Institutional Equities

Finding multi-baggers within small-caps

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Karan Khanna, CFA
karan.khanna@ambit.co
+91 22 3043 3251
Bhargav Buddhadev
bhargav.buddhadev@ambit.co
+91 22 3043 3252
Nitin Bhasin
nitin.bhasin@ambit.co
PRIVATE & CONFIDENTIAL. NOT FOR CIRCULATION
+91 22 3043 3241
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Contents Page Number

 Finding multi-baggers within small caps 3

 Can multi-baggers be identified irrespective of valuations? 4-5

 Identifying unique characteristics of multi-baggers 6-8

 Approaches that investors can follow to invest in these stocks 9-12

 Example of our Beachcombing report- Garware-Wall Ropes 13

 The dilemma- Which screen of Ambit should you follow? 14

 Disclaimer 15-16

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Finding multi-baggers within small caps

Multi baggers can be identified irrespective of broader market valuations

 As investors search for ideas within the small caps universe with rising equity flows, with this
note we bring to you one of several frameworks to identify multi-baggers within this space.
 Using empirical evidence, we note that multi-baggers can be identified irrespective of
broader market valuations. For instance, in Mar-07, 112 stocks (~14% of the listed
companies universe between Rs1bn – Rs20bn mcap) became multi-baggers.
A top-down approach to screen for multi-baggers
 Over the years we have built several screens for investors based on their outlook. To this list
we now add another screen to help investors identify multi-baggers within small-caps.
 Key characteristics of these multi-baggers: Reasonably cheap valuations, lack of excessive
leverage, decent cash conversion, healthy RoCE and reasonably high promoter holding.
 Historically, a combination of these factors has increased the chances of identifying a multi-
bagger to nearly 2x (~38% of the shortlisted universe) while reducing the number of stocks
to <4% of the overall small-caps universe.
How should investors invest in these stocks?
 Investors can buy the entire bucket of stocks that do well on a combination of these factors. Click here for our
 For bottom-up approach, we advise investors to use Ambit’s beachcombing expertise. first Beachcombing
report on
 Over the course of the next twelve months we will highlight 15-20 investment ideas from Garware-Wall
the listed companies’ universe with mcap between Rs3bn to Rs30bn.
Ropes.
 This analysis would be based on extensive channel checks across distributors, competitors,
customers and ex-employees, in addition to a careful reading of ten years annual reports

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Current valuation for the markets and small cap are rich
Exhibit 1: Current valuation multiples for Sensex are within Exhibit 2: Mid-cap valuation multiples have been inching
touching distance of its historical highs higher in recent years…
22.0 NSE Mid Cap Index P/B to Nifty P/B
1.1
20.0
1.0
18.0
0.9
16.0
0.8
14.0 0.7
12.0 0.6
10.0 0.5
8.0 0.4
Feb-06

Apr-07
Nov-07
Jun-08
Jan-09

Mar-10
Oct-10

Nov-14
May-11

Feb-13

Apr-14

Jun-15
Jan-16

Mar-17
Jul-05

Sep-06

Aug-09

Dec-11
Jul-12

Sep-13

Aug-16
0.3

Jan-06

Jan-07

Jan-08

Jan-09

Jan-10

Jan-11

Jan-12

Jan-13

Jan-14

Jan-15

Jan-16

Jan-17
Jul-05

Jul-06

Jul-07

Jul-08

Jul-09

Jul-10

Jul-11

Jul-12

Jul-13

Jul-14

Jul-15

Jul-16
1 Yr blended fwd Sensex P/E Historical avg.
Source: Bloomberg, Ambit Capital research Source: Bloomberg, Ambit Capital research

Exhibit 3: …whilst valuations for small-caps are now at

decadal highs
BSE Small Cap Index P/B to BSE Sensex P/B  Current valuation multiples for the broader market
0.80
appear rich - Sensex forward P/E multiple is near
0.70
Mar ‘07 levels
0.60
0.50  Further, even without a meaningful economic recovery,
0.40 mid-caps and small-caps have rerated significantly
0.30 over the last 3-4 years
0.20
 In fact, ratio of the valuations for small-caps (versus
Jul-05
Jan-06
Jul-06
Jan-07
Jul-07
Jan-08
Jul-08
Jan-09
Jul-09
Jan-10
Jul-10
Jan-11
Jul-11
Jan-12
Jul-12
Jan-13
Jul-13
Jan-14
Jul-14
Jan-15
Jul-15
Jan-16
Jul-16
Jan-17

