Once you decide that you do want a small stock portfolio, the next question is obvious: “Okay, but what do I actually buy?” Most investors start in the worst possible way: a friend’s tip, a TV “idea for tomorrow”, or a stock that’s just doubled in the last year.The right way is much simpler and much more boring: buy long-term compounding businesses at sensible prices.Let’s unpack what that really means in plain language.Compounding businesses vs “exciting” storiesImagine two companies over the last 10-15 years:
- Company A: quietly grows its sales and profits at 15-18 per cent a year, keeps debt low, and earns a high return on capital.
- Company B: has exciting announcements, big plans, frequent news, but profits jump and crash, and it keeps issuing shares or taking more debt.
If you had invested Rs 1 lakh 15 years ago, it is very likely that:
- Company A would be worth around Rs 8-12 lakh today
- Company B might be at Rs 1.3-1.5 lakh or even below your original Rs 1 lakh
The likes of Astral, PI Industries are some of the best outcomes of those in the first category having grown 30-40 times over the last 15 years. Whilst companies like Suzlon, Reliance Power, and Vodafone Idea fall in the latter category.The lesson is simple: wealth is built by businesses that keep doing well year after year, not by stories that sound great for a few months.A simple checklist before you buy any stockBefore you buy a share, run it through a few basic filters. You don’t need complicated ratios to start with.Here’s a simple checklist:
- Is the business understandable? Can you explain in one or two sentences what the company does and how it makes money? If not, skip it. If you can’t describe it simply, you don’t own it, you’re just renting it.
- Has the company grown steadily? Look for steady growth in sales and profits over at least the last 3-5 years. One great year and many bad ones is a warning sign.
- Is it consistently profitable with good returns on capital? Basic thumb rule: ROE/ROCE should be comfortably above the cost of capital, say above 12 per cent for many Indian businesses.
Is debt reasonable? For most non-financial companies, high and rising debt is a problem. Look for either low debt or a clear declining trend.
- Does cash flow match profit? If a company shows big profits but weak or negative cash flows year after year, be careful. Cash is reality; profit is a story.
At the stock advisory service at Value Research, we start with these kinds of filters to narrow thousands of stocks down to a much smaller universe of potential long-term compounders. You can use the same logic in your own short-listing.Promoter behaviour and governance: the invisible backboneNumbers are important, but behaviour often matters even more. Ask a few questions:
- Have promoters been regularly pledging their shares?
- Do they keep issuing new shares and diluting existing shareholders?
- Are there frequent related-party transactions that benefit the promoters more than the company?
- Are there sudden changes in auditors or qualified audit reports?
One or two items may be explainable. A pattern is not.Many of the biggest blow-ups in Indian markets looked perfectly fine on simple ratios just before they collapsed. The early warning signs were usually in promoter behaviour and governance, not in the headline numbers.A “great story” with poor governance is not a long-term compounding business. It’s a ticking time bomb.Price still matters, but only after qualityEven a wonderful company can be a poor investment if you pay any price for it. We’ll devote a separate column to valuations, but here’s the order that works:
- First: Is this a good, clean, growing business?
- Then: Am I paying a reasonable price for it?
In practice, that means:
- Avoid low-quality businesses even if they look “cheap”
- Avoid excellent businesses if the valuation has gone to extremes, where even small disappointments can hurt you
At our stock advisory service, the process is exactly this: quality and durability of the business first; valuation bands and margin of safety next.For your personal checklist, it’s enough to remember: don’t overpay for junk, and don’t overpay crazy prices even for gems.Build a watchlist, not an impulse listA good way to avoid impulsive buying is to maintain a watchlist:
- Make a list of 20-30 companies that pass your basic quality filters
- Read about them, track them for a few months, and understand their cycles
- Decide at what kind of valuation or price range you’d be comfortable starting a position
Then, when markets correct or a good business has a temporary problem, you already know what you’re looking at. You’re not scrambling for tips; you’re executing a prepared plan.Our stock advisory service essentially gives you a curated list of such businesses, with the homework already done. You still have to decide how it fits into your overall portfolio and risk appetite.The bottom lineIf you remember only one thing from this column, let it be this: The right stocks to buy are not the ones everyone is talking about today. They are the businesses that will quietly keep compounding for the next 10-20 years.To find them, you don’t need secrets. You need:
- Basic filters on growth, profitability, debt and cash flows
- Respect for governance and promoter behaviour
- The patience to hold good businesses through ups and downs
If you want to own stocks at all, make sure they are the kind of businesses you’d be happy to still own 10 years from today, even if nobody is boasting about them at parties.(Ashish Menon is a Chartered Accountant and a senior equity analyst in Value Research’s Stock Advisor service.)
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