Four Proven Approaches to Picking Multibagger Stocks

October, 2010

Index of Contents

Preface 2

Approach I Buying Stocks With Low Price in Relation to Earnings 4

Approach II Buying Stocks With Low Price in Relation to Book Value 6

Approach III Buying Stocks With Low Price in Relation to Liquidating Value 8

Approach IV Buying Stocks Using Benjamin Grahams Magic Multiple 10

A Universe of Stocks On Sale 11

Equitymaster Agora Research Private Limited

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Preface
Stock markets had a great year so far in 2010, with its best performance in around 2 years, post
the slowdown. Those who invested at the right time would be laughing their way to the banks.
But what about those who missed the rally? They would certainly be itching to make up for lost
time and invest right away.

However, it may not be that easy anymore. The huge run up in stocks has done one harm. It has
made valuations expensive and thus there are fewer stocks that are available at cheap valuations
than what was the case in March 2009 when the current rally started.

But why look for cheap stocks? Will any good stock not suffice? Certainly not!

Buying stocks should not be different from buying things on sale in a supermarket or waiting for
the auto companies to offer special incentives. The time to buy stocks is when they are on sale
i.e., selling cheap, and not when they are priced high because everyone wants to own them.

The objective of this report is to validate this very fact stocks selling cheap tend to give better
returns over a long period as compared to those selling at expensive valuations, all things
remaining same.

As part of the analysis that went into preparing this report, we dug deeper into history and
studied whether the approach of buying cheaply valued stocks has delivered good returns over
the long run. For the purpose of our analysis, and to be in sync with the current times, we took a
time in history when the broader stock markets were expensively valued as they seem to be as of
now.

The year we have used as our base is early 2000 - when the dot-com bubble was in its prime and
the benchmark BSE-Sensex was trading at around 30 times earnings.

And what has been the conclusion of our study?

Less valued stocks, bought even when the markets were seemingly expensive like they were in
the year 2000, have performed brilliantly over the next ten years. Whether one bought stocks
trading at low P/E, or low P/BV, or even low liquidation value (we will explain this in a bit), the
returns have been great.

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Using this analysis as a backdrop, we have compiled some lists of stocks that pass these low
priced criterion as of now. You can treat this as a universe from which to find your next multi-
bagger stocks.

But just a word of warning here these lists present just the universe of stocks that pass these
criterion. One still needs to analyse a companys past performance record, its management
credibility, and future prospects before making the final buying decisions.

We hope this report is of some help to you in your search for some brilliant long-term
investment opportunities.

Heres to your long term financial well-being.

Warm regards,
Team Equitymaster

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Approach I - Buying Stocks with Low Price in Relation to

Earnings
Stocks bought at low price/earnings (P/E) ratios offer higher earnings yields than stocks bought
at higher P/E ratios. The earnings yield is the yield that shareholders would receive if all the
earnings were paid out as a dividend.

Investing in stocks that are priced low in relation to earnings includes investments in companies
whose earnings are expected to grow in the future. To paraphrase Warren Buffett, value and
growth are joined at the hip. A company priced low in relation to earnings, whose earnings are
expected to grow, is preferable to a similarly priced company whose earnings are not expected
to grow.

The fact that buying low P/E stocks can get you better returns than stocks trading at high P/E is
validated by the under-mentioned chart. It shows the average returns of stocks over the past 10
years across different range of P/E multiples.
Avg. return for stocks based on P/E
2,400
From a universe of 174 of BSE-500
% Returns over 10 years

stocks that were listed 10 years back

1,800

1,200

600

0
<5 5 to 10 10 to 20 20 to 25 >25
P/E in February 2000
Data Source: CMIE Prowess
Excludes banking & financial companies,
and stocks with market capitalisation below Rs 10 bn
Comparison has been done with Feb 2000, as the market was at its peak at that time

As the chart shows, stocks in the year 2000 with P/E multiples of less than 5 times, or even
those with multiples of between 5 and 10 times, have generated the biggest returns over the
following ten years.

Remember we are talking of a year when the dot-com bubble was at its peak, and so were Indian
markets (BSE-Sensex) that were trading at a P/E of almost 30 times. Needless to say, returns
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from the Sensex since then till date has been just around 250% that will form part of the
category that has generated the least return as per the above chart.