Sensex) is now close to its decadal highs

Source: Bloomberg, Ambit Capital research

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Multi-baggers could be found at similar rich valuations, 10 years back

 Such punchy valuations (see the previous slide) beg the

question whether can multi-baggers be identified at such
exorbitant valuations?
 To answer this we go back in history to assess the probability
of identifying multi-baggers irrespective of broader market
valuations. ~13%...
 For instance in Mar ‘07, when Sensex was trading at peak …of the listed universe in 2007 became
valuations, we note that ~385 stocks (~37% of the listed multi-baggers 10 years hence
universe with mcap > Rs 1bn) managed to outperform the
benchmark Sensex index over the next ten years.
 Of these 385 stocks, 140 stocks (~13% of the universe) went
on to become multi-baggers; i.e. these firms delivered
>20% CAGR returns over the next ten years.
 Further, 112 of these stocks were small caps (i.e. stocks with
mcap between Rs1bn-Rs20bn); suggesting that the odds of a
small cap stock becoming a multi-bagger are much higher.
112…
…of these 140 stocks were small caps,
suggesting that the odds of a small cap
stock becoming a multi-bagger are much
higher

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Finding the starting characteristics of multi-baggers

 We start with the 112 small cap stocks that have compounded at >20% (CAGR terms) over
Mar ‘07 – Mar ‘17.
 For the sake of simplicity, we exclude BFSI stocks from the universe (thus giving us a list of
99 non-BFSI stocks that have compounded at over 20% in CAGR terms over Mar ‘07 - Mar
’17).
 Next, we map these stocks with quintiles at the universe level across following four broad
categories of parameters, very well knowing the fact that using one point in time data may
not be the best thing

Sr. No. Category of parameter Measure(s) used

1 Valuations FY07 Mcap to revenues

2 Profitability and cash flows FY07 RoCE; cumulative Free cash flows to median
revenues (over FY03-07)
3 Leverage FY07 Debt equity

4 Promoter holding Promoter shareholding in the company as of Mar-07

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Results of our analysis
Exhibit 4: Mapping the multi-baggers (Mar ‘07 – Mar’ 17) with quintiles across the various parameters
Probability that a given stock compounds at >20% over next ten years:
Quintile: Cum. FCF to
Mcap to revenues Promoter holding RoCE Debt/Equity Combination
median revenues
Q1 26% 14% 11% 13% 14%
Q2 13% 17% 15% 18% 11%
Q3 13% 12% 15% 16% 14% 33%
Q4 11% 14% 15% 12% 18%
Q5 2% 8% 11% 6% 9%
Source: Bloomberg, Ambit Capital research. Note: Universe for this exhibit is all listed companies with mcap greater than Rs1bn (as of Mar ’07) ex-BFSI. ‘Q1’ denotes the best
quintile on mcap to revenues, promoter holding, RoCE, cumulative FCF to median revenues and debt/equity while ‘Q5’ denotes the worst quintile on mcap to revenues,
promoter holding, RoCE, cumulative FCF to median revenues and debt/equity. GREEN denotes stocks featuring in that quintile have the greatest probability of becoming a
multi-bagger while RED denotes stocks featuring in that quintile have the least probability.
Exhibit 5: Combination of the factors significantly
The share price performance of quintiles across the various improves the odds of identifying multi-baggers
factors suggests:
 Stocks from the cheapest quintile on mcap to revenues have
a greater probability of becoming a multi-bagger;
 Stocks with reasonably high promoter holding have a
greater probability of becoming a multi-bagger; but
 Stocks from the worst quintile on RoCE, cumulative FCF to
median revenues and debt:equity have the least probability
of becoming a multi-bagger.
 Further, a combination of these factors (see exhibit 5 on the
right) significantly improves the odds of identifying multi-
baggers.
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Testing the robustness of this lucky find - results from our back-testing

