How to pick multibagger stocks

In the vast world of stocks and securities, the constant overflow of analyst reports and calls make it difficult for most investors to build a process to choose winners. An investing philosophy should be fluid, open to change and not overly structured, but doing so is easier said than done. Nonetheless, today I will be outlining my investment strategy and the methods I use to pick multibagger stocks. Do keep in mind that I am talking about stocks with the potential to give consistent compounding, not about penny stocks which people trade daily for high returns.

Understanding The Business

An important thing one has to understand before investing in a stock is, that upon buying said stock, you essentially become a part owner of a company and its business. This makes it almost a no brainer, to understand its intricacies and have a clear grasp on what goods or services it provides. Don’t invest in companies with business models you don’t understand. The next thing I do is to look at the demand of that product or service, and if a large section of the population is its consumer. This is why, most stocks I invest in, are those with products or services that I have seen in my daily life, or are those whose goods I know will remain in demand for various sectors. To take an example, as a member of India’s vast middle class family sector, my household buys, let’s say 5 products each of Vaseline, Dove and Lifebuoy a year. These are product lines which through the years have edged the rest to become industry leaders, and my family will, likely not stop buying and using them for decades to come. Now, if my family is heavily dependant on these products, it is likely that so are most, if not all middle class families. Such families comprise of 33% of India’s total population, and that number set to double in 25 years. This means, that companies with such product lines, in this case Hindustan Unilever, if maintain their competitive advantages, use proper accounting practices and use their money wisely, will likely continue to generate and increase their cash flow, and maintain good fundamentals, and hence be great stocks to invest in. While looking at stocks, I do a similar analysis to see how my life, and those of others is impacted by its products; analysing current and future outlook of the company, industry and market.

Intrinsic Value

The second, and by far the most important aspect of my investment strategy is figuring out intrinsic value. In basic sense, intrinsic value is the fair price of a stock. The concept of intrinsic value is fairly easy to understand, but the difficult part is actually ariving to that number. There are many methods which can be used, but I use one which comes to a value by analysing cash flow. Using a company’s free cash flow gives a good understanding if it is utilizing its money well, and capitalizing on competitive advantages to be cash positive. By using a method called Discounted Cash Flow analysis ( I will talk about this in later blogs, you can understand more through this great book by Monish Pabrai I take out a stock’s intrinsic value. Although I will talk about this in later blogs, one thing investors need to realize is that though the market might be volatile in the short term, at the end of the day, in the long run, the market will go towards its intrinsic value, which itself can change. This is why I invest in stocks with heavy discounts to intrinsic value. Such stocks are undervalued, and if you are able to understand the reason why that is, you can find great investments. Stocks which are heavily undervalued and have great fundamentals are very few, but finding those few gems in the dust is necessary for winning big in the market. Intrinsic value is a very broad topic, and I will be talking about it soon in another blog.

Analysing Fundamentals

The third step of my investment strategy, that helps me narrow down and screen stocks even further, is analysing fundamentals. By fundamentals, I mean the basic ratios of a stock. To most, these may seem very basic, but these simple percentages and numbers can show you the whole picture of company. By utilizing and analysing fundamentals like a company’s return on assets, equity, invested capital and capital employed gives a wonderful view into how efficiently it is able to run and handle its money. At the end of the day, the main criteria for a business, that makes it successful or a failure, is if it can generate money, and fundamentals give an insight into how well a company can do that. Even comparing basic information like the PE ratio or PB ratio of a company with that of its peers or industry can tell you how good of a stock one is. Fundamentals also help you get a perspective as to what the growth of the business has been like. By using data related to Earnings Per Share growth, or even increase in dividend yields, you can understand a lot about a company and how it has grown. Now this might seem unusual to some, but, although not a “fundamental,” I also spend time looking at the management of companies I might invest in. At the end of the day, even if I am a shareholder of a company, it is in the hands of its management, and that is what makes it important for me to have a check on them; whether the management of a company is talented and experienced, or just family members of the promoter. Apart from the above mentioned factors, I also take into account, what I call safety ratios: Current ratio, debt to equity ratio, equity dilution among others, to understand the basic financial health of a company. That brings me to my next, and final step.

Decoding Financials

The last and final step of my investment strategy is decoding the financials of a company. By using basic and available tools like the balance sheet, profit loss statement and cash flow statment of a company, you can understand how financially healthy it is, and if it is growing or not. The financials of a company are more important than most believe. Through data like the current ratio or debt to equity ratio, we can understand if a company is going through a rough patch, or by using information like the pledged holding and financial leverage ratios, if it might go through bad times in the future. Through financials, we can also get unique perspectives of how the business is run, and what their goal or mindset towards generating money is. After having passed a stock through this, and the rest of the steps of my investment strategy, I then go ahead to decide my amount of investment in that company, which I will talk about in another blog.

The above mentioned steps aren’t concrete, they keep on changing everyday, the way they should, as I learn and understand new things. This is just a template or draft to start with and build upon for oneself, to understand investing, and eventually start picking multibaggers.

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