Identifying multi-baggers

Just one multi-bagger (MB) can turn an otherwise mediocre portfolio into an excellent one. While such stocks are not very common, there are different places where an investor can look for them. The most popular method is to try to pick up a new business with high growth prospects.

Venture capitalists and private equity investors do this at very early stages. The primary market player does this when a company goes public. Some IPOs do offer fabulous returns. But it is a lottery because the process is uncertain, apart from the usual risks of buying new businesses. The subscriber doesn't know how many shares he or she will be allotted.

The primary market is inactive at the moment, so this strategy is ruled out. A second situation where multi-baggers are common is during bubbles. The internet/IT bubble offered fabulous returns to those who invested in tech stocks in 1998 and 1999 and cashed out in early 2000 before the bubble burst, or just after it burst. Those who held on too long, or bought too late, lost huge sums. Similar situations arose during the real estate bubble of 2007-08, or the infrastructure bubble of 2005-2007. Those who got in early made pots of money, if they got out before the bubble burst, or just after it burst. As of now, there are no obvious bubbles brewing anyway.

A third place to seek multi-baggers is in space of cyclical turnarounds. There are many industries with defined cycles. In such businesses, share prices and profits can multiply from a trough to the adjoining peak. Note that firms can go into losses for many reasons such as poor management, adverse technological change, etc. But this style focusses only on loss-making stocks, which are essentially sound players in highly cyclical industries. When the cycle hits bottom, the business goes into the red and it makes handsome profits when cycle peaks. Unlike a new business, where the track record is unknown and growth prospects hard to judge, a cyclical business may have been established for decades. Growth trends for cyclicals are predictable. The investor can guess at probable time-periods of a given industry cycle and also at likely earning expansion rates.

There will be industry-specific signals. An interest-sensitive business will gain when rates are cut. Demand may expand for some service, as in the case of Y2K-related coding in 1999. Or raw material prices may drop in a manufacturing business. Shipping, automobiles, real estate, paper, cement, steel, other metals and commodities, can display this sort of cyclic behaviour. At this instant, everyone is expecting an acceleration in GDP growth. If that comes about, it will lead to even sharper accelerations in earnings growth. Judging valuations for such turnarounds can be tricky. A reversal from losses to small profits (low positive EPS) might make valuations very high at the point of turnaround. Valuations might also drop rapidly if a turnaround sustains and EPS rises quickly.

Investors seeking this sort of cyclical turnaround could apply the following filters. Seek firms that made losses until September or December 2013. The first positive flag could be profits in the Jan-March 2014 quarter. The second positive signal would be higher profits quarter-on-quarter in April-June versus January-March 2014. An aggressive investor would be looking for just one quarter of turnaround. But two quarters is safer. If a stock has seen a two-quarter turnaround, it is worth examining. Some of these might be potential multi-baggers. Such stocks are usually high risk and high return plays. Once the stock passes the basic filter, a case-by-case analysis is required to understand why a given stock has turned around and what its future prospects might be.