cost-cutting | Trap | Limited. Efficiency gains are finite. Eventually plateaus. 3M |
| 4. Declining Giant | Q1→Q4 | High initial ROE, declining growth, ROE eroding | Trap | Caution. The compounding engine is weakening. IBM |
| 5. Revenue Chaser | Q3→Q4 | Revenue grows, but earnings flat or declining | Trap | Problematic. Growth without profit is not compounding. Uber |
| 6. Inefficient Allocator | Q4 | Earnings growth slower than ROE, capital wasted | Trap | Avoid. Management is destroying value through poor allocation. GE |
The key insight:
Trajectories 1 (The twin engines are firing. The math works.) and 2 (Stable, cash-generating, but lower growth. The stabilizer role) are the targets. Trajectories 3-6 are traps of varying severity. They may look like compounders, but lack the internal dynamics to sustain long-term wealth creation.
The 15/15 Rule
As a practical filter to identify Quadrant 1 companies on Trajectory 1, look for:
- ROE of approximately 15-20%, sustained over multiple years
- Revenue growth of approximately 15%, aligned with or exceeding ROE
Why these numbers?
ROE of 15-20%:
This is high enough to indicate a competitive advantage (average companies earn 10-12%) but not so extreme that it cannot be sustained or improved.
A company earning 40% ROE is impressive—but where does it go from there? Often, it plateaus or declines as competition enters or reinvestment opportunities shrink. A company earning 18% ROE has room to expand to 25% or 30% as it scales.
Revenue growth aligned with ROE:
If a company earns 20% ROE and grows revenue 20%, it can reinvest all earnings at the same rate of return. The compounding flywheel is intact.
If revenue growth is lower than ROE, the company is generating excess cash it cannot reinvest productively. It will return capital via dividends or buybacks—fine for income, but not the exponential compounding sought.
The compounding math:
A company with 15% ROE that retains all earnings grows book value at 15% annually. If the market values it consistently at a stable multiple, the stock price also compounds at approximately 15%.
This is the mechanics of compounding: ROE × Retention Rate = Book Value Growth.
The Aligned Compounder in action:
Here is what this looks like concretely—a company with 15% ROE, 15% revenue growth, and full earnings retention:
|
After 5 years: Revenue has grown 75%. Book value has grown 75%. Earnings have grown 75%. The ROE remains constant at 15%.
Now extend the horizon:
| Year | Book Value | Earnings | Cumulative Growth |
| 1 | 100 | 15 | — |
| 5 | 175 | 26 | 1.75x |
| 10 | 352 | 53 | 3.5x |
| 15 | 709 | 106 | 7x |
| 20 | 1,423 | 213 | 14x |
At 15% compounding, money roughly doubles every 5 years. After 20 years, a $10,000 investment becomes approximately $140,000—without any multiple expansion.
Add multiple expansion:
If the market also re-rates the company from 15x earnings to 25x earnings over this period (as it recognizes the durability of the compounding):
- Earnings growth: 14x
- Multiple expansion: 1.7x
- Total return: ~24x (a 24-bagger)
This is the twin engines in action. Neither engine alone produces extraordinary results. Both together transform a good investment into a life-changing one.
The key insight:
The 15/15 rule is not about finding the highest ROE or the fastest growth. It is about finding sustainable, aligned compounding—where the business can reinvest all earnings at high returns, and the market has not yet fully priced this in.
The Christensen Filter
Clayton Christensen’s research on disruptive innovation adds a crucial lens: where is this company in its lifecycle, and what threatens it?
The disruption trap:
Successful companies face a paradox. The metrics that please investors (high ROE, high margins, capital returns) are achieved by focusing on the most profitable customers and abandoning lower-margin segments.
But disruption comes from below. New entrants serve the customers incumbents abandoned—at lower margins, with simpler products. Over time, these disruptors improve, move upmarket, and eventually threaten the incumbent’s core business.
