Tuesday, October 6th, 2015

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Picking Stocks for the Long Haul

Buying stocks you can hold in your portfolio for years is quite a different process than buying a stock you expect to sell next week. Of course, there is no guarantee that once you buy a stock with an eye to the long-term you’ll never have to sell it. But identifying companies that are more likely to turn in a solid performance over the next five to 10 years isn’t that difficult if you focus on three key areas: Growth, Quality, and Value.

Going for Growth

Long-term stock investors hold one truth to be self-evident — that ultimately, over the years, one factor can usually drive a stock’s share price higher and higher. That single factor is the growth of a company’s earnings (the company’s profits). In turn, a company’s overall growth is ultimately dependent on the company’s growth of sales or revenues. Companies that sustain earnings growth over the years are likely to be rewarded with ever-rising share prices. On the flip side of the equation, companies with no profits can rarely be considered solid long-term holdings because it’s impossible to predict when (or if) those companies will be able to maintain growth over the years or even stay in business.

A company reports its earnings per share, or EPS, each quarter and each year on its financial statements, which are summarized in reports filed with the Securities and Exchange Commission. Other financial news web sites report the EPS growth in the past as well as the future growth expected by analysts.

If a company demonstrates the ability to grow its earnings over time, you can reasonably expect similar performance in the future. Just remember, though, that since most companies experience a slowdown in growth as they get larger, you should expect the growth of even the best companies to slow a bit over the years.

Growth is the first benchmark to look for as you go through the process of selecting a stock to buy. If the company you’re researching doesn’t have a solid history of earnings growth, consider it a candidate for speculation, not investment. A company may increase its sales year after year, but unless it also consistently demonstrates its ability to convert those revenues into earnings (or profits), you can’t be sure the company will ever figure out how to make a buck.

The Quest for Quality

Once you’ve identified that a company is growing at a reasonable rate and should continue to do so in the foreseeable future, you’ll want to make sure it is built upon a stable foundation of quality. Besides being able to grow its sales, the company has to be able to generate sufficient profits from those sales and, in addition, provide a sufficient return for its investors. Well-run companies that consistently achieve these two goals will outperform their peers.

If you are looking for stocks that you can buy and hold for many years, you want to own solid, well-run companies. A company’s management holds the keys to its success. But since you can’t conduct in-depth interviews with the CEO and other members of the management team, you’ll have to look at some other criteria. For instance, how do the company’s profit margins stack up against those of their competitors? Has the company generated a decent return for its shareholders over the years?

A View on Value

The final benchmark in your quest to purchase suitable long-term stock is value. While you should aim to own a portfolio of well-run growth stocks, you have to be able to recognize when a stock is selling for a bargain price and when it’s selling at a premium. Simply finding high-quality, growing companies isn’t enough to make a successful investment. You also have to know when it’s the right time to buy a particular stock. Buying a stock when it is undervalued will enhance your possible total return. Knowing the potential upside of your investment, as well as the potential downside, is key to making sure you have a good shot at your target rate of return.

The most common measure of a stock’s value is its price/earnings (P/E) ratio. The P/E ratio compares a stock’s price to its earnings. It’s often described as how much investors pay for each dollar of a company’s earnings. P/E ratios can be used to compare a stock’s current price with its historical prices to give you an indication of how the stock is valued today compared to a point in the past. You can also compare the P/E ratio of a stock to other stocks in its industry, or to the market in general, or to an industry average.

Putting Dollar-Cost Averaging to Work

Rather than try to find the absolute best time and price to buy a stock, many investors use dollar-cost averaging to invest in shares over a long period of time. Dollar-cost averaging allows you to build a portfolio by investing a fixed amount on a monthly or other regular basis. When you use this method, you can choose companies that are well-managed and growing nicely, and then invest in their shares on a continual basis without worrying whether the stock is currently under-valued or over-valued. Your dollars automatically buy fewer shares when the price of a stock is high and more shares when the price is low.

Dividends Can Add to Your Returns

For dividend-paying stocks, the dividend can provide an extra boost to your investment return and should also be considered. The amount of dividends a stock pays on an annual basis is its yield. A stock with a yield of 2.3% is expected to pay dividends that amount to 2.3% of the current purchase price of the stock. You can compare the yield to the interest you receive on an account at your bank, but it’s important to note that dividends aren’t guaranteed and could rise or fall.

Wrapping Up

By following the three benchmarks of Growth, Quality, and Value, you have a better shot at investing successfully in common stocks and growing your portfolio. You can learn a great deal about a company by reading its financial statements, press releases, news stories, annual reports, and other documents. As you become more experienced, you’ll learn how best to interpret the information you discover in those documents in order to help you make better investing decisions.

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