But remember, investing in stocks has inherent risks. If you don’t like taking on too much risk, long-term investing is your best bet. Companies that boast stable financials and deliver consistent returns can be the backbone of such a portfolio.
At Equitymaster, we always favour long-term investing over short-term. We strongly believe that long-term investing in fundamentally strong stocks is the best way to maximise returns while keeping risk under control.
The stock market generally rewards those who stick to the rules of long-term investing. These rules also allow an investor to sleep peacefully at night, knowing they don’t have to check their portfolio constantly.
So what kind of stocks make for good long-term investments?
How to find the best long-term stocks
#1 Debt
It’s always a good idea to start with the debt of the company you are considering. Ideally, a company should have little or no debt, which is true of many fundamentally strong stocks. Check out this list of debt-free companies.
It’s also a good idea to look for companies that are actively reducing their debt.
#2 Dividends
Next, you should check the dividend payout.
Fundamentally strong companies have rock-solid cash flows, which they often share with investors in the form of dividends. The best companies usually have a long track record of paying dividends, which makes them appealing to long-term investors.
In fact, during market downturns, dividend-paying stocks are in even higher demand that usual as investors find safety in dividends.
Some outstanding companies increase their dividends every year. A certain type of stock offers the best of both worlds: capital appreciation and growing dividends. These are called dividend growth stocks.
Check out this list of dividend growth stocks.
#3 Growth
Companies with consistent sales and profit growth will always be in demand. Check for good growth in both revenue and net profit. The higher the better.
For large companies, 15% consistent growth is excellent but 12% is good enough. For mid caps and small caps the cutoff should be higher – 20% or more. These stocks are usually not cheap but their valuations become more reasonable when the market falls. This is because profit growth combined with a falling stock price makes these stocks attractively priced from a long-term perspective.
Fast-growing stocks get to this point sooner than slow-growing stocks. Unfortunately, these stocks tend to be overvalued at the start of the correction, so the downside can be significant. This is a risk investors must keep in mind.
Essentially, it’s a waiting game with high growth-stocks. If you invest too early you may end up buying the stock before its valuation has corrected sufficiently. But if you are patient, the stock market will sometimes present you with a golden opportunity to buy such a stock at a wonderful price. These make for the best long-term investments.
Just remember to avoid companies that are growing revenue but are struggling to grow net profit. This risk is usually not worth taking.
Check out this list of the top growth stocks.
#4 Past performance
Most investors get carried away with the growth prospects of a company and forget to study its past. This is what separates average long-term investors from good long-term investors.
If a company’s financials have been poor in the past, you need to be absolutely sure the tide has turned and the future will be better. If not, you will be taking a huge risk.
Also, if a stock has done well in the past, it’s worth checking out if the price movement was driven by fundamentals or speculation. If the reason was strong fundamentals, and those fundamentals are still intact, you could have a multibagger on your hands.
Check out this list of multibagger stocks.
#5 Return on equity
The return on equity (RoE) is one of the best measures of the quality of a company. It’s the net profit of a company divided by its book value or net worth.
High RoE with low debt is a great combination to look for. Only a minority of listed companies have grown consistently over the long term with little or no debt while maintaining an RoE above 15%.
All great long-term stocks have good RoEs, usually well above 15%. Just be sure to use it along with metrics such as high growth and low debt.
Here’s what to do first
The points above will help you get started with long-term investing, but there’s something you should do first: clean your current portfolio.
Here’s how to do it.
- First, check for junk stocks. These are companies with high debt, low profits (or losses), and low return ratios. It’s best to get rid of these stocks, even at a loss. You will find better stocks for the proceeds.
- Of the remaining stocks, check to see if the reasons you bought each one are still valid. In some cases, the fundamentals may have deteriorated, the growth story may not be playing out as expected, or corporate governance issues may have cropped up. Sell these stocks.
- Finally, check the valuations of the remaining stocks. Some of them may have run up far too much and may be trading at price-to-earnings ratios above 100. Consider selling these overvalued stocks.
Your portfolio will now have a manageable number of high-quality stocks with potential upside. You can hold on to these and use the proceeds from the rest to invest in fundamentally strong stocks when they are undervalued.
Final points to consider
- Ignore all stock tips
- Don’t fall victim to FOMO (fear of missing out)
- Stay focused on your investing goals
- Never take on debt to invest in stocks
- If you aren’t a professional trader, don’t trade
- Don’t take on so much risk that it affects your sleep
Conclusion
Investing in stable, fundamentally sound companies can sometimes deliver outsized returns as such companies can weather short-term market volatility better than others. The key is to do your own research and invest for the long term.
However, there’s no reason to believe long-term winners of the past will remain so in the future. Monitoring their performance, analysing industry trends, and studying significant developments is therefore crucial.
Happy investing!
Disclaimer: This article is for information purposes only. It is not a stock recommendation and should not be treated as such.
This article is syndicated from Equitymaster.com