The warning signs:
- Management obsessed with “returning capital to shareholders” rather than investing in growth
- Product innovation is incremental (sustaining), not transformative (disruptive)
- Margins are defended by retreating upmarket rather than competing
- The company has stopped taking risks
The filter question:
“Is this company painting itself into a corner?”
A company with 30% ROE achieved by abandoning growth and focusing only on premium customers may be a value trap. The metrics look great today. The business may not exist in 15 years.
Contrast with a company reinvesting heavily in new markets, accepting temporarily lower returns to capture future growth. The metrics look worse today. The business may dominate in 15 years.
The implication:
Don’t just screen for high ROE. Ask how the ROE is achieved and whether the strategy is sustainable or self-liquidating.
The Unified Checklist
Before a company enters Bucket 3, it must pass these filters:
Quantitative: – ☐ Revenue growth: Consistent, ideally 10-20% annually – ☐ Book value growth: Through retained earnings, not dilution – ☐ ROE: Stable at 15-25%, not extreme or erratic – ☐ Debt: Minimal—the company can survive a recession – ☐ Dividends: Low or none—earnings are reinvested, not distributed – ☐ Valuation: Reasonable multiple with margin of expansion
Qualitative: – ☐ Moat: Durable competitive advantage (brand, network effects, switching costs, scale) – ☐ Moat trajectory: Strengthening over time, not eroding – ☐ Reinvestment runway: Large addressable market, ability to deploy capital at high returns – ☐ Management: Aligned with shareholders, rational capital allocators – ☐ Disruption risk: Not painting itself into a corner
The integration:
No company passes every filter perfectly. The checklist is not a scoring system—it is a conversation guide. Each item raises a question. The answers reveal whether this is a true compounder or a pretender.
Selection for Bucket 4
Amplifiers require looser criteria. The search is not for proven compounders—it is for asymmetric optionality.
What to look for:
- Extreme upside if the thesis plays out (10x, 20x, or more)
- Limited downside relative to portfolio (small position size)
- Catalyst for re-rating (new product, market expansion, turnaround)
- Misunderstood or ignored by the market
What to accept:
- Unproven business model
- Negative earnings (if path to profitability is visible)
- High volatility
- Binary risk (it works or it doesn’t)
The difference from Bucket 3:
In Bucket 3, the durability of a business model is being underwritten. The company must prove it can compound.
In Bucket 4, optionality is being underwritten. The company might fail. But if it succeeds, the payoff overwhelms the losses on other Amplifiers.
The overlap:
Some Bucket 4 positions will, over time, prove themselves as compounders. They graduate to Bucket 3. This is ideal—the early asymmetry was captured AND the subsequent compounding.
Some Bucket 3 positions will deteriorate as their competitive advantage erodes. They may need to be sold or, occasionally, moved to Bucket 4 as turnaround speculations.
The buckets are not permanent assignments. They are current roles.
The Selection Discipline
Selection is not a one-time event. It is an ongoing discipline.
Before buying: – Apply the checklist – Identify which bucket the position belongs to – Define the thesis: Why will this compound (Bucket 3) or explode (Bucket 4)? – Define the anti-thesis: What would prove me wrong?
While holding: – Monitor the fundamentals quarterly – Ask: Is the thesis intact? – Ask: Has the position grown large enough to require trimming? – Ask: Has anything changed that would move this between buckets?
Before selling: – Apply the lenses (especially Ergodicity and Harvesting) – Distinguish between price volatility (noise) and fundamental deterioration (signal) – If selling, know where the capital goes next
Selection is the alpha engine. The buckets hold what is selected. The lenses calibrate how it is managed. But without rigorous selection, the entire system is built on sand.
The structure is built. The lenses are calibrated. The selection criteria are defined.
But even the best system needs exceptions. What happens when a position becomes a 100-bagger? When the rules say sell but the opportunity says hold? When success itself breaks the allocation?
That is the domain of exceptions.