6 Signs a Stock Might Be a Good Long-Term Investment
Though Nothing Is Certain, Great Stocks Tend to Have Certain Characteristics
When I invest, I don’t think about whether a stock will be up or down a year from now. It’s not relevant to the task of building wealth as I see it. When I buy a stake in a firm, I have no idea — and neither does anyone else, no matter what they might tell you — whether the shares will be up or down 50 percent within the arbitrary period it takes this little rock upon which we live to orbit the nearest star (to borrow a phrase).
What I am interested in is acquiring as much ownership as I can in a broad collection of wonderful businesses; firms that reward me, my husband, and our family with our share of the sales and profits from the underlying productive enterprise. To use a concept that will be familiar to other value investors, we want to make money by owning businesses, not by renting stocks.
Accordingly, we spend most of our time looking for the types of businesses we want to own, then waiting — sometimes years on end — for them to be available at a price that we think is attractive. We then buy them and sit on them.
For new investors who have no experience examining different businesses, I thought it might be useful to create a short, high-level checklist that provides a rudimentary overview of some of the things that I look for when searching for companies I want to own. Though they are not a guarantee of success — theoretically, a company could possess all of these attributes and still go bankrupt due to a low-probability event — they are a good place to begin when trying to identify the productive assets you want churning out dividends for you for years to come.
Here are the six things I look for.
Six Signs a Stock Might Be a Good Long-Term Investment
1. You can easily describe, in a few sentences, how the company makes money.
You might be astonished how many inexperienced investors risk their hard-earned money buying ownership in a business that they don’t understand. Any time you take out your checkbook — or, these days, transfer money into your brokerage account, Roth IRA, global custody account, or another investment account — to buy shares of a firm, you should be able to explain, in plain English, to a student in elementary school in no more than a few sentences exactly how the company generates its profits. You should be able to talk about the major cost inputs.
For example, if you’re examining a tire manufacturer, the cost of rubber and other materials is going to matter. If you’re examining a freight company, the cost of fuel is going to matter.
2. The company generates high returns on capital with little to no leverage.
The ultimate ability of a company to generate returns for its long-term owners over many decades is going to be determined by the return on capital it produces. The best businesses produce high returns on capital without the need for a lot of, or any, borrowed money. Instead, they are profit-printing machines that churn out cash which the owners can extract without harming the core enterprise. Within this basic truth is the secret to the reason as to why certain industries tend to produce a disproportionate share of the most successful investments over 25+ year periods.
Alcohol, tobacco, laundry detergent, dish soap, chocolate … done right, a business in an area such as these can make a lot of money without constantly having to make large capital expenditures the same way a steel mill might require.
3. The company’s products or services have some sort of durable competitive advantage.
Most people don’t care which brand of screw they pick up at the local hardware store or which farmer grew their corn. They do care, on the other hand, whether a convenience store carries their favorite candy bar or beverage; whether a local discount merchant sells their favorite toothpaste or mouthwash. In cases where consumers are fiercely loyal to a product or service, the manufacturer or provider can generally charge higher prices. This leads to a feedback effect where they grow larger, gain better economies of scale, and then generate even more surplus cash flow.
That surplus cash flow allows them to pay for increased marketing and innovation which, in turn, drives brand loyalty even more. This is a virtuous cycle that can produce a lot of wealth for those who are patient enough to ignore the stock market and stick their stock certificates in a vault for fifty years.
A major problem with this point is that inexperienced investors often mistake temporary hype with companies that have durable competitive advantages. A company being popular does not give it a durable competitive advantage. A company generating high growth in earnings per share doesn’t give it a durable competitive advantage.
4. The company’s management has a history of putting the interests of shareholders first.
They have a history of returning surplus cash in the form of intelligently-executed share repurchase plans and/or a dividend that grows at a rate comfortably in excess of the broader rate of inflation in the economy
This point is so important that I once wrote an article on it called 7 Signs of a Shareholder-Friendly Management. The short version is this: You want to go into business with executives who have your best interest at heart. You want them guided by the right incentives. You want them to nurture an environment that measures success by how the firm does for you, the owner, as well as other stakeholders such as employees.
More than a few times in my career, I’ve come across a business that had wonderful economics only to find managers were raiding the toy chest through obscene options grants, overly generous salaries, or questionable deals with inter-related entities that were controlled by family members. You're the one risking your hard-earned savings. You're the one on the hook if the whole thing collapses. You should get your fair share of any prosperity built on your precious capital.
5. The company’s market capitalization and enterprise value relative to net income are reasonable.
Even the best business in the world can be a terrible investment if you pay too high a price for it. Specifically, price is arguably the most important variable in the long-run as even a terrible business bought at a sufficiently cheap price can result in wealth accumulation under the right conditions. One of my favorite sources of research on this topic is out of Wharton, where one professor demonstrated the power of reinvested dividends in companies that were perpetually undervalued due to their sub-par economics.
While they aren't as good as a wonderful business bought at a fair price, it's still an important lesson.
6. The company has a strong balance sheet that would allow it to survive difficult economic or industry conditions.
Storms have arrived, and will continue to arrive, in the economy as well as the capital markets. Often, these storms will provide no warning before showing up and wreaking havoc on your financial life. One way to mitigate this risk is to focus on disproportionately collecting businesses that have the financial strength necessary to survive even the darkest days of a period like 1929-1933 without having to issue stock at severely depressed prices (which, from an economic perspective, amounts to you, the old owner, having to sell off your ownership in exchange for a bailout).
Sure, these businesses might grow a little slower or provide a fraction of the excitement you might get from other businesses but you'll be grateful you put your trust in them when the maelstrom is raging around you. While the past is no guarantee of the future, it seems to be a reasonable probability bet that firms selling the essentials of everyday life are, as a group, going to have an easier time maintaining their dividend distributions compared to companies such as, say, those involved in manufacturing automobiles.
Closing Thoughts on Investing in Stocks
It is worth noting that it doesn't matter how good a business is, the stock market is volatile by its very nature. Even the best long-term investments fluctuate meaningfully, sometimes to a degree that can seem almost unbelievable if you haven't lived through it.
Consider one of the most successful investments of all time, Berkshire Hathaway, the holding company of billionaire Warren Buffett. The firm's Vice Chairman, Charles Munger, once remarked in an interview that no fewer than three times in the fifty plus years they ran the business, they watched the quoted market value of their Berkshire Hathaway shares collapse by 50% or more peak-to-trough. Despite this, the stock ultimately ended up increasing from around $8 per share when Buffett began building his position to $216,200 per share.
What if they had borrowed against their stock? Unless they had some outside source of liquidity that could be tapped to meet a margin call, any one of those three situations could have resulted in them being forced to liquidate their Berkshire Hathaway shares at a price far below long-term intrinsic value, ultimately costing them a fortune. In fact, one early Berkshire investor (who ended up becoming very, very rich, regardless) did exactly that. The moral of the story is to pay cash for your securities.
In fact, you may want to even avoid having a margin account in the first place to avoid rehypothecation risk in addition to the risk of a margin call.