Rules to spot hidden nuggets

How do you dig out golden opportunities? Go for stocks where the management has a sustainable edge in the business, the company has an opportunity and space to grow and the business has a limitless horizon to expand.

Dipen Sheth | Print Edition: Nov 29, 2007

Dipen Sheth
Dipen Sheth

There is serious money to be made in digging out small, unknown companies and patiently riding their fortunes. How do you know which stock will give stupendous returns? The answer is you don’t. But you can do a few things to improve your chances. Before we list these ground rules, let’s define the asset allocation for this high-risk game: do not allocate more than 15-20% of your portfolio to this category.

Rule 1

Spot the capability: Make sure that the management has a sustainable edge in the business. If they are not better in a known and definable way, there’s no chance they can ever become big. Example: Diamond Cables, a oncesick company whose promoters were technocrats and knew more about conductors than people many times their size. The company has multiplied seven times in value in the past 30 months.

Rule 2

Size of opportunity: If the stock is to grow multifold, the business must have an opportunity and space to expand. There’s no point trying to find such stories in the tea, jute or the textiles business. You could have taken a sensible punt on Bharti Airtel five years ago simply because we had less than 30 million cellular consumers in a nation of over a billion. Or gone long on Opto Circuits, sensing that its optical sensors business had a once-in-a-lifetime opportunity to address the vast US market once it got the necessary approvals.

Rule 3

Occurrence of “future shift”: Often, a breakthrough change in the rules or economics of the business opens up a limitless world of opportunities. In Opto’s case it was the expiry of a patent that enabled it to market its optical sensors to the entire industry. For Bharti, it was the progressive dismantling of the revenue-share regime that made calls cheaper, resulting in explosive market growth.

Let’s take Easun Reyrolle as a case study. Last week I visited its Hosur factory. It’s a respected player in power protection devices and systems that is now attempting a big leap—switchgear, automation, projects. It has even made a foreign acquisition in a niche area: power system recorders.

Applying Rule 1 is easy. There’s no dearth of capability at this company. It’s competing successfully against biggies such as Siemens, ABB and Areva. Rule 2 is what got us into this stock in the first place. We were rummaging for aggressive growth plays in the power sector. The opportunity in this sector is great. India is slated to add over 60% of its existing power capacity by 2012.

Rule 3 was confirmed with the arrival of power reforms, though this part is yet to pan out.

Internally, Easun has been quietly making the transition from mostly a relays and protection devices company into a multiproduct company. Equally important, it is now focusing on end-toend projects rather than mere product sales, a shift that is visible in its first half revenue break-up. Compared to its current market cap of $120 million, Easun plans to raise $60 million in the overseas markets. Some of this money will be used for an acquisition and the rest will probably fund working capital.

If Easun is able to pull it off, it might deliver wonderfully as a stock from its current level of Rs 300-odd, where it’s quoting at 20 times estimated 2007-8 earnings. For a business that can grow at 50% YoY for the next 4-5 years, that’s cheap in today’s euphoric markets!

Dipen Sheth, Head of Research, Wealth Management Advisory Services. He can be reached at dipen@wealthmanager.ws

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