But even if one had picked up low P/E stocks (P/E of less than 10 times) then, the returns till
date would have been spectacular. As against this, those who picked up stocks with P/E
multiples of over 10 and 20 times have generated considerably lesser returns. The performance
of stocks trading at above 25 times has been poor to say the least.

It must be noted that the analysis for this chart excludes small-cap companies, or those with
market capitalisation of less than Rs 10 bn. This does away with the argument that the base for
fastest growing stocks might have been lower. The analysis also excludes stocks of banking and
financial companies, as P/E is not the right metric to assess their valuations. Price to book value
is, as we will study in the next chapter.

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Approach II - Buying Stocks with Low Price in Relation to

Book Value
Apart from P/E, another ratio that is commonly used to value stocks is price to book value or
P/BV. This is arrived at by dividing the market price of a share with the respective company's
book value per share. Book value is equal to the shareholder's equity (share capital plus reserves
and surplus). Book value can also be arrived at by subtracting current liabilities and debt from
total assets.

Stocks priced at less than book value are purchased on the assumption that, in time, their market
price will reflect at least their stated book value, i.e., what the company itself has paid for its
own assets. All things remaining constant, such stocks generate higher returns over the long run
as compared to stocks that trade at higher P/BV ratios.
Avg. return for stocks based on P/BV
4,800
% Returns over 10 years

From a universe of 283 of BSE-500 stocks

that were listed 10 years back
3,600

2,400

1,200

0
<1 1 to 1.5 1.5 to 2.0 2.0 to 3.0 >3.0
P/BV in February 2000
Data Source: CMIE Prowess
Excludes stocks with market capitalisation below Rs 10 bn
Comparison has been done with Feb 2000, as the market was at its peak at that time

See for instance the chart above. Stocks trading at P/BV of less than 1 time in the year 2000
have far outperformed those that traded at a higher valuation (1 times and above). Analysis for
this chart also excludes companies with market capitalisation of less than Rs 10 bn. This
analysis includes banking and financial companies.

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Based on this analysis, it becomes clear that buying a basket of low P/BV stocks may get you
outstanding returns over the long term. But you may do even better if you can determine which
of the low P/BV stocks are worth purchasing and which are about to go bankrupt. Looking for
companies with a good overall track record, and manageable to low debt among stocks trading
at discount to their book value can present great investment opportunities.

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Approach III - Buying Stocks with Low Price in Relation

to Liquidating Value
The idea here is to buy stocks at a cost less than their net current asset value (NCAV), and
thereby giving no value to the fixed assets. But why just current assets? Because it includes
items like cash and other assets that can be turned into cash within one year, such as accounts
receivable and inventory, and is therefore a good measure of a companys worth if it were to be
liquidated. This was a stock selection technique successfully employed by Benjamin Graham.

Graham believed that stocks selling below NCAV were worth more dead than alive. He stated if
a stock was selling below liquidating value, either the price is too low or the company should be
liquidated. He also states that stocks are real bargains as per the NCAV method only if these
companies are in no danger of squandering these assets, and have formerly shown a large
earning power on the market price.

The fact that the NCAV rule works cannot be doubted. But it is difficult to find stocks that sell
at a discount to NCAV in bull markets. It was the case in 2000 as well. While there were several
stocks that were trading at low P/E and P/BV, but not many were trading at discount to their
respective NCAV.

As such, for our analysis, we have studied the premium on NCAV at which stocks from our
universe were trading at then. And the result is that - stocks that were trading at the lowest
premium to the NCAV (less than 5 times NCAV) in the year 2000 have returned the most in the
subsequent ten years. As compared to this, stocks trading at multiples of more than 5 times
NCAV have turned out a poor performance over these years.
Avg. return for stocks based on MC/NCAV
2,000
% Returns over 10 years

From a universe of 174 of BSE-500 stocks

that were listed 10 years back
1,500

1,000

500

0
<5 5 to 10 10 to 15 >15
MC/NCAV (Times) as in March 2000
MC-Market capitalisation, NCAV Net current asset value; Data Source: CMIE Prowess
Excludes banking & financial companies, and stocks with market capitalisation below Rs 10 bn
Comparison has been done with Feb 2000, as the market was at its peak at that time
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Approach IV - Buying Stocks Using Benjamin Grahams

Magic Multiple
If you are confused which of the first two ratios - P/E or P/BV - to use to determine whether a
stock is trading cheap, Benjamin Graham has a magic formula to suggest!

