This Article was originally published in The Global Analyst

With markets delivering very healthy returns during the last few years, it now very common to see Whatsapp claims from friends on how they hit the jackpot on some of the small-cap stocks. When your stock investment appreciates not in percentage (like 25%) but in times (like 10x or 200x), that’s what we term as multi-baggers. Everyone wants to hit that jackpot, isn’t? However, the odds are extremely low.

Today`s blue chips like Infosys, Bajaj Finance, Reliance, etc., had all started as micro caps before progressing to become small cap, mid cap and finally large cap. If you were lucky to have identified them early on, you would be sitting on a goldmine today. Hence, the trick lies in catching them early, or identify them early. But then, it is easier said than done. For, we have more than 5,000 listed stocks on our exchanges. So, you can imagine the enormity of the task and what a nightmarish proposition it could be.

Moving on, while I said the odds are low, I did not rule them out. So, if you still are in the hunt for the treasure, the key would be to start early and be prepared for a long and arduous journey with these picks. That requires phenomenal mental strength. Furthermore, since the odds are few, it would not be a bad idea to spread your bets far and wide and hope some or few turn out to be potential winners or multibaggers. However, in order to identify them, we need a good investment process. And, that is what this article focuses on.

Two broad Steps and three sub-steps

My suggested investment process has two broad steps with three sub steps. They are:

Step 1: Do basic checks and identify the stock/s

Step 2: Take a small position (with three sub steps)

Step 1: While doing some basic checks, there are some suggested things to look for. Either you can take the entire universe and apply some filters (which presumes you have access to enormous data) or you can apply some checks on recommendations that come your way. Once a name pops up as a great multi-bagger opportunity, one needs to ensure that the said company is financially sound, enjoys healthy margins (implying pricing power), low/zero debt, and not in the news for the wrong reasons (like fraud, regulatory misgivings, etc.). At this stage, it is not essential to look for cheap valuation, high liquidity or institutional interest in the stock. The reason being, they are almost always thinly traded and hence price is not a true reflection of value. Only when these stocks migrate successfully from micro to small to mid to large, do they develop good liquidity and therefore better price discovery. Also, institutional interest on stock investment typically develops only during the mid cap phase and hence they mostly avoid small caps.

Step 2: If a company passes the basic test, then it is recommended to take a small position (ignoring market timing). Repeat this process for several companies in order to spread the risk.

The process gets interesting only after Step 2. Once, you have invested in a stock, there are three possible outcomes:

1. The stock price appreciates rapidly: This may be rare but it means the lucky stars are well aligned for you. The suggested strategy would be to set some margin of safety in terms of returns (say 100% or 2x) at which point you may want to double down (buy more) on the stock on dips. The reason being price is a great point of reflection. If the stock price appreciates rapidly usually there is a good business reason why this happens and hence doubling down may be a good strategy. It also means, that you are betting on winners. At this stage, it will be good to cross check step 1 again.

2. The stock price stays flat: This is the interesting path to watch as it can test one’s patience immensely. The suggested strategy is to keep invested as long as there is no significant loss or profits (even if this means 10 years!). The reason being, in the history of a company, breakout moments happen but it is impossible to predict them in advance. Selling them out due to boredom will mean missing out on the point when they breakout for multi-bagger returns.

3. The stock price falls: This path is the most painful as the investor is now sitting on a loss. The normal psychology is to think that it is an opportunity for averaging. However, the suggested strategy is to set a “loss threshold” (say 25%) based on your risk tolerance. The idea is to stick with the stock till the loss threshold is breached, after which selling is recommended. The reasoning again is that price fall embeds some known/unknown bad news. In other words, by selling those out you are not betting on losers. In our quest to find multi-baggers, we generally tend to cash out on winners and stick with losers, with a firm hope that they will bounce back. This may or may not happen.

Also, when we spread ourselves with several picks, the odds of finding some multi-baggers increases.

When to cash out?

Another key dilemma that an investor may face, is dealing with the huge profits of a multi-bagger. If a particular investment has gone up say 25x, should you sell at least some part to recover your investment or book profits? The usual temptation is to cash out and enjoy the profits.

However, it is quite possible that this stock is actually a potential 250x in which case you will appear silly selling them out early! The best time to sell some stock is not when they are up or down, but when the business thesis has changed (the company is losing margins, market share, debt is increasing, promoters are paying themselves huge salaries, politically compromised group, etc.). As long as you are “in the money” on a stock, just stay with them and enjoy the ride. Remember, there is no limit to upside in a multi-bagger!

Happy Investing!