Five thumb rules to follow while picking multibagger stocks

When we look back at the markets over the past few decades, there have been scores of multi-baggers in the Indian markets. Even if we consider a much shorter time frame post the global financial crisis in 2009, there have been numerous instances wherein small & mid cap stocks have multiplied wealth many times over on their way to become large cap stocks. That brings us to the core question of how to pick multi bagger stocks? Here's a look at a very interesting 5-point model.

Combination of growth and non-cyclicality

One key factor that creates value in the stock market is consistent growth across economic & market cycles. While markets values growth, it places an even greater premium on consistency in growth. Most of multi baggers 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 even oil. Economic cycles dissipate most of the wealth of these companies. It is also hard for a staid utility company to become a multibagger because it operates in a very constricted atmosphere.

Efficient utilisation of capital

There are different ways to approach shareholder returns. While there are multiple measures of capital utilisation two of the key measure are return on capital employed (ROCE) and Return on Equity (ROE). 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. ROE is a measure of shareholders return and a very important parameter for the investors. Some of the best wealth creators 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 for which markets are willing to pay a premium.

Low debt and an asset-light business model is the key to wealth

One of the reasons why it becomes difficult to find multi baggers from sectors like metals, infrastructure and utilities is because of the capital intensive business model which leads to very high leverage and low return ratios. High leverage increases insolvency risk in economic down cycles but when debt is low, the entire issue of financial risk is overcome. It is not necessary to be a zero-debt company as some amount of leverage may actually improve shareholders returns. On the other hand, very high leverage might actually end up destroying shareholders value.

High standards of corporate governance

Markets place great emphasis on corporate governance and are willing to pay a premium for it. Some of the key traits of companies with good corporate governance are:  

• Alignment of management interest with minority shareholders
• Very high standards of disclosure of shareholder related information. In fact, Narayana Murthy best summed up this sentiment with his famous words, "When in doubt, just disclose".

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.

However, one needs to consider other parameters like return ratios and brands that the company has created which can go a long way in determining potential valuation. While there is no guarantee that the above mentioned parameters would always help investors identify multi baggers, but they will surely go a long way in helping investors avoiding companies which may end up being value destructors.

The author is deputy vice president, Research at Angel Broking.