What are Multibagger Stocks?
Coined by Peter Lynch in his book ‘One Up On Wallstreet’, multibagger stocks refer to stocks that return several times the initial acquisition cost within a short period. In other words, multibagger stocks give more than 100% return in a short span of time.
Multibagger stocks are not a category of stocks like large caps or small caps. Instead, they explain the nature of stocks that have high growth potential. Multibagger stocks are undervalued and are often found in high-growth industries. These stocks have strong fundamentals, such as sound management and innovative production techniques, making them ideal investment opportunities. They often look like risky bets and take a very long time to show results. However, once they start growing, it takes less time to deliver multibagger returns.
Multibagger stocks can be low-priced or high-priced but are definitely undervalued. By undervalued, we mean stocks that are trading below their intrinsic or true value. Undervalued stocks have a low price to earnings ratio, and a high margin of safety and hence are considered good investments for the long term.
However, multibagger stocks can trap investors in an economic bubble which might lead to heavy losses.
Characteristics of a Multibagger Stock
To identify a multibagger stock, look for the following characteristics.
Multibagger shares tend to deliver good financial performance consistently. They have high revenue and profit growth, increasing dividends, and high return ratios (return on equity). Moreover, their revenue multiples (price to sales and enterprise value to sales) are also low, indicating a high growth potential.
A company with high debt on its books has a higher default risk than a company with low debt. High debt can become problematic for a company if it doesn’t manage it well. The debt to equity ratio shouldn’t be more than 2x. But usually, high-growth companies tend to have a high debt on their books. Hence also look at its interest coverage ratio and return on capital. An increasing interest coverage ratio and consistent return on capital show that the company is managing its debt well.
By studying the price to earnings ratio of different stocks, an investor can identify a potential multibagger. The P/E ratio of multibagger stocks tends to grow at a faster rate than its stock price.
Multibagger stocks take time to deliver results. Hence when they first enter the market, they are hardly recognized by investors. These companies are under-researched and undervalued and have high growth potential. Hence look for undervalued stocks with strong fundamentals.
Identify companies that have a competitive advantage or economic moat. Competitive advantage differentiates a company from its peers and results in high profits. A company’s competitive advantage can be its low-cost production, high market share, patents, brand recall, or innovative practices. Multibaggers tend to have a competitive edge over their peers.
A company with good leadership can achieve anything. Understand the management practices, corporate governance, vision, strategies, and policies. See how the management has steered the company during economic downturns to understand the management’s ability. If a company changes its business model too many times, it is clearly a red flag.
An industry with immense potential for growth will harbour future multi-baggers. Take, for example, the FMCG sector. Branded consumer goods were introduced by FMCG giants HUL and ITC and had immense potential for growth a few decades ago. These companies easily penetrated the market, increased their market share, and gave their shareholders multibagger returns quickly. Hence look for companies in industries with high growth potential.
Risks Associated With Multibagger Stocks
Multibagger stocks have the potential to give multifold returns to investors and help in creating wealth. However, they also have certain risks associated with them.
- Substantial losses: To earn substantial returns from multibagger stocks, one has to invest a substantial amount of money. Only then will the profits be sizable. However, during a market downturn, the losses will also be enormous.
- Economic bubble: Many investors invest in companies due to the high demand for a stock. However, the demand could be temporary and created by bulk investors to increase the price of the share. Once the price is high enough, they could short-sell the investments, resulting in losses for retail investors.
- Low liquidity: In the initial days, such stocks suffer from liquidity issues. One bad news can pull the share price down and take months for the company to revive.
- Long duration: It could take years before multibaggers could deliver good results. Hence investments can be locked-in for a good amount of time.
Alternative Investment Options to Multibagger Stocks
For an investor who is investing with limited funds and has just entered the market, picking multibagger stocks might not be a wise decision. Instead, they could look for alternatives, such as mutual funds, to accumulate wealth.
Mutual funds are professionally managed investments with a diversified portfolio of stocks, bonds and other securities. There are different mutual funds for different purposes, and all you have to do is invest in a fund that aligns with your goals and risk tolerance levels.
However, if you wish to get equity exposure, investing in the following categories of funds would help you benefit from capital appreciation over the long term.
- Hybrid funds: These funds invest in equity and debt securities and strike an optimum balance between risk and return. You can earn through capital appreciation from equity and also benefit from limited risk due to exposure to debt securities.
- Large cap funds: These funds invest in large cap companies. Unlike multibagger stocks, large cap stocks are well-established. They stand strong during economic downturns and have the ability to recover faster. Their superior financial performance, good management practices, and high customer loyalty make them a safer bet than multi-bagger stocks.
- Mid cap funds: If you want to test the waters and take slightly more risk, then you can go with mid-cap funds. Mid cap funds invest in mid cap stocks. These stocks have the potential to become future large-cap stocks. Since these companies’ business is small, they grow at a higher rate than large cap stocks. However, they are prone to more market volatility than large cap stocks. But are less risky than small cap stocks. These funds are ideal for long-term goals.
Frequently Asked Questions
No, multibagger stocks are not risk-free. In fact, these stocks come with substantial risks. They are less liquid in their initial days and are highly affected by market sentiments. Multibagger stocks can also give investors sizable losses in an economic downturn.
A stock is considered a multibagger if it gives a return of 100% or more. Any stock giving less than 100% is not a multibagger stock. So you can expect a 100% return from a multibagger stocks, provided you have done your due diligence and checked the company’s fundamentals.
Multibagger stocks can be very risky. Hence Investors with a very high-risk tolerance can invest in them. Moreover, these stocks take a long time to give good returns. Investors with long-term goals can consider investing in these stocks.
As Carlos Slim said, ‘No matter how bad a crisis gets … any sound investment will eventually pay off.’ This means any company with innovative products and services, good financial performance, low debt, a competitive advantage, and good management practices tends to grow in the long term. Such companies tend to become future multibagger stocks.