Multibagger is a very vaguely used term in stock market. But very few people really know how to spot them. In this post we are going to discuss about characteristics of a multibagger stock, what makes a stock multibagger and how to spot one?
Before we understand the characteristics of a multibagger stock, it is important to understand the real definition of a multibagger stock.
Usually a multibagger stock is believed to be the one that gives exceptional returns in a short span of time. That’s not true.
Stocks that appreciate in price overnight may not be able to sustain the growth and fall back(reversion to means).
The truth is, multibagger stocks are backed by business that grows consistently over a period of time, have some unique characteristics such as strong financial performance, honest management, efficient capital allocation strategies and large free cash flows.
In other words, multibagger stocks are not created overnight, you have to be patient with them and give them time to grow.
The question now is, What makes a stock multibagger? What are the characteristics of a multibagger stock and how to spot one?
Spotting characteristics of a multibagger stock is not as difficult, if you are familiar with their traits.
There are two broad characteristics of a multibagger stock:
- Qualitative Characteristics
- Quantitative Characteristics
Qualitative Characteristics of a Multibagger Stock:
“You can’t make a good deal with a bad person”
Behind every great business, there is an honest management.
Qualitative characteristics show how well the management of the company is running the business. Some of the major qualitative factors of a company are:
Durable Competitive Advantage (Monopoly, Branding):
Durable Competitive advantage is one of the most important characteristics of a multibagger stock. It is the ability of a company to stay ahead of the competition by providing better products or services or by building a brand.
This allows companies to achieve better pricing power, and bigger market share compared to its peers.
How to find it? In order to spot a durable competitive advantage, you need to ask these questions while analyzing a business.
Is the company offering a unique product? Companies like Coca Cola have achieved durable competitive advantage by patenting the formula they use to manufacture their beverages, providing a unique product no other company can copy. This works as a huge competitive advantage for Coca Cola. No wonder, for the past 100 years, Coca Cola has given 15% CAGR returns to investors.
Is the company a big brand or a Monopoly? Brand means trust. When people trust a brand, they are willing to pay higher price for it. This allows the company to command higher margins and consistent sales for a long time.
Companies like HUL and Godrej have strong brand names. Both the companies have very strong profit margins and have been able to grow their sales consistently. Pidilite Industries (makers of Fevicol) good example of monopoly. Company has hardly any competition in the organized market and has created a brand that is hard to take down.
Caution: Beware of “value traps”, These are companies that do great for a short period of time, but ultimately lose their competitive advantage to their peers.
They grow exponentially in the beginning, but drop off quickly as they get taken over by competitors.
Some of the tech companies like Snapchat lost its advantage to peers as all the unique features offered by snapchat are now available on other social sites as well.
Honest and able management:
The management of the company is the heart of a business. The second most important characteristic of a multibagger stock is honest management.
An honest management discusses its business goals clearly and presents a blueprint on how it is going to achieve it.
How to find it? Trustworthiness of the management can be assessed by reading the annual report or management interviews on business news channels.
While analyzing the honesty of the management, you need to ask these questions:
Has the company set clear goals for its business in the future?
An honest management is very vocal about the business and its future prospects with its shareholders.
If the company management frequently talks about its growth plans for the future, and how it is going to achieve them, you can trust the management.
How is the management going to achieve those goals?
Just talking about growth is not good enough. An honest management must be able to demonstrate a plan or a blueprint about its growth estimates. A clear, and time bound targeted goal must be laid out in front of investors.
For example: If a company says ”we expect to grow exponentially in the future” but does not present a plan on how it is going to do so, better be careful.
On the other hand, if the management says “we expect to grow at 20% in the coming 5 years” and offers a plan of action about how they are going to achieve it, then you can trust the management of the company with your hard earned money.
Has the company achieved the past goals it had set for itself?: Being ambitious about future goals is one thing, and being able to achieve it is another.
In order to understand how ambitious the management of the company is, you need to look at its past performance as well.
Analyze the past performance of the company, what goals and plans they had, and how successfully they have achieved, them.
If the management has missed its past targets by wide margins most of the time, better be cautious and tread carefully, history often repeats itself.
Strong Promoter holding:
Promoters are the group of people that start, fund and in many cases actively operate the business.
They are the ones that build a business from scratch.
Companies with strong Promoter holdings indicated trust of the founders in the business.
Low promoter holding indicates that founder have pulled out their fund from the business, which may be seen as lack of trust of the promoters in the business.
As a thumb rule, good business usually have promoter holding above 50%.
However, there are some exceptions where promoter holding is distributed and there is no single promoter with majority stake in the company (example ITC)
Financially Conservative Management:
Multibagger stocks use their financial resources with prudence. Before allocating capital to any project, they carefully analyze expected return on investment and risk-reward ratio.
How to find them? Companies that are prudent asset allocators achieve high return on invested capital.
Another evidence of financially conservative management is that they generate lots of free cash flow (free cash flow = cash flow from operations- purchase of fixed assets). The free cash flow can be used to fund future expansions or pay dividends to shareholders.
There are some additional points that indicate qualitative factors such as corporate governance, related party transactions, remuneration to the directors. These factors should also be considered while analyzing the qualitative factors of a company.
Before we move on to analyze the Quantitative Characteristics of a multibagger stock, Here is an info graphic summarizing all the points:
The next part that we should be looking at while analyzing characteristics of a multibagger stock are the quantitative factors.
Quantitative Characteristics of a Multibagger Stock:
While qualitative characteristics of a multibagger stock help us understand if a company is good or not, what it does not tell us is “how” good it is?
To answer the question, we need to evaluate the quantitative characteristics of a multibagger stock by analyzing financial statements.
