We have all heard of that one friend who made thousands of dollars trading stocks and chances are they have been in multibagger stocks.

For an investor  or day trader, finding a stock whose price will appreciate multiple times the initial investment value is a dream. When traded wisely, stocks can offer huge returns.

However, making the right stock choice is a process that takes a lot of knowledge and a little bit of luck.

In this article, we explore the ins and outs of multibagger stocks.

Not only does this include a list of what to look for in a stock that could potentially be a multibagger, but we also explain why you should invest in multibagger stocks and the risks associated with them.

Multibagger stocks explained

As the name suggests, multibagger stocks are stocks that generate returns multiple times higher than their associated cost of acquisition i.e. investment in a stock more than doubling.

These are stocks that have the potential to report explosive growth and generate multiple bags of money over a period of time.

For example, a five bagger stock is a stock that gives a return of 5 times the original amount invested, and a ten bagger would give a return ten times more than the initial investment.

The phrase “multibagger stock” was coined by Peter Lynch, a legend in the mutual fund industry who is known for investing in fast-growing companies that are increasing their profit margins at a faster pace than peers.

He wrote about these stocks in his 1988 book, One Up on Wall Street.

Lynch was a fund manager of Fidelity Magellan Fund. During his tenure, he helped the fund generate returns of approximately 29.2% annually from 1977 to 1990,  and made more than a million Americans richer.

Lynch retired from the fund in 1990 at the age of 46.

If you had put $1,000 in the fund on the first day Lynch took over and sold when he left, your investment would have been worth $28,000.

What to look for in a stock that could potentially be a multibagger

Now that you know what multibagger stocks are, let us gear up further on identifying the companies behind these stocks.

There are certain variables you should keep in mind while trying to identify these multibagger stocks, those are:

• Earnings growth: Earnings help traders know which companies are performing, which generally makes the shares more valuable and pushes their price higher. A company that is earning profits from its products or services is more likely (but not guaranteed) to see the price of shares of company stock increase. If a company has posted steady and consistent earnings growth over time, its shares could be your multibagger.
• Fundamentals of the company: The story behind a company is one of the most important thing that you should consider. Keep a track on the overall picture of its business and the chances of success in light of the information. Debt should not be high, the company ought to be able to settle debts from its internal accruals.
• Efficient management: How well is the company managed? What is the general culture? Do you feel that those at the helm are competent? A visionary management team, outstanding customer service, and first-class execution is what drives the long-term company results and the stock price.

Example of a multibagger stock

Zoom Video Communications (NASDAQ: ZM)

 

When it comes to its growth rate, video conferencing service Zoom Video Communications has lived up to its name. Zoom offers cloud-based software that sets up video calls, with chat tools also available.

Users can also easily share content. Its basic video-calling package is free.

Many people were quite skeptical that the company could ever justify the valuation it had been assigned by Wall Street during the coronavirus pandemic-fueled first quarter.

However, Zoom posted some truly eye-popping financial results in early June.

The ease and flexibility of the company’s customer-friendly software and “freemium” business model was enough to spur torrid paid subscription growth as the pandemic forced millions to work, learn and socialize remotely.

Zoom saw its revenue grow 169% on a year-over-year basis in the quarter ended April 30 to $328.2 million, as it added more than 180,000 users since January – far more than it had anticipated.

It also made a profit of $27 million in the quarter, which is more than it made in all of the previous financial year.

Zoom stock had its initial public offering on April 18, 2019 when it opened surged 80% to $65 a share. By April 2020 had become a cultural phenomenon amid the pandemic and the stock was trading near $200 a share.

Now it is currently hovering at $470.

Risks associated with multibagger stocks

Regardless of the type of stocks you are buying, all investments carry an element of risk. Sure, the investment return of multibagger stocks can be excellent and a big payoff is certainly on the cards.

However, it is important to remember that the average trader does not always have deep knowledge of market trends and conditions, which may cause serious miscalculations.

Traders buying multibagger stocks can also get caught up in an economic bubble or value trap. As a result, there is every chance you will incur massive losses when the bubble pops and the stock price slumps.

This is why you should always consider creating a diversified portfolio.

This means that you will be holding dozens of stocks from several different industries. In doing so, you will not be overexposed to a specific stock.

Bottom Line

Multibagger stocks are often difficult to find, buy you can identify them thorough fundamental analysis that helps you in creating a strong portfolio.

Generally, these stocks are issued by companies demonstrating sound management, superb production techniques and tremendous growth potential.

The companies also exhibit excellent research and development skills, allowing their product to attract high demand in the market.

However, it is important to perform your research. In truth, it can take a lot of time to build up the required skills to identify multibagger stocks effectively.