Many investors are confused when it comes to the stock market; they have trouble figuring out which stocks are good long-term buys and which ones aren't. To invest for the long term, not only do you have to look at certain indicators, but you also have to remain focused on your long-term goals, be disciplined, and understand your overall investment objectives.
In this article, we explain how to identify good long-term buys and what's needed to find them.
KEY TAKEAWAYS
- Picking stocks is both an art and a science, and even the best-looking bets can fail to pay off.
- There are several strategies to increase your chances of finding a great investment.
- A combination of bottom-up fundamentals and top-down economic analysis can help steer you in the right direction.
Focus on the Fundamentals
There are many fundamental factors that analysts inspect to decide which stocks are good long-term buys and which are not. These factors tell you whether the company is financially healthy and whether the price of the stock has been brought down to below its actual value, thus making it a good buy.
The following are several strategies you can use to determine a stock's value.
Dividend Consistency
The consistency of a company's ability to pay and raise its dividend shows that it has predictability in its earnings. It also shows that it's financially stable enough to pay that dividend (from current or retained earnings). You'll find many different opinions on how many years you should go back to look for this consistency—some say five years, others say as many as 20—but anywhere in this range will give you an idea of the dividend consistency.
Examine the P/E Ratio
The price/earnings ratio (P/E) ratio is one common tool used to determine whether a stock is overvalued or undervalued. It's calculated by dividing the current price of the stock by the company's earnings per share. The higher the P/E ratio, the more willing some investors are to pay for those earnings. However, a higher P/E ratio is also seen as a sign that the stock is overpriced and could be due for a pullback. A lower P/E ratio could indicate that the stock is an attractive value and that the markets have pushed shares below their actual value.
A practical way to determine whether a company is cheap relative to its industry or the markets is to compare its P/E ratio with the overall industry or market. For example, if the company has a P/E ratio of 10 while the industry has a P/E ratio of 14, this would indicate that the stock has an attractive valuation compared with the overall industry.
Watch for Fluctuating Earnings
The economy moves in cycles. Sometimes the economy is strong and earnings rise. Other times, the economy is slowing and earnings fall. One way to determine whether a stock is a good long-term buy is to evaluate its past earnings and future earnings projections. If the company has a consistent history of rising earnings over a period of many years, it could be a good long-term buy.
Also, look at what the company's earnings projections are going forward. If they're projected to remain strong, this could be a sign that the company may be a good long-term buy. Alternatively, if the company is cutting future earnings guidance, this could be a sign of earnings weakness, and you might want to stay away.
Avoid Value Traps
How do you know if a stock is a good long-term buy and not a value trap (the stock looks cheap but can head a lot lower)? To answer this question, you need to apply some common-sense principles, such as looking at the company's debt ratio and current ratio.
Debt can work in two ways:
In good economic times, debt can increase a company's profitability by financing growth at a lower cost.
During times of economic uncertainty or rising interest rates, companies with high levels of debt can experience financial problems.
The debt ratio measures the amount of assets that have been financed with debt. It's calculated by dividing the company's total liabilities by its total assets. Generally, the higher the debt, the greater the possibility that the company could be a value trap.
There is another tool you can use to determine the company's ability to meet these debt obligations—the current ratio. To calculate this number, you divide the company's current assets by its current liabilities. The higher the number, the more liquid the company is. For example, let's say a company has a current ratio of four. This means the company is liquid enough to pay four times its liabilities.
By using these two ratios—the debt ratio and the current ratio—you can get a good idea as to whether the stock is a good value at its current price.
Analyze Economic Indicators
There are two ways you can use economic indicators to understand what's happening with the markets.
Understanding Economic Conditions
The major stock market averages are considered forward-looking economic indicators. For example, consistent weakness in the Dow Jones Industrial Average could signify that the economy has started to top out and that earnings are starting to fall. The same thing applies if the major market averages start to rise consistently but the economic numbers are showing that the economy is still weak.
As a general rule, stock prices tend to lead the actual economy in the range of six to 12 months. A good example of this is the U.S. stock market crash in 1929, which eventually led to the Great Depression.
Evaluate the Economic "Big Picture"
A good way to gauge how long-term buys relate to the economy is to use news headlines as an economic indicator. Basically, you're using contrarian indicators from the news media to understand whether the markets are becoming overbought or oversold.
A good example of this occurred in 1974 when a cover of Newsweek showed a bear knocking down the pillars of Wall Street. Looking back, this was clearly a sign that the markets had bottomed and stocks were relatively cheap.
