Trying to pick a good stock for a long-term investment may seem like an exercise in futility.
After all, you are trying to pick a stock that will continue to build wealth for the next 5, 10, 20 years or more. No one can seen that far into the future.
That is certainly true. When you consider the many factors that shape the global economy, not to mention the national economy, it is hard to see very far into the futuree.
Add to that the vagrancies of the market and toss in predictable, but unknown political problems and it is enough to make investors throw up their hands in frustration.
While many investors do just that and park their money in mutual funds so someone else can make the decisions. investors in individual stocks usually are looking for a more hands-on approach.
If you would rather make your own decisions, you must be willing to do your homework. If you can't or won't do the homework, mutual funds are a good choice.
So, how do you pick a stock that will build wealth for years to come? The answer is: you don't.
No one can see the future - it is unknown and unknowable.
The only way that makes any sense is to start with what you can know today and that is a lot.
You can easily find tons of information on almost any stock traded on a major exchange. In previous articles, I have talked about picking a stock.
Here are the key factors I believe you should look for when researching a company for a long-term investment:
- Understand that you are investing in a company, not it stock
- Look for companies with solid financial statements
- Make sure debt is at or, preferably, below industry peer norms
- Look for a strong free cash flow
- Look for a competitive advantage (also known as an economic moat)
- Look for management that invests in the future (technology, research and so on)
- Watch out for accounting tricks that make the financials look better than they are
- Buy at the right price
Investing in a company
If you engage in short-term trading, you buy a stock. If you are investing for the long term, you buy a company. It is the company, not the stock that builds wealth for the investor.
For the long-term investor, the stock is a reflection of the company, but not always a clear one because is can be distorted by temporary market conditions.
Solid financial statements
Many investors jump at stocks that represent companies that have never made a profit and maybe never will. Buying on potential is worth considering, but not for more than 10-15% of your portfolio. Potential is often a code word for "not a business."
Relatively low debt
Different industries have different levels of acceptable debt levels. The best idea is to compare a company to its peers. In that comparison, look for companies that are at or below the average debt of its peers. Debt used wisely is an important tool in building a company (the same with families).
However, too much debt is a serious drag and more so when the business cycle slows.
Strong free cash flow
Free cash flow is loosely defined as whats left over after operations have been paid for. The individual analogy is money left at the end of the month after you have paid all your bills and funded your retirement account.
Free cash flow means a company has options. It can reinvest the cash into the business, acquire a competitor or buy back shares on the open market, all of which can enrich the investor/owner.
Companies with a competitive advantage (or economic moat) have a degree of protection from competitors that lets them dictate business practices. A competitive advantage could include things like proprietary technology, patents, trademarks, market loyalty and so on.
A company with a competitive advantage makes it expensive and difficult for competitors to steal market share.
Invests in the future
When management invests in the future, it is creating wealth for the long-term owners. That investment could be technology, market share or other factors that will help keep the company profitable in the future.
Avoids accounting tricks
There are many ways management can make the books look the way that puts the managers in the best light or avoids embarasing revelations.
Look for transparency in management - investors should know why a certain course of action was taken.
Buy at the right price
Buying at the right price means you patiently wait to buy the stock when it is below its intrinsic value, which leaves you room for a profit when the market re-prices the stock to reflect that value. Buying too high may mean you wait a long time to see any growth in wealth.
Since the future is fluid, it is important to review at least annually, your long-term investments. Grade them each year as if you were investing for the first time. Is the stock reasonably priced relative to the market and economy?
If you would buy the stock again based on this analysis, you made a good decision. If not, consider alternatives.