High Earnings Growth:
The first important factor among quantitative characteristics of a multibagger stock is high earnings growth.
Understanding how fast a company is growing is critical to evaluate its financial performance. While there are many ways to calculate earnings growth (such as revenue growth model, profitability model etc), one of the most accurate measure is EPS (Earnings Per Share) growth. EPS is calculated by dividing net profit by total number of outstanding shares.
Formula: EPS= Net Profit/ Number of outstanding Shares
EPS shows how much a company is earning against each share.
How to calculate earnings growth using EPS? It’s a simple three step process:
First, Take previous and current years’ EPS.
Second, Subtract last years’ EPS from current year and divide the number by previous years’ EPS
Third, Multiply the number by 100.
Current year’s EPS = 20
Previous years’ EPS =15
Step 1: 20-15=5
Step 2: 5/15=0.33
Step 3: 0.33*100=33%
Higher the EPS growth, healthier the company. In most cases, multibagger stocks grow at much faster than their industry growth rate.
High Profit Margins:
Multibagger stocks usually command higher profit margins. This is due to the fact that they have little or no competition or have a strong brand presence allowing companies to charge a premium over the products or services offered.
For example, a local soap and a branded soap may not be very different in quality, but since the branded soap is trusted by people for its quality, consumers are willing to pay higher price for it.
You can calculate Net Profit Margins by dividing Net Profit by total sales/revenue of the company.
Formula: Net Profit Margin = Net Profit/Sales
Multibagger stocks command higher profit margins that their peers. As a thumb rule, a potential multibagger stock should have profit margins above 10%.
Word of Caution: Some companies try to paint a rosy picture of their financial performance by manipulating numbers, thereby falsely increasing Net Profit Margins. For example, a company may sell an asset (such as land, plant, machinery etc), the proceeds from which, will be added to net profit artificially boosting the net profit margins. Since this is a one time earning, while calculating net profit margin, such numbers should be subtracted from net profit to get the right growth estimate.
Little or No Debt:
Debt can destroy a company’s business. While picking multibagger stocks for investment, make sure they do not have huge debt on their books.
A debt free company is the best candidate for multibagger stock.
The easiest parameter to analyze the debt levels of a business is by looking at debt to equity ratio. You can calculate debt to equity ratio by dividing the total debt(liabilities) by total shareholders equity.
Formula: Debt to Equity = Total liabilities/shareholders equity
Some companies try to manipulate debt to equity ratio by issuing more equity, giving a false impression of comfortable debt levels. To check if fresh equities have been issued, find if there has been any change in the share capital of the company.
While investigating banks and NBFC companies, you should look at NPA(Non Performing Assets) rather than debt to equity.
Free Cash Flow:
One of the most important characteristics of a multibagger stock is that they generate high free cash flow.
Free cash flow is the total “cash” left with the company after accounting for capital expenditures such as purchase of plants and machinery etc.
Free cash flow can be used for future business expansion, payment of debt or distribute dividends.
Free cash flow is a metric widely popular among value investors and is used in different valuation models such as Discounted Cash Flow (DCF), a valuation model use in mergers and acquisitions of companies.
The reason why free cash flow is so important is because it is difficult to manipulate cash flow numbers, due to which investors get a clear picture of the company true financial performance.
Free cash flow can be calculated by subtracting capital expenditures from operating cash flows
Formula: Free cash flow = operating cash flow- capital expenditures
Companies that consistently generate higher free cash flows are the strongest candidates to become multibaggers.
Here is a important note while analyzing the free cash flow of a company. If a company has negative free cash flows it does not necessarily mean that company financials are deteriorating.
When companies expand their business aggressively, they spend a lot of capital acquiring assets, using their free cash flow.
Since these assets are expected to generate more cash in the future, negative free cash flow is not bad if company’s capital expenditure is increasing.
Here is a info graphic that sums up all the quantitative characteristics of a multibagger stock:
Apart from major characteristics of a multibagger stock mentioned above, I would like to share some additional bonus tips that will help you in understanding if the stock is potential multibagger.
Future Growth Potential:
An investor today cannot make money from the past. One of the characteristics of a multibagger stock is that it should have immense growth potential in the future.
The best way to understand future growth potential is by reading the vision and mission statement of the company. You can find it in the annual report of the company.
If a company is very vocal about its vision and is able to explain the steps being taken by the management to achieve them, then the company has lot of future growth potential.
Small Size Companies that are Market Leaders in their Segment:
Small sized companies can also have the right characteristics of a multibagger stock, especially if its a market leader in business segment.
Many companies that are smaller in size but have captured large market share in their niche have potential to become multibagger.
Such companies have potential to expand exponentially as there is little space for new players, as the market itself is small.
Acquisitions and Takeovers:
There are two ways a company can grow. Organic growth and inorganic growth. Organic growth is when company expands its business by investing capital and creating assets.
When companies follow inorganic growth, they start acquiring assets of other company by acquiring or taking over their business.
Organic growth is a great way to expand and grow a business, but it takes time as companies have to create assets from scratch.
Inorganic growth on the other hand, if done right, is a much faster and better approach to expanding a business.
Companies that grow inorganically can grow much faster and become multibaggers in shorter span of time.
An example of multibagger stock that has become multibagger because of inorganic growth is Minda Industries.
Minda Industries is an auto ancillary company that has recently made multiple international acquisitions in the past. Company acquired many auto part manufacturers in South America and Europe. No wonder in a matter of three years, Minda industries almost tripled in value.
I have written detailed analysis of Minda Industries and what made it a multibagger stock. you can red it from the link below:
So these were some of the most important characteristics of a multibagger stock. I hope you find this post useful and knowledgeable.