In contrast, a Time magazine cover from Sept. 27, 1999, included the phrase, "Get rich dot-com"—a clear sign of troubles down the road for dot-com stocks and the markets. What this kind of thinking shows is that many people feel secure when they're in the mainstream. They reinforce these beliefs by what they hear and read in the mainstream press. This can be a sign of excessive optimism or pessimism. However, these kinds of indicators can take a year or more to become a reality.
What Are 10 Tips for Successful Long-Term Investing?
Ride a Winner
Peter Lynch famously spoke about "tenbaggers"—investments that increased tenfold in value. He attributed his success to a small number of these stocks in his portfolio.
But this required the discipline of hanging onto stocks even after they’ve increased by many multiples, if he thought there was still significant upside potential.1 The takeaway: avoid clinging to arbitrary rules, and consider a stock on its own merits.
Sell a Loser
There is no guarantee that a stock will rebound after a protracted decline, and it’s important to be realistic about the prospect of poorly-performing investments. And even though acknowledging losing stocks can psychologically signal failure, there is no shame recognizing mistakes and selling off investments to stem further loss.
In both scenarios, it’s critical to judge companies on their merits, to determine whether a price justifies future potential.
Don't Sweat the Small Stuff
Rather than panic over an investment’s short-term movements, it’s better to track its big-picture trajectory. Have confidence in an investment’s larger story, and don’t be swayed by short-term volatility.
Don't overemphasize the few cents difference you might save from using a limit versus market order. Sure, active traders use minute-to-minute fluctuations to lock in gains. But long-term investors succeed based on periods of time lasting years or more.
Don't Chase a Hot Tip
Regardless of the source, never accept a stock tip as valid. Always do your own analysis on a company before investing your hard-earned money.
Tips do sometimes pan out, depending upon the reliability of the source, but long-term success demands deep-dive research.
Pick a Strategy and Stick With It
There are many ways to pick stocks, and it’s important to stick with a single philosophy. Vacillating between different approaches effectively makes you a market timer, which is dangerous territory.
Consider how noted investor Warren Buffett stuck to his value-oriented strategy and steered clear of the dotcom boom of the late '90s—consequently avoiding major losses when tech startups crashed.
Don't Overemphasize the P/E Ratio
Investors often place great importance on price-earnings ratios, but placing too much emphasis on a single metric is ill-advised. P/E ratios are best used in conjunction with other analytical processes.
Therefore a low P/E ratio doesn't necessarily mean a security is undervalued, nor does a high P/E ratio necessarily mean a company is overvalued.
Focus on the Future and Keep a Long-Term Perspective
Investing requires making informed decisions based on things that have yet to happen. Past data can indicate things to come, but it’s never guaranteed.
In his 1989 book "One Up on Wall Street" Peter Lynch stated: "If I'd bothered to ask myself, 'How can this stock possibly go higher?' I would never have bought Subaru after it already had gone up twentyfold. But I checked the fundamentals, realized that Subaru was still cheap, bought the stock, and made sevenfold after that."2 It’s important to invest based on future potential versus past performance.
While large short-term profits can often entice market neophytes, long-term investing is essential to greater success. And while active trading short-term trading can make money, this involves greater risk than buy-and-hold strategies.
Be Open-Minded
Many great companies are household names, but many good investments lack brand awareness. Furthermore, thousands of smaller companies have the potential to become the blue-chip names of tomorrow. In fact, small-cap stocks have historically shown greater returns than their large-cap counterparts.
From 1926 to 2017, small-cap stocks in the U.S. returned an average of 12.1% while the Standard & Poor's 500 Index (S&P 500) returned 10.2%.3
This is not to suggest that you should devote your entire portfolio to small-cap stocks. But there are many great companies beyond those in the Dow Jones Industrial Average (DJIA).
Resist the Lure of Penny Stocks
Some mistakenly believe there’s less to lose with low-priced stocks. But whether a $5 stock plunges to $0, or a $75 stock does the same, you've lost 100% of your initial investment, so both stocks carry similar downside risk.
In fact, penny stocks are likely riskier than higher-priced stocks, because they tend to be less regulated and often see much more volatility.
Be Concerned About Taxes but Don't Worry
Putting taxes above all else can cause investors to make misguided decisions. While tax implications are important, they are secondary to investing and securely growing your money.
While you should strive to minimize tax liability, achieving high returns is the primary goal.