Steps to shortlist longterm compounders

Stage 1: Coffee Can Screening

1. Revenue Growth $\ge 10\%$ CAGR every year
2. Return on Capital: $ROCE/ROE$ $\ge 15\%$ every year
3. Leader in a niche: deep economic moat
4. Negligible debt and clean accounting

Stage 2: Valuation Screening

1. Historical Relative $P/E$: Current $P/E<1.25\times \text{Historical Median P/E}$
2. PEG Ratio: Target a PEG $\le 2.0x$ to $2.5x$ for proven wide-moat compounders.
   • Formula $\text{PEG}=\frac{\text{Current P/E}}{\text{Forward 3-Yr Expected Earnings CAGR}}$
3. Reverse DCF: Implied Free Cash Flow growth rate the current stock price demands over the next 10 years. The industry and the business model should have that growth potential feasible.

Stage 3: Promoter Screening

Promoter Alignment

1. Holding Band: $>45\%-50\%$ promoter/founder holding (or significant institutional holding where no individual promoter exists, such as in professional board-run firms like L&T or ITC)
2. Zero or Minimal Pledging: Promoter pledge must strictly be $0\%$
3. Pattern of Insider Selling during bull runs
4. Promoter/executive salary growth scales proportionally with net profit growth, ideally remaining under $5\%$ of net profits

Capital Allocation

1. Management should redeploy cash back into high-ROCE core business lines ($>18\%$). No hoarding of unproductive cash.
2. Empire Building should be on logical grounds: Flag any use of high-margin cash flows from the core franchise to fund unrelated, low-return acquisitions or speculative ventures.
3. Value-Accretive Share Buybacks: Top-tier management executes share buybacks primarily when the stock is undervalued, rather than issuing stock options (ESOPs) that dilute shareholders.

Candor

1. Transcript Candor: Review quarterly earnings calls. Look for management that openly admits operational mistakes, discusses long-term capacity building over quarterly earnings guidance, and avoids blaming macro factors for company-specific misses.
2. Conservative Guidance: Prefer leadership that consistently under-promises and over-delivers.

Succession

1. Key-Person Risk
   • Is the company overly dependent on a single charismatic founder
   • The moat should be in the product or the business rather than in the network (like contacts with ruling party)
   • Promoters holding active political offices, contracts without open tenders
   • Promoter facing criminal charges
   • Aggressive political donations
   • Related party shell entities with unrecorded cash siphoning or beyond reasonable cash transfers to the declared use case
2. Board Independence: Ensure the board includes reputable, vocal independent directors who actively question related-party transactions (RPTs).

Resources

1. Annual Reports (Contingent Liabilities & Legal Disclosures)
2. Search the promoter and company names in SEBI Enforcement Orders and the RBI Wilful Defaulters list.
3. eCourts Services / High Court Portals: Search company and promoter names for pending criminal litigation or serious civil disputes.
4. MDR (Ministry of Corporate Affairs / MCA21): Check director disqualifications under Section 164(2) of the Companies Act.
5. If a promoter or direct family member is politically active or contested elections, check their mandatory Form 26 affidavit, which publicly lists all active FIRs, criminal cases, and asset declarations.

Margin of Safety Cash Flow Health Technology Disruption Risk