 A combination of the factors discussed in the previous slide improves the probability of
identifying multi-baggers to ~33% (in 2007) whilst also significantly reducing the number
of stocks.
 We now back-test this combination to see if it does well in identifying multi-baggers over
other periods also (i.e. over the preceding three ten-year iterations starting from 2004
and the subsequent iterations until 2012).
 Back-test of this lucky find suggests a combination of the factors identified above improves
the odds of identifying multi-baggers in most years.
 For instance, in Mar-04, using a combination of these factors improved the odds of
identifying multi-bagger from 21% to 36%.
 Through this framework, the odds of identifying multi-baggers improves to
nearly 2x while reducing the number of stocks to <4% of the overall small-caps
universe

Exhibit 6: Back-test of the framework starting from the year 2004 suggests odds of identifying multi-baggers improves
by ~17% whilst reducing the number of stocks to <4% of the overall universe
Average no.
2004-14 2005-15 2006-16 2007-17 2008-17 2009-17 2010-17 2011-17 2012-17 Median
of stocks
Combination* 36% 29% 4% 33% 38% 69% 42% 44% 43% 38% 25
Universe 21% 16% 7% 13% 18% 39% 24% 27% 36% 21% 719
Source: Bloomberg, Ambit Capital research. Combination* denotes the list of stocks that clear all our filters (see slides 6 and 7 above). Universe for the above exhibit is all listed
companies with mcap greater than Rs 1bn (as of March every year) ex-BFSI.

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How should investors invest in these stocks?

Approach 1- Buying the portfolio of stocks

OR

Approach 2 - Use Ambit’s beachcombing expertise

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Approach 1- The portfolio approach

Clients can buy the entire bucket of stocks that do well across the combination of these
factors.
The exhibit below shows the returns for these buckets on an equally-weighted and free float
mcap-weighted basis over the last few years.

Exhibit 7: Equally-weighted and mcap-weighted returns for portfolio of stocks that do well across a combination of
these factors (versus BSE500 index)
2004-14 2005-15 2006-16 2007-17 2008-17 2009-17 2010-17 2011-17 2012-17 Average

No. of stocks 14 24 27 27 32 16 26 27 28 25
Equally-weighted portfolio returns 13% 12% 6% 12% 17% 28% 18% 17% 19% 15.7%
Free float mcap-weighted portfolio
11% 9% 6% 13% 18% 27% 13% 6% 18% 13.4%
returns
BSE500 index 14% 15% 8% 10% 8% 17% 9% 9% 13% 11.6%
alpha (equally-weighted portfolio vs
-1% -3% -3% 2% 9% 11% 9% 7% 6% 4.1%
BSE500 index)
alpha (free float mcap-weighted
-3% -6% -3% 3% 10% 10% 4% -3% 5% 1.8%
portfolio vs BSE500 index)
Period over which returns have been Mar'04- Mar'05- Mar'06- Mar'07- Mar'08- Mar'09- Mar'10- Mar'11- Mar'12-
calculated Mar'14 Mar'15 Mar'16 Mar'17 Mar'17 Mar'17 Mar'17 Mar'17 Mar'17
Source: Bloomberg, Ambit Capital research. Note: In the exhibit above, returns have been calculated on a CAGR basis on a Mar-Mar basis over the next ten
years (except for years after 2008 where returns have been calculated over the subsequent 9,8,7,6 and 5 years respectively)

For the list of stocks that do well as of today, kindly contact your relevant sales
representative at Ambit or email the authors of this note.

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Approach 2- Use Ambit’s Beachcombing expertise

Exhibit 8: Distribution of no. of companies that cleared all the filters over 2004-12

35

30

25

20

15

10
Mar-04

Mar-05

Mar-06

Mar-07

Mar-08

Mar-09

Mar-10

Mar-11

Mar-12
No. of stocks that cleared all parameters
Source: Bloomberg, Ambit Capital research

 Typically these screens post a number of companies- for instance only 14 stocks cleared all
the factors in Mar-04; in contrast in Mar-08 this number was as high as 32 stocks.
 Thus, whilst the approach discussed in the preceding section should serve investors well in
identifying multi-baggers from a top-down basis, for a more bottom-up approach, we
recommend using Ambit’s beachcombing expertise.