It is the multiple of a stocks P/E and its P/BV.

Graham has put an upper limit to the output of this ratio - 22.5. This he derived using a
maximum P/E of 15 times, and maximum P/BV of 1.5 times - the highest multiples he was
ready to pay for stocks.

Our analysis shows that, on applying this multiple to our universe, stocks where the output of
P/E multiplied by P/BV was lower then 22.5, have generated more returns than those whose
output was greater than 22.5.

Avg. return for stocks based on Graham's multiple

2,250
% Returns over 10 years

1,500

750

0
<10 10 to 22.5 >22.5
Graham's multiple as in February 2000
Data Source: CMIE Prowess
Excludes banking & financial companies,
and stocks with market capitalisation below Rs 10 bn
Comparison has been done with Feb 2000, as the market was at its peak at that time

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A Universe of Stocks On Sale

After reading the above approaches to picking up cheap stocks, you must be wondering whether
this can work in the current environment where stocks across the board are looking expensive.
Before we dispel your doubts, remember that we have done the above analysis with the year
2000 as a base - a year when the dot-com bubble was in its prime and the broader markets were
trading at expensive levels.

Even now, when the Sensex is trading at around similar valuation levels, you can still find cheap
stocks using all these four approaches. We will make your task easier by producing four lists of
stocks using all these methods.

But we must warn you that all these lists present just the universe of stocks that pass these
criterions. One still needs to analyse a companys past performance record, its management
credibility, and future prospects before making the final buying decisions.

In short, it is important to do a proper homework before jumping on to opportunities that present

them as having low P/E, low P/BV, low price as compared to liquidating value, and low as per
Grahams magic multiple.

These valuations criteria can just be considered as one of the important stepping-stones in your
search for multi-bagger stocks.

But these are stones you would not want to trip over!

So read the next four pages very carefully. You never know your next multi-bagger(s) could be
out of these.

Disclaimer: Stocks listed in the following four tables are just representative of the ideas and must
not be treated as recommendations from Equitymaster

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I. Stocks with Low Price in Relation to Earnings

Company Name P/E
Shree Ganesh Jewellery House Ltd. 4.60
Geodesic Ltd. 5.88
Birla Corporation Ltd. 6.26
Peninsula Land Ltd. 6.28
J K Cement Ltd. 6.49
Alok Industries Ltd. 6.99
Balkrishna Industries Ltd. 7.03
Gujarat Fluorochemicals Ltd. 7.12
Nava Bharat Ventures Ltd. 7.13
Vardhman Textiles Ltd. 7.35
J S L Stainless Ltd. 7.49
Rolta India Ltd. 7.57
S R F Ltd. 7.95
H E G Ltd. 8.05
Gujarat State Fertilizers & Chemicals Ltd. 8.12
Great Offshore Ltd. 8.18
Electrosteel Castings Ltd. 8.19
Prakash Industries Ltd. 8.32
Graphite India Ltd. 8.38
Binani Cement Ltd. 8.86
Welspun Corp Ltd. 8.95
Balmer Lawrie & Co. Ltd. 8.98
Jindal Saw Ltd. 9.03
Jindal Poly Films Ltd. 9.30
Finolex Industries Ltd. 9.35
Madras Cements Ltd. 9.38
Allied Digital Services Ltd. 9.57
Maharashtra Seamless Ltd. 9.62
Kesoram Industries Ltd. 9.67
Deepak Fertilisers & Petrochemicals Corpn. Ltd. 9.68
Note: Data as on October 15, 2010; Click on the company name to get more information on the stock;
Excludes banking & financial companies,
and stocks with market capitalisation below Rs 10 bn

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II. Stocks with Low Price in Relation to Book Value

