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How to succeed in the stock markets

N Mahalakshmi | April 01, 2004

"To achieve satisfactory investment results is easier than most people realise; to achieve superior results is harder than it looks." - Benjamin Graham

For most investors in stock markets, all that matters is a couple of stock tips which can make them really rich. Just a few stocks which could probably multiply some 10 or 20 times in value.

And it is not that stock markets do not present such opportunities. Of course, they do. Unfortunately, ordinary investors lack the vision to spot such opportunities.

During 2003, for instance, there were 734 companies which tripled in value and created wealth of at least Rs 100 crore (Rs 1 billion). How many of these stocks did you own? For many of us, the answer is probably none.

But don't fret. The market is going through a corrective phase now, presenting investors with a good opportunity to pick up stocks cheap. And to help you do that we bring to you insights from the Motilal Oswal Wealth Creation Study which analyses the process of wealth creation in mutli-baggers.

Scoring away

Years

No. of
companies

Earnings
yield

G-Sec
yield

Earnings/
G-Sec yield

90-92

118

4.80

12.00

0.40

91-93

20

3.81

12.00

0.32

92-94

3

1.44

11.00

0.13

93-95

67

4.52

12.75

0.35

94-96

7

4.40

12.5

0.35

95-97

2

5.10

12.35

0.41

96-98

13

6.60

14.00

0.47

97-99

38

3.06

13.65

0.22

98-00

115

2.86

12.15

0.24

99-01

17

4.14

12.25

0.34

00-02

10

3.49

10.85

0.32

01-03

20

6.11

9.80

0.62

02-04

428

7.72

7.40

1.04

03-05

734

9.41

6.15

1.53

Some hot tips from the study and with a little bit of luck, you could expect to buy into some mutli-baggers which can change the complexion of your portfolio.

Here are the key lessons from the study:

  • Bad businesses can never create a multi-bagger, though they can create transitory multi-baggers during short phases when the conditions are good.
  • Bad managements with good businesses are likely to create only transitory gainers.
  • Overpriced shares have no chance of becoming multi-baggers ever.

So the only way one can hope to find lasting multi-baggers is by buying into great businesses run by good managements purchased at huge margin of safety.

When can you find multi-baggers?

According to the study, every period is not amicable for a multi-fold increase in stock prices and unless there are more than 25-30 multi-baggers of reasonable sizes spread across industries in the market, it is quite likely that the common investor would miss an opportunity to spot them.

A study of the bi-annual data of all the companies since 1990 reveals that the latest bull run has seen the maximum number of triplers with at least Rs 100 crore (Rs billion) of net-wealth created in two years. The study also reveals that the bull run of 2003 is different from the bull runs in 1998-2000 and 1990-92.

This time, the study says, the rally provided a conducive environment to find multi-baggers in general. The factors that propelled the bull run were:

  • Drop in interest rates from 12 per cent to 6 per cent

Values in business markets are relative. The relative valuation of stocks over bonds has increased significantly. It was at the historically highest level of 1.53 in March 2003. It was at its worst at 0.13 when the Sensex P/E was 70 in 1992.

The Sensex rally in 1998-2000 was very sector-specific and it did not have a non-tech earning support. The Sensex tech weight was quite limited and the rally could not sustain at a relative value of 0.32.

  • Acceleration in corporate earnings

Drop in the interest cost has led to an increase in the corporate profits. Last year, corporate profits went up by 44 per cent even though sales growth was only 11 per cent because interest cost was very muted.

  • Severe depreciation in 2003

Though the relative value increased, investors remained at a distance from the stock market in 2002-03. They decided to put their money in bonds because bond prices were going up whereas stock prices were falling. Now that the bond rally is over, investors will flock back to stocks.

Why some multi-baggers destroy wealth eventually

Having said that, it is not that one could get rich forever by buying multi-baggers. The study says there are two types of multi-baggers: Enduring multi-baggers and transitory multi-baggers.

Enduring multi-baggers are those companies whose wealth creation is long lasting and correction from the peak valuation is limited. In fact, they continue to exist as multi-baggers even after the correction.

Top enduring baggers

Company

Net wealth created (Rs Cr)

Wipro

36322.49

Infosys Technologies

33738.74

ICICI Bank

16221.37

Satyam Computer Services

10196.78

HDFC Bank

7968.43

Cipla

6607.20

Sun Pharmaceuticals Ind

5208.66

Moser Baer (India)

2801.60

Zee Telefilms

2387.25

Nirma

2226.75

The enduring multi-bagging companies like Infosys, Wipro, HDFC Bank, Dr Reddy's, Hero Honda and Cipla are typically few and difficult to be spotted, and most of the time they appear to be expensive at the time of buying because of the lack of faith in their longevity and size of growth.

Transitory multi-baggers, on the contrary, are easier to be spotted but they always end up giving nasty end results. Corrections are typically almost 100 per cent. Cyclicals broadly come under this category. The tragedy with this class of companies is that if you cannot sell in time, nothing is left in your hand.

