How To Find Multibagger Stocks For Your Portfolio ?

A lot of us are in search to find those high-quality stocks which will create wealth for us, but how do we figure out which are those 15-20-25 stocks worthy of being in our portfolio from over 6,000 stocks listed on the NSE and BSE?

It looks quite difficult or to make it even more simpler can you figure out the stocks suitable for your portfolio only from Nifty 500 or BSE 500? Many of you say no since it is difficult to choose from companies and identify your multibagger stocks for your portfolio. Some of us could not compare between the two stocks since both of them are good.

Yesterday while scrolling Quora , I saw many of us has asked there same questions like What are some stocks to invest now for 3+ years ?, How do I find good stocks for my portfolio etc.

Looking for the ‘right’ stocks from this vast universe is like searching for needle in a haystack, you often end up wasting too much time with in analyzing waste stocks. As retails investors, it is difficult to conclude with any degree of confidence that a specific company is high-quality, which is often an abused term to just refer to a bunch of stocks which recently outperformed the markets like small-caps in 2017 or large-cap consumer stocks in 2019.

Before proceeding further ,I would like to tell that at Earnstock we don’t believe in concept of market cap basis analyzing. Like you must have heard that market pundits says that currently is the time of midcap so invest heavily in midcaps. We believe in company specific fundamentals , if the fundamentals are good there is no doubt it will yield returns whether they are small cap, mid cap or large cap. There are examples of companies who have performed every time whether in 2017 when small caps outperformed or in 2019 when large cap outperformed.
Like Infosys ( a large cap stock ), Divis Laboratories ( a pharma stock which was giving returns even when no one is looking at pharma ) or Relaxo Footwear ( a mid cap stock ) etc.

So It is my advice to all of my fellow retail investors avoid looking all these thing just focus on the companies fundamentals and the macro events so as your portfolio is resilient and alpha generating portfolio.

Filter Based Approached of Stock Selection

But how about we turn the question on its head and instead identify the ‘wrong’ stocks which we must avoid? Stocks where we can lose our capital permanently? Stocks where we can point to something evidently questionable and conveniently filter them out – Business models which are getting obsolete or disrupted , over-leveraged balance sheets leading to solvency risk, businesses run by crooked managements with shaky corporate governance and so on and so forth. Management Integrity is a separate topic, I will discuss it in upcoming post

The idea behind this post is to show step by step how we, at Earnstock Financial Services, follow this elimination process and ultimately arrive at the investable universe of stocks from which we make most of our high conviction ideas for our clients.

To begin with we have a gigantic list of 5000+ stocks listed as per Ace Equity:

  1. Filter Out Dormant Stocks : We removes the stocks on which the volume for past 7 days is less than 10000 quantity. This ensures you don’t get trap into illiquid securities. By applying this filter our list contracted by more that 50% to 1856 stocks ( approx.).
  2. Nano/Penny Stocks ( Market Capitalization Filter ) : We then remove penny stocks with market capitalization of less than Rs. 100 crore , since they operate at a very small scale and there is no sufficient data is available in public domain. And Operators use these stocks to manipulate stocks prices by using SMS, whatsapp messages or spreading rumors etc. Specially retails investors trap into these stocks most of the time. So by applying this filter , we are left with just 1257 stocks ( approx. ).
  3. Solvency Risk/ NPA and advances ( For financial institution ) : the biggest reason for a business failure is excessive leverage. Leverage is like two edged sword it can benefit you and harm you at the same time, so it is your responsibility to how wisely you use it. So let’s filter out the ones with weak balance sheets – debt-equity ratio of more than 2 or interest coverage of less than two. we are just left with 728 stocks.
  4. Working Capital: Sometimes management just focus on increasing revenue so they can create false image about company in the eyes of stakeholders. Management increases revenue by giving credits to their customers , which shows that the customers are more interested in the product due to credit period offered. These measures can create dent on the balance sheet , increase cost of capital etc. We apply a filter of 50% of working capital to sales ratio( it can vary from business cycle to business cycle so you need to change this accordingly ) the list again comes down to 604 stocks.
  5. Lack Of Interest : Businesses where promoter’s stake is less than 30% or he has pledged more than 15% of his stake. 532 stocks meet this criterion.
  6. Wealth Destructors : Companies with Return on Capital Employed less than 10%. This filter has reduced the list into 436 stocks
  7. PSU enterprises: All state & central government-owned companies whose real motive isn’t sustainable profit but either controlling natural and strategic resources or redistribution of wealth etc.
  8. Certain Business Groups, Capital Misallocation, Corporate Governance Red Flags & Negligible Float/Liquidity: In this last step we remove another bunch of stocks belonging to certain business groups with whom we don’t prefer to partner as minority shareholders, those run by incompetent promoters etc, those which fail on our corporate governance checklist, having poor track record of capital allocation and ones with negligible free-float/liquidity.

From this exercise, we have eliminated more than 95% of the listed companies and ultimately left with around 100-200 stocks which are almost our entire investable universe. If that still seems like a wide universe to track, you can make the filters slightly more rigorous like increasing RoCE hurdle from 10% to 15%, market cap threshold from Rs 100 Cr. to Rs 500 Cr. as per your risk appetite and knowledge and you would have further reduced the list to just about 100 stocks.

The next stage of research is much more difficult and involves deep dive in each of these companies and sectors individually. Each company-specific research would aim to address questions like:
Here you should take the help of expert instead of going on your own in case you are new to equities investing.

  • Is the sector to which this company belongs enjoying tailwinds or facing headwinds? How will technology can affect the companies in this industries ? How is this company placed versus the competition? ( For example , there is a drastic change in education industry students are shifting from offline classes to virtual classes and edutech companies are taking advantages of these ).
  • What would be the correct value of this business? What would be a fair valuation range or fair buying range? Is there a margin of safety at the current price?
  • Is the management competent and ambitious enough to take the business to the next level?

It is important to clarify that we aren’t suggesting these filtered stocks as ‘high quality’, rather we are saying that they are not that bad even to be considered .

Putting together a portfolio of 15-20 stocks from this filtered lot and making money is still going to be as much luck as skill. Investing is projecting on the future which obviously nobody can foresee, making it all probabilistic. There are so many things that even promoters or management can’t tell themselves can’t figure out what’s going to happen next quarter. For equity investors there is an added layer of uncertainty beyond projecting earnings, which is that of how would market value that earning stream a few years down the line.

Notes & Exceptions
  1. Institutionally owned & professionally run companies like ITC, CARE or MCX would move out in the filter as there is no promoter. Similarly, at this stage some large caps; most of the banks & NBFCs also get eliminated as promoter holding is less than 40% due to RBI regulation.
  2. Financial Institution will be removed out in debt equity ratio filter , since it is their nature of business to borrow money and lend that money.
  3. Each investing style involves different kinds of variables, most of the turnaround and cyclical opportunities may not appear in our final universe. We are long-horizon investors who like to identify profitable businesses with lean balance sheets, healthy operating cash flows and run by owner-operators with skin-in-the-game and hence you see majority filters around these.

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