In this article we’re going to look at how we can pick great long term stocks. I will try to keep it simple to understand; hopefully you’ll have a better understanding regarding how to pick good stocks for long term investing in your portfolio.
There are two main steps for picking good stocks for long term investing:
- Step one is to identify some potential companies; and
- step two is narrowing down those companies to the best long term stocks that we can find.
Now, one way we can find potential companies is to do a bottom-up analysis.
We start with the broader economy.
What does growth look like? Where are the opportunities? What are the weaknesses? Where do we think that economy is going to be in the next five, 10 or 20 years?
Now, if that outlook is good for that particular economy, that’s probably a good place to look. But given how the world is, we can get so much information; some from so many different places around the world. If in our home country, there isn’t a great opportunity; it might make sense to look in other countries. Now, let’s imagine that we’re looking at the US; and we conclude that there’s some long term opportunities in the US.
Next, we want to look at what sectors are there and where the potential opportunities. So here’s a list of sectors and maybe we think have opportunities.
Information technology (IT) sector has some opportunity in it. After all, technology has been really pushing the world forward over the past few decades. And maybe we think that will continue to happen over the next couple decades. Well, if we break down the IT sector now, we could look at what do the industry groups look like. Now, I could easily make a case for any one of these three industry groups. So maybe after we narrow down a bit, we look at some of the industries within those industry groups. Now one sector can really lead to a ton of potential companies.
For example, Microsoft and Oracle both fall in these systems (Software sub-industry). Meanwhile, Visa and MasterCard fall into the data processing and outsourced services sub-industry. So there could be a huge variety of companies that would fall into one information technology sector and those companies can oftentimes be quite different.
Looking at a sub industry like data processing where Visa and MasterCard are sitting well; how far out can we reasonably project? Based on the fact that less and less cash is being used; or at least more and more transactions are being done digitally. Well, I would say that this industry is likely to be far larger in, let’s say, 10 years. And I’m assuming that companies like Visa, MasterCard and similar companies are likely to get a bigger portion of that growth over the next few years. And using this very simple sort of logical process, I would bet that we could be reasonably confident that this industry is going to show some growth in the coming years. Once we’re confident that this in this particular case is southern history has shown some growth potentials.
Well, now it makes sense to try to find great stocks for long term investing within that sub industry. And by far the most important part of any company analysis is to truly understand the business. I’m sure that many of us have heard Warren Buffett say things like we need to stay within our own circle of competence or we need to truly understand any company that we want to invest in. And for me, this is one of the most important parts. After we identify an industry that we believe has some growth potential or at least the growth potential, we can logic that out.
A good place to start is to start with the companies individual business section from their annual report. As an example, if we like companies like, let’s say, Visa or Microsoft. Then reading the business section of their annual report should give us a much better understanding of what the company does. We should look at the segments of a business and then try to understand the history behind those segments, what where the revenue is being generated, perhaps where the profits are being generated. And the goal of that is ultimately to get a better understanding of where the company is heading. And the better we can do that, the better we can project where the business is heading, the better we know the better understanding we will have as to whether or not this is truly a good long term company.
Fundamental Analysis
Now, you may notice that up until this point, we haven’t talked about the numbers of the company. How much revenue do they have? What’s their growth rate? What’s their annual dividend? These are all great questions, especially for long term investing. But the goal of identifying great stocks for long term investing is a very difficult thing to do. It’s a difficult thing to quantify that simply, and the answers to these questions can vary from investor to investor; also the importance of the answers can vary from investor or investor.
For example, I like dividend stocks and with dividend stocks, I want a reasonable, reasonable amount of revenue growth and I want a consistent amount of profits and free cash flow that can at least cover the dividends that a company is paying up. But then if I’m looking at growth companies, while the growth companies, obviously we want more growth than we might require than our dividend companies.
Since growth companies at least tend to be younger companies and they generally have some sort of competitive advantage and hopefully they have decent margins. And as time goes on and competitors eventually catch up their margins will almost always shrink. So if a company has decent margins or above average margins now, when they solely give away some of that competitive advantage, as will surely happen at some point, at least their margins are likely to continue to produce growth for the long term investor.
Value Investing
Then there’s the long term value investing. So pretty much any stock can be a value stock. It’s simply a matter of staying disciplined and paying less than our calculation of fair value. The most important part of this whole thing is paying less than our calculation of fair value, even if that means sitting on the sidelines and waiting for a long time for the right opportunities. And at the end of the day, it’s a combination of value in either dividend or growth or in some cases both that make for a great long term stock. If we buy a great deal in stock and it pays a dividend reliably and a gradually increase that dividend and we bought it at a very good price. Well, why would we ever want to sell that stock?
The same is true on the growth side. If a company is growing and we bought it at a great price and their prospects are great and perhaps the industry, perhaps that company has some sort of competitive advantage in their industry. This makes for another great long term buy. If we buy it, perhaps stay. That growth stock is overpriced right now. But a year off now, the stock market crashes and we jump in and buy it then. Well, this might be a stock we hold for many more years to come. Assuming its business stays on track. This is one of the reasons that it’s so important to simply focus on the understanding of the industry and the business itself.
Conclusion
If we focus on finding great businesses and then trying to value those businesses as objectively as possible, then it’s only a matter of time until we eventually come up with a handful of great long term stocks that we truly have a great understanding of. Now, this is one of the reasons that we need to do so much company analysis. If we can review a whole bunch of investment opportunities that could be good companies or could be great long term stocks to buy something that we could each analyze further on our own.
If you’re interested in knowing about individual companies in the Indian stock market and seeing what companies might meet your personal investment criteria, you should definitely check out MKJ sir’s YouTube Channel.
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