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Any portfolio benefits from the identification of multi-baggers. One such big winner can compensate for several losers, or mediocre performers. Given this, it's an aspect of investing that should be focused on by all stock-pickers.
There are a few misconceptions about the type of stock that becomes a multi-bagger. Most investors look to identify a business with competitive strength, good financials, growth prospects and top-class management. Indeed such businesses can be multi-baggers. But they aren't very thick on the ground. They also tend to be traded at high valuations.
This subset - the great company with everything going for it - is less common than two other types of multi-baggers. One is the cyclical stock, which has hit rock-bottom in the business cycle. This is often a well-managed business struggling to cope with sector-specific issues. For example, a tyre manufacturer could be hit by rising rubber prices, or a refiner with high crude prices.
Another common type of multi-bagger is the turn-around. This is a company that has suffered for some company-specific reason and then staged a recovery. For example, there might have been some dispute among promoters, or an accident at a factory, or mismanagement in some fashion.
It is often true that a company in a cyclical business ends up suffering sector-specific and company-specific issues as well and vice-versa, company-specific issues tend to have more serious impacts in cyclical businesses. So these two types often shade into each other.
The cyclical turnaround is relatively easy to identify. Sector-specific factors affect every business in a given sector. If these factors are negative, every company suffers. The ones with more stressed balance sheets are hit harder. When sector-wide factors become favourable, the rising tide floats all boats. In a mature industry with well-established patterns, there will be some predictability of cyclical time periods and likely gains in earnings, from bottom to peak of the cycle.
Stock picking isn't a problem with cyclical turnarounds. If you enter early into an up-cycle, most businesses in a sector will give good returns. The shares will move in tandem. Valuations will be high in the initial stages of turnaround. As a company moves from net losses to breakeven or a small profit, it has a high P/E ratio. As the up-cycle strengthens, shareprices increase further. But P/E may drop since profitability accelerates quicker than shareprice gains.
Actually most industries are cyclical. This behaviour is replicated across many different industries at different times. The intensity of cyclical behaviour varies, as does the length of cycles. Some sectors see stock prices double from the bottom of a cycle to peak while others see stock prices rise five or ten times. The historical pattern may be a reasonable guide for intensity.
One problem for an investor is that profits must eventually be booked in this type of play. The stock cannot be held forever. Sometime in the future, it will hit a down-cycle again. It is impossible to pick the bottom or peak of a cycle with any consistency. So the pragmatic investor will be happy to get the trend right and book a decent profit.
The other kind of turnaround - the one that involves conquering company-specific issues - is more difficult to pick but often more rewarding. In these cases, the shareprice multiplier is often very high. There are a few signals suggesting a beaten-down company is ready for a turnaround.
First, the cash-flow situation improves. This may be due to drastic action like selling off assets to deleverage balance sheets. Second, the company starts implementing some plan to identify and address issues, and does so in timebound manner. Third, there are changes in senior management, or redefinition and re-allocation of responsibilities even if there are no changes in personnel.
There is a probabilistic element to finding turnarounds as well. Over a five-year period, there's a low probability that an industry leader will retain No.1 position. The probability that an industry laggard will challenge for leadership is higher than the probability that an industry leader will continue to be the leader. If you are investing over the long term, it makes sense to look at laggards even if this is counter-intuitive.
Corporate earnings growth has slowed for the last three years. The chances of finding turnarounds in 2014-15 is high. Cyclical turnarounds may be easier to pick up. Metals, auto, cement, real estate, heavy engineering, construction - all of these sectors could be candidates. There will also be many company-specific turnarounds. Bear the above factors in mind when looking for them.
