Picking the right stocks is a hot topic for so many investors. Since you are here, I assume it’s no different for you, and you, too, want to know how to pick stocks for long-term investment.
The answer to that question depends on how you invest. In this post, I will show you one way to single out stocks. It allows you to find well-positioned companies to bring good long-term returns. Or at least increase the odds of doing so because nobody can guarantee any positive returns.
For the purpose of this post, I have started my own test portfolio of quality stocks, so I can give you some valuable insights into what goes into them. I will share the companies I invest in and my analysis of them below.
If you are interested in how my portfolio will perform, simply subscribe to my newsletter to get monthly updates – it’s free and delivers valuable financial information I share with you right to your inbox.
Before You Begin, A Word Of Advice
Let’s directly cut through all the fluff: A long-term stock investing strategy for individual companies is hard work! And picking stocks is hard work!
You put your money into stocks in the hopes of outsized returns compared to the market – With the market, I mean the S&P 500 index. If your goal is not to achieve outsized returns, you should not invest in individual stocks. There is no reason to complicate your investment if you just want to get what the overall market returns. Your money is probably better invested in a mutual fund, index fund, or exchange-traded fund (ETF).
By investing in individual stocks for a long time, you must understand that you are investing in individual companies. That is a high risk, as many things can go wrong in a single company.
Investing in individual companies is a commitment that you make. It will require a lot of research and following the company’s earnings. You should prepare yourself to review the company’s results regularly. Some companies require more work than others. This is especially true if the company is small and relatively early in its growth stage. This complexity is the reason why this post is a bit longer than my standard post.
How to pick stocks for long-term investment is all about creating a system you can use to analyze your performance and the performance of your investments.
With that out of the way, let’s get into the details of how you can pick stocks for long-term investment.
Finding Stable Companies For The Long-Term
My framework, how to pick stocks for long-term investment, is geared towards finding companies with very stable earnings and durable competitive advantages in their business model. To find such companies, your tool is called fundamental analysis.
You will need to love numbers to use such a framework!
This type of analysis will single out stable, profitable, debt-conscious companies that can return big money to shareholders year-over-year. Their earnings are rather predictable, producing a lot of free cash flow – cash they can use to pay debt, dividends, share buybacks, etc. These are the best stocks you can invest in for stable long-term profits.
Another way to think about these companies is that they have operating leverage. But what does that mean? It means that the company is in good financial shape and can control its operating income by simply increasing its revenue.
Some Book Recommendations To Learn
The basis of this framework is financial literacy. Your main skill is being able to read financial documents, like Income Statement, Balance Sheet, and Cash Flow Statement. This is the language of business. If you want to learn that skill, I recommend 2 books that I read about this topic:
- The Basics of Understanding Financial Statements – Mariusz Skonieczny
This small book will give you a really basic and easy-to-understand foundation about financial statements in general. I love returning to this book because it is so compact and well-written. - Warren Buffett and the Interpretation of Financial Statements – Mary Buffett David Clark
If you want to know more details about some metrics and ratios discussed in my framework, this book is an excellent read for you! It is filled with investment wisdom from no other than Warren Buffett himself.
What To Track?
The world of fundamental analysis is vast. There are countless ratios and metrics you can follow for how to pick stocks for long-term investment. But the real value for you is to know which ones to use in which scenario.
My framework is inspired by Warren Buffett, with some adjustments I made. It concentrates on the following metrics.
Gross Margin
Percentage a company keeps from each 1$ of revenue after paying for Costs Of Goods Sold – the money it pays directly to produce the goods.
Operating Margin
Percentage a company keeps from each 1$ of Gross Profit after paying for Selling, General & Administrative costs – research and development, marketing, rent, utilities, equipment, insurance, employee costs, etc.
Profit Margin
Percentage a company keeps from each 1$ of revenue after paying for everything. A profit margin consistently above 20% is a good indicator of a durable competitive advantage. Below 10% can indicate a highly competitive market.