Company Name P/BV
Mahanagar Telephone Nigam Ltd. 0.47
Alok Industries Ltd. 0.65
Moser Baer India Ltd. 0.73
Reliance Communications Ltd. 0.73
Videocon Industries Ltd. 0.87
Great Eastern Shipping Co. Ltd. 0.88
Arvind Ltd. 0.89
Kesoram Industries Ltd. 0.90
Electrosteel Castings Ltd. 0.91
Amtek Auto Ltd. 0.92
Ansal Properties & Infrastructure Ltd. 0.96
I V R C L Assets & Holdings Ltd. 0.96
Essar Shipping Ports & Logistics Ltd. 0.97
Gujarat Narmada Valley Fertilizers Co. Ltd 0.97
Gitanjali Gems Ltd. 0.98
India Cements Ltd. 0.98
Bajaj Hindusthan Ltd. 1.00
Rei Agro Ltd. 1.00
J K Cement Ltd. 1.07
Chennai Petroleum Corpn. Ltd. 1.10
Dredging Corpn. Of India Ltd. 1.11
J S L Stainless Ltd. 1.15
Shipping Corpn. Of India Ltd. 1.17
Jammu & Kashmir Bank Ltd. 1.20
3I Infotech Ltd. 1.21
Anant Raj Inds. Ltd. 1.21
Gujarat State Fertilizers & Chemicals Ltd. 1.21
Vardhman Textiles Ltd. 1.21
C E S C Ltd. 1.22
Firstsource Solutions Ltd. 1.22
Note: Data as on October 15, 2010; Click on the company name to get more information on the stock;
Excludes stocks with market capitalisation below Rs 10 bn

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III. Stocks with Low Price in Relation to Liquidating Value

Company Name MC/NCAV
Gitanjali Gems Ltd. 1.16
Ansal Properties & Infrastructure Ltd. 1.20
Peninsula Land Ltd. 1.77
Jai Corp Ltd. 1.83
Housing Development & Infrastructure Ltd. 1.84
Orbit Corporation Ltd. 1.88
Puravankara Projects Ltd. 1.93
Shree Ganesh Jewellery House Ltd. 1.96
P T C India Ltd. 1.99
Electrosteel Castings Ltd. 2.01
Parsvnath Developers Ltd. 2.02
Geodesic Ltd. 2.07
Dredging Corpn. Of India Ltd. 2.19
Graphite India Ltd. 2.40
Sobha Developers Ltd. 2.41
Ingersoll-Rand (India) Ltd. 2.49
Mahindra Lifespace Developers Ltd. 2.62
Allied Digital Services Ltd. 2.65
Maharashtra Seamless Ltd. 2.74
Redington (India) Ltd. 2.89
Patni Computer Systems Ltd. 3.02
Zuari Industries Ltd. 3.10
Vascon Engineers Ltd. 3.14
B E M L Ltd. 3.16
Polaris Software Lab Ltd. 3.17
Heidelberg Cement India Ltd. 3.20
Hexaware Technologies Ltd. 3.30
Omaxe Ltd. 3.31
Merck Ltd. 3.31
Jyoti Structures Ltd. 3.37
Note: Data as on October 15, 2010; Click on the company name to get more information on the stock;
MC - Market capitalisation, NCAV - Net Current Asset Value;
Excludes banking & financial cos., and stocks with market capitalisation below Rs 10 bn
Consolidated numbers taken

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IV. Stocks with Low Price in Relation to Grahams Multiple

Company Name Graham multiple
Kingfisher Airlines Ltd. 0.8
I T I Ltd. 2.1
Alok Industries Ltd. 4.5
J K Cement Ltd. 6.9
Electrosteel Castings Ltd. 7.5
Shree Ganesh Jewellery House Ltd. 7.9
Geodesic Ltd. 7.9
Peninsula Land Ltd. 8.6
J S L Stainless Ltd. 8.6
Kesoram Industries Ltd. 8.7
Vardhman Textiles Ltd. 8.9
Gujarat Fluorochemicals Ltd. 9.8
Gujarat State Fertilizers & Chemicals Ltd. 9.8
Rolta India Ltd. 10.7
Birla Corporation Ltd. 10.7
Rei Agro Ltd. 11.1
Great Offshore Ltd. 11.4
Graphite India Ltd. 11.5
Videocon Industries Ltd. 11.6
Nava Bharat Ventures Ltd. 12.3
Prakash Industries Ltd. 12.5
Great Eastern Shipping Co. Ltd. 12.5
Gitanjali Gems Ltd. 12.9
S J V N Ltd. 13.3
C E S C Ltd. 13.4
H E G Ltd. 13.6
H C L Infosystems Ltd. 13.7
S R F Ltd. 13.7
Balkrishna Industries Ltd. 14.1
Jindal Saw Ltd. 14.2
Note: Data as on October 15, 2010; Click on the company name to get more information on the stock;
Excludes banking & financial companies, and stocks with market capitalisation below Rs 10 bn;
Source (for all tables): CMIE Prowess

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