Top transitory baggers

Company

Net wealth created (Rs Cr)

Pentamedia Graphics

-1238.35

NIIT

-1050.78

Silverline Technologies

-1008.99

Pentasoft Technologies

-911.24

Trigyn Technologies

-763.68

SSI

-493.21

DSQ Software

-379.38

Himachal Futuristic

-318.05

Morepen Laboratories

-253.91

Vikas Wsp

-170.69

But as correction is inevitable, market as a whole is left high and dry with a bad experience. These companies are plenty and easy to be found, and they attract a lot of crowd.

The study looked at the sustainability of the companies that were multi-baggers during the period between 1998 and 2000 when 115 companies more than tripled. The assumption: All these stocks were purchased on April 1, 1998, and sold on December 31, 2003.

The result reveals that most of the multi-baggers were transitory in nature during this period and they threw back all the wealth that had been created on their journey upwards.

What is the winning strategy?

"Stocks are simple. All you do is buy shares in a great business -- with managers of the highest integrity and ability - for less than the business is intrinsically worth. Then you own those shares forever." - Warren Buffet

According to Raamdeo Aggarwal, managing director, Motilal Oswal, there are three factors investors must look at: Business, management and the price of the stock relative to its value.

Business: Improvement in business conditions leads to a change in earnings trend. That is typically the starting point of dismantling the pessimism on the stock. The study finds that a positive change is a must for any type of stock though such change can be temporary or permanent.

The problem arises when the business condition or the opportunity is temporary in nature. Take the example of private banking system - the switch in favour of private banking system is long lasting and permanent in nature. Similarly the changes happening in businesses like pharma, infotech services, auto ancillary and consumer non-durables will have a lasting impact.

However, the changes in fortunes of businesses like steel, cement and shipping are driven by mere price changes and, hence, transitory in nature.

Management: Management plays a major role in creation of enduring multi-baggers. But how does one judge whether a management is good or bad? The study examined capital allocation of some companies. It is clear that SSI could not manage its capital allocation properly while Infosys could make a comeback due to its superior and sustained capital productivity.

The study observed that in businesses like banking and pharma, the importance of management is clearly visible. As the assessment of new private sector for the period 1998-2003 reveals, good managements can make a difference to the wealth created.

For instance, HDFC Bank gained 361 per cent in market-cap during the five-year period when its net worth grew by 687 per cent. At the same time, Global Trust Bank saw its market-cap erode by 73 per cent as its net worth was down 99 per cent.

In cyclical businesses, management efficiency is even more necessary because every business cycle brings different challenges.

Allocating capital at the time of cyclical downturn requires a lot of conviction because it may be found to be against popular opinion. Similarly, resisting huge build-up capacity at the peak of the cycle requires insightful management. Hence, the contribution of good managements cannot be undermined in cyclical businesses, too.

In essence, weak managements will lead only to transitory gainers whereas good managements can shine only if business performance helps.

As per Warren Buffet: "With a few exceptions, when management with a reputation for brilliance tackles a business with a reputation for poor fundamentals, it is the reputation of the business that remains intact."

So it boils down to the fact that for the making of enduring multi-baggers, a good business with a good management is necessary.

Price/value: "Have the purchase price be so attractive that even a mediocre sale gives attractive returns." - Warren Buffet

One factor, which is absolutely important for making a multi-bagger, is gross under-valuation or huge margin of safety in price at the time of purchase.

The study refers to the work by Tweedy Brown and Co entitled What has worked in investing. Some of the pointers to under-valued stocks are one or more of the following:

  • Low price in relation to asset value
  • Low price in relation to earnings and cash flows
  • Sustained purchase by insiders
  • A significant decline in stock prices
  • Small market capitalisation with growth

The study concludes that the above findings are relevant in the Indian context, too. Also, the best time to get a huge margin of safety is when:

  • Business conditions are unfavorable and near-term prospects look poor.
  • When low prices of stocks reflect the current pessimism either in a particular stock or in the market as a whole.
  • When a large company's performance is hit and the pessimism is fully reflected in the price.

Low P/E and P/B
works because:

  • The reinvested earnings are substantial in relation to the price paid. The effect of large earnings addition year after year keeps adding to the intrinsic strength of the stock and, hence, can't be ignored by the market for long.

Value game

P/B

CAGR

Re 1=

Quartile 1

0.17

0.14

1.01

Quartile 2

0.35

-4.81

0.78

Quartile 3

0.61

-4.88

0.78

Quartile 4

2.68

-6.73

0.71

P/E

CAGR

Re 1=

Quartile 1

1.8

0.79

1.04

Quartile 2

3.68

-5.38

0.76

Quartile 3

7.08

-4.16

0.81

Quartile 4

43.93

-7.9

0.66

Sensex

-4.8

0.78

  • The bull market is typically very generous to low-priced issues and thus will raise the typical bargain issue to at least a reasonable level.

  • There could be chances of smaller companies with high earnings being taken over by larger ones as a part of diversification programme.



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