SG&A To Gross Profit
How much of the Gross Profit does a company invest back into its business. You want to see a stable percentage between 25-50%. Companies in their growth stage will invest a lot of money in marketing and research, sometimes exceeding the gross profit entirely.
R&D To Gross Profit
How much of the Gross Profit does a company invest back into its research. You want to see a stable percentage between 25-50%. Companies with high R&D costs can indicate a very competitive industry. Some companies do not require any research to conduct their business, which can be a big advantage.
Interest Expense To Gross Profit
How much of the Gross Profit does the company use to service its debt? An interest Expense between 0-10% is a good indicator of a durable competitive advantage.
Deprecation To Gross Profit
A low Deprecation to Gross Profit between 0-10% is a good indicator of a durable competitive advantage – The company does not depend on costly equipment that will need financing.
Total Debt To Shareholder Equity (Treasury adjusted)
Sometimes, good companies have so much cash flow and competitive advantage that they don’t need to maintain a lot of shareholder equity. Sometimes it can even be negative. By adding back the treasury shares acquired by stock buybacks, we can get a much clearer picture and compare the value much more easily. The resulting value can be interpreted as the amount of $ of debt for every 1$ of Shareholder Equity. A value below 0.8 is a very good indicator of a durable competitive advantage.
Years To Pay Off Long-term Debt
This metric compares the shareholder equity and treasury stock of a company and compares it to the company’s total liabilities. It gives you an idea of how long it would take the company to pay off its entire debt if it were to concentrate on that.
Capital Expenditures To Net Income
Companies with a durable competitive advantage use a smaller portion of their earnings for capital expenditures.
Debt-to-equity
Compares the company’s long-term debt to its total equity. A value below 2 is what we are looking for.
Quick Ratio
We compare the company’s most liquid money reserves (cash, short-term investments, and accounts receivable) to its current liabilities – the liabilities due within the next 12 months. A value below 1 means that the company does not have enough money to cover its obligations.
Current Ratio
We compare the company’s current assets to its current liabilities – the liabilities that are due within the next 12 months. A value below 1 means that the company does not have enough money to cover its obligations.
Return On Assets
This metric measures the company’s profitability in relation to its assets. A value of >10% is what we are looking for.
Return On Equity
This metric measures the company’s profitability in relation to its shareholder equity. A value of >10% is what we are looking for.
Earnings Per Share
This metric measures the earnings per individual share. We want to see a steady rise over many years. Fluctuating values can indicate a company operating in an industry with fierce competition.
Putting Everything Together Into A Framework
I have created my own Google Sheet to track the annual and quarterly financials of the companies I follow and invest in. It gives me a quick way to see how the company’s financials develop over time.
Additionally, I can do the same analysis on a company’s main competitors and get a one-to-one comparison of their earnings qualities. This comparison teaches you the most about the company’s quality.
For the purpose of this post, I have created a test portfolio of 9 value stocks singled out using this framework. I invested an equal amount of money in these companies on February 6th, 2024, and will create monthly posts to look back at the portfolio performance compared to the S&P 500.
DISCLAIMER
These stocks are by no means a recommendation. They are my results for how to pick stocks for long-term investment. You should do your own research and never blindly invest in what you read here. They are solely provided for informational purposes and to test my framework.
My Value Portfolio – My Stocks For Long-Term Investment
For my test portfolio of 9 stocks, I have invested $555 into each company stock – regardless of the stock price at the time. I will not add or remove any money from any position. I will revisit the portfolio each month and look at how it performs. All dividends will be reinvested.
Important Note
I wrote this article from the perspective of a long-term investor. I want to ensure that my readers get information based on my investment philosophy when it comes to stock investment:
#1 Buy and hold Stocks for 5+ years
#2 Have at least 25 Stocks
#3 Don’t overreact on short-term news
#4 Reinvest into your winners
Note that this portfolio is not the only investment I have in the stock market. I invest in many more companies in addition to these 9. A portfolio of just these 9 companies is not well diversified from my perspective.
Inception Date: 2/6/2024
Total investment: $4,995
Here are the 9 companies and their value analysis.
