Every investor wishes to own multibaggers in his or her portfolio but it is not an easy task to find such stocks. Primarily, there are three factors one needs to look at when scouting for these gems. The presence of all three is imperative if you are looking to identify long-term wealth creators in your portfolio. Let’s take a look at them below:

1) High Growth + High Return on Capital Employed (ROCE)
For a stock to turn multibagger, the company has to consistently grow its earnings at a high rate and has to achieve the same without deteriorating its returns on capital employed. The table below highlights few multibaggers that have consistently compounded their earnings at a very high ROCE.

2) Growing Cash Flows
The cash flow of a company is the most accurate yardstick to assess a company’s performance. The cash flow statement determines the ability of the company to grow its earnings in the future. If the company isn’t able to generate cash from operations, it will have to repeatedly tap markets to raise money either in the form of debt or equity capital to grow its business.

Multibagger companies, apart from compounding profits, also consistently compound their operating cash flows (cash profit – incremental working capital) enabling them to grow at a fast pace year after year. Companies that may perform well on the earnings and cash flow front but not on the growth front may be in a stagnant phase of their existence and hence might not earn returns for investors.

Given below are a few companies that although are profitable in their core business (having high ROCE) are unable to grow their cash flows in high double digits.

3) Prudent Allocation of Capital
Finally, we come to the point of prudent allocation of capital. As we now know, wealth creation is all about long-term compounding of earnings and cash flows. Companies that tick the above two criteria tend to generate huge amounts of cash and capital but how a company allocates that cash becomes the key differentiator between a good company and a great multibagger stock.

Given below are a few examples of companies that have prudently allocated capital and generated incremental ROCE greater than base year.

Given below are a few examples of companies that have misallocated capital generating incremental ROCE lower than base year ROCE.

We have also noticed that companies that have misallocated capital in the past and have corrected their course in the future have seen their valuations/price performance also correct its course.

  • Havells: In 2008, Havells India had acquired Sylvania, an MNC bigger than itself. Sylvania was making operational losses. The company had taken loans to acquire the stake in the company. In 2015, Havells decided to sell 80% stake in Sylvania. From 2008-2015, Havells was trading at an average PE multiple of 15x and post this announcement the stock rerated and since has traded at an average PE multiple of 35x.

  • Sundram Fasteners restructured its international operations in order to maximize the revenue potential and shareholders’ value.

  • VRL Logistics withdrew their plans of operating a regional airline.