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Characteristic of Multibagger Stocks

A company that satisfies three of these rules has much less potential to become a multibagger.

The four rules are:

1.    Capital efficiency

The first rule seeks to identify companies able to generate consistently higher returns on their shareholders' equity going forward. The idea is the more profitable the company gets, the more value it will create.

2.    Low leverage

The second rule seeks companies with minimal debt. The idea here is to look for businesses consistently reducing their external loans and borrowings.

3.    Profitable with low capex scheduled

The third rule looks for companies that have already done the hard work of building plants and machinery for future growth. They are now in a ripe phase to benefit from their efforts.

4.    Undervalued

The fourth rule seeks businesses that are 'out of favour', where the markets are taking a dim and depressed - yet incorrect - view of the future of the stock.

The Great Business

Great business requires very less or negligible amount of investment to produce higher returns. Such businesses are wonderful to own as they keep on generating wealth for shareholders. There are many possible reasons why it happens in case of a great business but mostly such business will inherit below characteristics:

·         These businesses will have some kind of business moat which defends them from competitors.

·         They usually operate in a stable environment.

·         They have a pricing power on consumers.

·         They generate more cash than they consume.

·         They have very low working capital requirements or negative working capital requirements.

·         Typically, companies falling in these segment will have asset light business model.

Examples of great businesses:

The Good Business

Good businesses are also ideal for investment as they keep on generating good returns over investment. Mostly great businesses are generally overpriced, so good businesses can give us better returns if purchased at right price. There is no point in buying a great business at earning multiples or TTM P/E of 45 or 60 as most of the cream is already gone. Good businesses need to burn cash to generate money, so typically they are from automobile sector, manufacturing, etc. Below are the characteristics of good businesses:

·         They need to deploy cash to continue operations.

·         They are run by management which has great capital allocation skills sometimes even better than management of great businesses.

·         They enjoy moderate competitive advantage.

·         Good in exploiting economies of scale.

Examples of Good businesses:

·         Asian Paints Ltd. (ROCE 5 Years: 42%)

·         Bajaj Auto Ltd. (ROCE 5 Years: 38%)

·         Pidilite Industries (ROCE 5 Years: 37%)

·         Titan Company (ROCE 5 Years: 32%)

·         Dabur India (ROCE 5 Years: 32%)

·         Hindustan Zinc (ROCE 5 Years: 25%)

The Gruesome Business

Don’t own them. These businesses need to eat a lot of cash to generate revenues. This typically results in poor return on investment and poor earnings per share. Some of these companies may have higher growth in earnings which can attract innocent investor but these earnings are fulled by underlying ever growing need of capital. Because they generate low rate of return, they lack enough strength to fund additional inflationary business need, let alone the capacity to venture into new businesses. Please beware as this leads to mostly destruction of capital for owners as well as shareholders.

Warren Buffet talked about these businesses as follows.

“The worst sort of business is one that grows rapidly, requires significant capital to engender the growth, and then earns little or no money. Think airlines. Here a durable competitive advantage has proven elusive ever since the days of the Wright Brothers.” – Warren Buffet in 1992.

Typical characteristics of these businesses are as follows:

·         They do not have any pricing power. Consumer will switch to other provider at the drop of a hat. Think of airlines or telecom operator.

·         They need to invest in new assets or maintain costly assets for operational sustainability.

·         Often intervened & restricted by market regulators. Think of TRAI’s spectrum sale at unaffordable rates to telecom providers.

·         They lack good management skills as promoters continue to pour money into the business despite dismal returns. Management is often in love with the business and want to keep it afloat irrespective of ground realities. Think of Kingfisher Airlines.

Examples of Gruesome Businesses:

·         Suzlon Energy (ROCE 5 Years: 9.6%)

·         Jet Airways (ROCE 5 Years: 8.6%)

·         GMR Infrastructures (ROCE 5 Years: 6.09%)

·         Bank of Baroda (ROCE 5 Years: 4.7%)

·         IDBI Bank (ROCE 5 Years: 0.23%)

·         Fortis Healthcare (ROCE 5 Years: -0.8%)

·         Reliance Communications (ROCE 5 Years: -6.1%)

·         Kingfisher Airlines (ROCE Before shutdown -4592%)

Conclusion

ROCE can serve as a good indicator of a business strength & moat. If you find a high ROCE company trading at lower price, you can invest into it for good returns in future. Comparing on basis of ROCE is even more tricky in small cap segment. One of the problem with ROCE is that it focuses on past performance. Even with high ROCE but lower stock price, one has to take care not to invest into a value trap as some companies may be trading lower for a reason. Mostly, their business moat must have been eroded or they are facing some industry headwinds. Similarly, a turnaround company may have a lower ROCE based on past data but in future, it can surprise everyone. Such cases are common in case of change in company management. We have seen a few Indian companies taken over by foreign management or next generation management and this has turned things around. If you can get into such stocks in time, no one can stop you from multibagger returns.