During these days, when there is nervousness and panic across street and most of the retail investors are bearing lot of pain in their equity portfolio, Sensex & Nifty are further sprinkling salt on their burns by hitting new highs fuelled by only a handful of index heavyweights. In fact, many retail investors who entered in equity market during 2016 - 2017 are in dilemma to know whether the stocks in their portfolio are good long term investment candidates or the dud stocks.
Hence, its important to know the basic criteria’s which make a company a right investment candidate with potential to multiply wealth in long term.
Rules to follow while Identifying Multibagger StocksBelow are the 6 basic rules which we must follow to pick right companies having multibagger potential.
1. Quality management with high integrity
Alignment of management interest with minority shareholders is one of the key parameter. High standard of corporate governance ensures that company is not involved in any wrong doings. Proper and timely disclosures of shareholder related information by the companies build trust over time. Past track record of promoters, disclosures and dividend pay-out history can help us to check on this crucial parameter.
If the management is not honest, will they want to share the goodies with you? No, they will look for the first opportunity to siphon off the profits and pull the wool over your eyes. We have seen how the investors of LEEL Electricals have lost 95% of their capital over last 1 year due to personal enrichment of LEEL promoters by siphoning off company's profit from the sale of its consumer durable division to Havells.
2. High ROE & ROCE – Efficient use of capital
Return on Equity (ROE) measures a company's profitability by comparing its net income to shareholders equity (book value). ROE is a speed limit on self-funded growth (company's profit). That is, a company cant grow earnings faster than its ROE without raising cash by borrowing or selling more shares. For instance, a 15% ROE means that the company can’t grow earnings faster than 15% annually by relying only on profit to fuel growth. ROCE measures the overall returns for all stakeholders and is a relatively good measure of the overall efficiency of the company. A consistently low ROCE signifies that there is something inherently wrong with the business or the company.
Wealth creator stocks usually have very high ROE and the ROCE relative to the rest of the industry. Typically, companies with high ROCE and ROE would also be generating positive free cash flows consistently. Increasing ROE and ROCE every passing year with low / negligible debt on books is one of the key aspect in spotting multibagger stocks.
3. Low Debt and Free Cash Flows
Its important to learn the lesson from financial crisis of 2011 and now of 2019 that companies with high debt simply get slaughtered. While debt is not bad in case if the company is able to borrow at a lower rate and deploy it in its business at a higher rate as the operating leverage works in its favour, however excessive debt with high interest and repayment obligations can crunch the stock in times of downturn. So, as a long-term investment philosophy, it is best to steer clear of high-debt companies.
Recent episode of stock prices falling liking nine pins of ADAG companies (Reliance Power, Reliance Infra, Reliance Com, Reliance Capital), Essel group companies, Jain Irrigation etc indicates how unbearable high debt burden on books can destroy investors wealth in shortest span of time.
4. Asset Light Business Model - No High Capex Requirements
We know the demerits of investing in stocks like Suzlon & GMR Infra which have an insatiable appetite for more and more capital. To feed their perennial hunger, these companies dilute their equity by making FPOs, GDRs & FCCBs resulting in total destruction of shareholders wealth. This is the simple reason why we do not see multi-bagger opportunities from sectors like metals, infrastructure and utilities because of the capital intensive business model which leads to very high leverage and low return ratios.
Companies should be lean and mean requiring minimal capital but generating huge returns with free cash flows which can be used not only to reward shareholders but also to expand business in future. It is not necessary that company should be a zero-debt company as some amount of leverage can actually improve shareholders returns.
5. The Scale of Opportunity & Non-cyclical Business
Multi-bagger stocks are created because they are able to scale the opportunity rapidly. Titan Industries is a great example. In 2003-04, Titan was a small company with market capital of 500 crores. As on date, its a large cap with more than 1 lakh crores market cap. The fact that India is a booming marketplace of 132 crores consumers means that most products and services have a head start at trying to scale up their activities.
One key factor that creates value in the stock market is consistent growth across economic & market cycles. While markets values growth, it also pay higher premium on consistency in growth. Most of multi-baggers of past like Asian Paints, Titan, Page Industries, United Spirits, Marico, Aurobindo Pharma are typically high growth companies in non-cyclical businesses. It is extremely rare to find a multi-bagger in a typical commodity business like steel, aluminium or oil.
6. Valuations & Future Growth Prospects
Most investors are obsessed about valuations, refusing to buy any stock that is expensive. However, one must remember that expensive is a relative term. If a stock is compounding at 25% on an annual basis, paying a price to earning multiple (P/E ratio) of 30 may be very reasonable. A stock like Nestle or HUL, for instance, has always been expensive. However, a great company with an impeccable pedigree may not always be a good stock to buy. This could be due to the fact that most of the triggers are already in the price and future growth potential does not justify the valuations. The PEG ratio (which is PE ratio divided by sustainable growth) is a simple way to measure valuation relative to growth.
But it is equally important to consider other parameters like financial ratios and brands that the company has created which can go a long way in determining potential valuation. A particular company may look expensive to an investor who have a 2 years horizon but may be a screaming buy for investor who wish to hold it for next 5 to 7 years.
There is no guarantee that the above mentioned parameters would always help investors identify multi-baggers, but these parameters will surely help investors to invest in right set of companies and avoiding those which may end up being value destructors. Moreover, we can learn by following key traits of successful investors who have created enormous wealth in past.
Making Money by Investing in Fast Growth Multibagger Stocks“The investor of today does not profit from yesterday’s growth.” Warren Buffett
Infy has given CAGR returns of whopping 42.6% to investors during last 25 years (that too after keeping dividend payouts aside). Infosys got listed in June 1993 at price of Rs. 145 per share and investment of Rs. 9,500 in June 1993 is valued at ~6.73 crores today. But, is Infosys still the key to riches? As often repeated, past performance is no guarantee of future results. So, how does one find out the next ‘Infy’?
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