We have all heard the story that if you would have invested Rs. 10,000 some 10-15 years back, it would have been equal to one lakh, five lakh or even more in some cases. Be it Wipro, Bajaj Finance, Relaxo Footwear or any other stock that have become multibagger over the years. However, in real life investors in search for multibagger stocks more often than not get trapped with penny stocks which are barely making any profits. So what is a multibagger stock and how can you identify them?
What is a Multibagger Stock?
In short any stock which gives returns that are several times from than the investment value are multibagger stocks. The term was coined by Peter Lynch in his 1988 book “One up on Wall Street”. These are companies which usually have strong fundamentals, sound balance sheet, and promising growth prospects.
Important factors to identify Multibagger stock ideas (2020)
Well, truth be told, there are no fixed ways to ascertain that a particular stock is multibagger. But, just like any recipe requires quality ingredients, these below factors will help you potentially find multibagger stocks. Is it foolproof? Of course not, if it was, we would not be writing this article. These parameters are definitely very important but sustenance or constant improvements are essential for the stock price to keep delivering returns. The moment any of the factors starts to show any signs of cooling off/slowing down, the returns would moderate.
Therefore, many experts stand by the view of holding a portfolio of stocks rather than one due to simple investing principle of not putting all your eggs in one basket and hoping it to become multibagger. This is because businesses are constantly changing, challenges/competition is increasing, and therefore, holding a portfolio of stocks helps you diversify.
Let’s look at the factors –
Understand of the sector
It is extremely important to understand the sector in which the company operates as it will give you a deeper understanding of the market size, key players, and more importantly potential growth drivers. The growth drivers could be favourable government policy (Make in India), changes in consumption or saving patterns, government spending on key sectors (infra, Rail etc) or improving economic indicators like per-capita income etc.
Besides, it is also vital to understand the cyclicality of the sector i.e how cyclical is the sector with respect to the economy. We have all seen that economic growth tend to move in a cycle which includes different phases like expansion, peak, recession, trough and repeat. Therefore, the higher the cyclicality of the sector, the deeper is the impact on the business during an economic recession.
For example, commodity stocks (Metals, Oil &Gas) are highly cyclical as compared to Autos and Banking which in turn is highly cyclical when compared to FMCG or Pharma (also known as defensives). It does not mean that high cyclical sectors cannot become multibaggers, it is just that these sectors require extra attention as economic tailwinds are not there during the recessionary phase and the company has to step up its game to maintain or grow its business.
Promoter and Management Capability
They are the one who runs the show and businesses cannot run efficiently without a capable and strong management team. These include qualitative characteristics such as expertise in that business, past track record etc. Not only this but the corporate governance issues like board structure, pledged holding, compensation structure plays an important role in company’s growth prospects.
An economic moat refers to the businesses ability to maintain a competitive advantage over its competitors. It could be in the form of an entry barrier, its brand image, or simply the ability to disrupt the industry. Economic Moat helps companies have pricing power in which way they can expand their margins or protect them in adverse conditions. Further, in order to maintain its advantages, the company needs to constantly innovate and stay ahead of the market in order to succeed. A key way to look at it is through their investment in R&D and new product launches frequency.
Promoter's Holding in the company
If the promoters of a company do not have enough skin in the game, then those companies should fall in the ranking of potential multibagger stocks. Because, if the ones who started the business is not committed, then there is very little scope for the business to prosper. Ideally, more than 50% promoter holding is good, but anything above 40% is also acceptable. The important thing to see is that the promoters are not consistently looking to reduce their holdings.
What is the use of the above factors if they cannot translate into sales for the company, Right? It is needless to say that sales give a clear picture of the business and its growth. It also gives us an understanding of how the company has performed through economic cycles. Further, in the long run, for the stock price to keep delivering returns, it is imperative that the core business of the company should continue to grow.
Scope for margin improvement
Not only is the sales growth important, but margins also play a crucial role to enhance profitability. There are multiple ways to achieve this, one that it could be due to market forces (commodity prices have gone down), hence the margins have improved but these would be temporary as when commodity prices inches higher the same benefit would not be there. The second one is more important which is a medium-to-long-term strategy to expand margins. Some examples for these include sourcing raw material locally (to avoid currency exposure), premiumizing or extending its product portfolio, or adoption of better technology leading to cost efficiencies.
Earnings Growth and Cash Flow
No matter what the sales growth or operating margins are for the company, but if it does not translate into earnings it is of no use to the shareholders as they get paid when the company earns profits. Not only this, but the profits should also translate to cash flow for the company so that it can either expand or pay it to the shareholders in the form of a dividend.
Balance Sheet and Return Ratios
These companies should have a strong balance sheet with minimal debt levels. Debt is like a two-edged sword as when times are good, it can help the company to grow, however during trying times it becomes a burden as companies need to keep servicing the debt. Usually, companies with higher debt are less attractive and have lower valuation as compared to a company having all things the same except that it is debt-free.
The potential multibagger stocks usually have high or expanding return ratios typically higher ROCE and ROE. It means that the company has made efficient use of the capital and managed to run or expand its business.
The most important question is at what valuation to buy?
At what valuation do you buy is extremely important as whatever we might know about the company is possibly priced in by the market till now. The biggest example of a multibagger stock – Bajaj Finance which filled almost all the criteria mentioned above and started to trade at a valuation which was higher than even most of the large private sector banks. However, fortunes turned as COVID-19 raised fears of a sharp slowdown in growth and even a rise in NPAs and then there was near ~60% correction.
This is what happens with growth stocks as they command higher P/E as compared to value stocks. But the important question to ask is not the valuation by itself, but can it sustain its growth to maintain that valuation multiple. HDFC Bank, for example, has sustained to command premium valuation over the last decade or even more thanks to its robust growth and best-in-class asset quality.
Look at the P/E ratio of the company and compare it with its historical averages (5-Year, 10-Year) and peers in the industry and ask yourself why is it trading at a premium and can it sustain? Or if it is trading at a discount then what could be reasons behind it? And can it improve? Based on this and your take on the above factors make a decision whether to invest in that stock. And most importantly HAVE PATIENCE as multibaggers are not created in a day, month or a year, it takes time.