Beachcombing: Beachcombing is an activity that consists of an individual "combing" (or

searching) the beach and the intertidal zone, looking for things of value, interest or utility. A
beachcomber is a person who participates in the activity of beachcombing.

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Procedure used while screening and researching stocks for our
Beachcombing reports
Broad universe for our Beachcombing reports
 Mcap between Rs3bn – Rs30bn.
 Whilst liquidity would not be a constraint, we will not compromise on accounting quality.
 Accounting quality- ‘D1’ to ‘D7’ on Ambit’s HAWK. Only exception- for companies where a
low score on our framework could be justified by the company’s business model and is not
necessarily an ill-intent on the part of the company in question.

Exhibit 9: According to a Duke survey, corporate managers

Procedure have been more optimistic about their own company than
 No formal coverage of these stocks. they have been about the economy as a whole!

 According to a Duke Survey, corporate managers

are subject to the same behavioral biases as the
rest of us (see exhibit 9 on the right).
 Thus, in our beachcombing reports, the time
spent with company management would be less
than 5% of the overall time.
 In contrast, our analysis would be based on
extensive channel checks across dealers,
distributors, competitors, customers and ex-
employees, and a careful reading of the
company’s annual report over the past decade.
 Endeavor will be to highlight 1-2 investment Source: 18 November 2005 research paper : “Seven Sins of Fund Management” by Dresdner
Kleinwort Wasserstein (click here for the report).
ideas from the small caps space every month.

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Example of our Beachcombing report - Garware-Wall Ropes

Click here for our 18 April 2017 detailed note Beachcombing Garware-Wall Ropes.

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The dilemma- Which screen of Ambit should you follow?
Over the past few years we have built several screens for investors based on their outlook. We
have summarized these screens below along with a description of the ideal investor for each
of these screens:
Sr. Portfolio construct Recent report on the construct
No.
1 Good and Clean Click here for our 03 April 2017
portfolio note: ”G&C 11.2 - Keeping faith in
quality, raising share of cash”
2 Ten-bagger portfolio Click here for our 06 January
2017 note: “Ten Baggers 6.0”
3 Coffee Can portfolio Click here for our 17 November
2016 note: “The Coffee Can
Portfolio 2016”
4 Turnarounds Click here for our 20 March 2017
note: “Identifying ‘fallen angels'
using HAWK”
5 Small-caps: Little Giants Click here for our 25 July 2016
note: “India’s Little Giants”
5 Small-caps: Finding The current report discusses this
Multi-baggers within construct
small-caps
6 ‘Magic’ screen Click here for our 06 October
2015 note ”The Magic Formula
and Value Traps”
Ambit Capital Pvt. Ltd.
Ideal for?
Short-term investor with quarterly
performance focus
Conventional buy-and-hold
investor with 1-3 year horizon
Long-term investors with a ten-
year outlook
Investors wishing to identify
companies on the cusp of a
turnaround
Investors aiming to identify high
quality franchises in the small-
caps space
Long-term investors aiming to
generate alpha in the small-caps
space
Investors wishing to identify
‘quality’ and ‘cheap’ stocks
PRIVATE & CONFIDENTIAL. NOT FOR CIRCULATION 14
Disclaimer

* In case the recommendation given by th e Research Analyst becomes inconsistent with the rating legend, the Research Analyst shall within 28 days of th e inconsistency, take appropriate measures (like change in stan ce/estimates) to make the recommendation consistent with the rating
legend.
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variations. The ability to assess such risks may also be limited due to significantly lower information quantity and quality. By accepting this document, you agree to be bound by all the foregoing provisions.

D isclosures
29. The analyst (s) has/have not served as an officer, director or employee of the subject company.
30. There is no material disciplinary action that has been taken by any regulatory authority impacting equity research analysis activities.
31. All market data included in this report are dated as at the previous stock market closing day from the date of this report..

A n alyst C ertification
Each of the analysts identified in this report certifies, with respect to the companies or securities that the individual analyses, that (1) the views expressed in this report reflect his or her personal views about all of the subject companies and securities and (2) no part of his or her
compensation was, is or will be directly or indirectly dependent on the specific recommendations or views expressed in this report.

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