This blog first appeared on Flawlessguide.com. 

When you buy a stock, you buy a fractional ownership of a business. And your returns from that investment would depend on how the business performs. If the business performs well, then more people would demand for ownership in that business, driving the share prices up. And if the business performs poorly, then more owners like you would want to exit the investment causing an excess of supply of shares and therefore a lower share price. 

Therefore, if the outcome of investing in stocks depends on the outcome of the business, the question to ask is: what kinds of businesses to invest in?

What kind of businesses to invest in:

In India, there are over 4000 listed businesses. A majority of the businesses are just mediocre and therefore we need to filter those out from our consideration and focus on the smaller set of about 200 businesses. Here is a broad checklist to look for:

• You want to invest in businesses that provide a high Return on Capital Employed (ROCE). A company that generates a high ROCE, is more efficient and can produce more profits per Rupee invested than a business with a lower ROCE. 
• The second important factor to look for is businesses that can reinvest their profits. A business that pays out all profits as dividends is like a Simple Interest machine. But a business that not only has a high ROCE but can also reinvest profits to grow the business is like a Compound Interest machine. The fundamental difference is that the principal invested in Simple Interest remains the same every year and so does the profits. But in Compound Interest, the principal grows and so do the profits. Markets reward efficiency (ROCE) and growth.
• Thirdly and probably most importantly – you want to invest in businesses that you can easily understand and is being run by good, honest and capable people. One way to test if you understand the business is to try and explain it to a child. 

But why not fixed deposits (FDs)?

Compound Interest works exponentially, not linearly. To understand the exponential nature of Compound Interest let’s do a small thought experiment. Say there are three investment opportunities – first one compounds capital at 24%, the second at 12% p.a and the third at 6% p.a. And let’s say you invest Rs 1 Lakh in each of them.

At the end of 12 years, the first would amount to Rs 8 Lakhs, the second to Rs 4 Lakhs and the third to Rs 2 Lakhs. At the end of 24 years, the first would amount to Rs 64 Lakhs, the second to Rs 16 Lakhs and the third to 4 Lakhs. So every 12 years, the first one multiplies itself by 8 times, the second 4 times and the third 2 times. The longer the time horizon, the more the divergence. 

FDs tend to be like the third investment category- the one that provides a mediocre return. On the other hand, in India, there are 280 listed companies that have a ROCE of 24% or more. If we could diligently work at it, we could identify about 10 to 15 businesses from this list that meets our investment criteria. And remember, the demand for shares of a good company only increases over time and therefore so does the share price. 

A second reason why not FDs is because inflation tends to silently eat away most of our returns. Between 2010 and 2020, we had an average inflation of 7%. In other words, what Rs 100 could buy in 2010, today it costs us Rs 200! Suppose, you invested Rs 100 in FDs in 2010 and today it is worth Rs 190, are you better or worse off?

Therefore, to conclude:

• The stock market is just a market to buy stocks. Stocks are fractional ownership in businesses. And businesses are a great proxy to compound interest.
• Compound Interest is exponential in nature and we can make this great force work for us by investing in businesses with high ROCE and reinvestment opportunities. 
• Parking money in FD for the short term is okay but in the long run inflation eats away the purchasing power of our savings leaving us worse off.