Why long-term investing is the best bet to grow your wealth

-Warren Buffett

The recent saga around the trading activities of Jane Street have brought to light the huge advantage institutional traders have over retail traders.

It’s very hard for the little guy to compete with the big boys of Dalal Street even if the playing field was completely level, which it’s not.

Whenever there is a big event that moves the market, the retail crowd always ends up chasing prices. On the other hand, the ‘smart money’ is already profiting from the price move that retail traders are trying to ride. This is because they were already in a position to profit.

This can be disheartening to investors or traders who don’t have a lot of money at their disposal.

But it need not be that way.

There is a simple, proven way of creating wealth in the stock market: long-term investing.

Here’s all you need to know about it.

Long-term investing allows an investor to sleep peacefully at night knowing they don’t have to constantly check the stock price every morning.

Also, long-term investing in fundamentally strong stocks can potentially maximise returns while keeping risk under control.

On the other hand, the stock market is not a kind place for speculators and gamblers.

Those who don’t understand the fundamentals of the listed companies they’re trading in will end up losing their money.

When you become a long term investor, you put yourself in a position to beat the market. This is becausethe stock market rewards those who successfully apply therules of long-term investing.

 

Best Long-Term Stocks

If you are ready to take the plunge as a long-term investor, the first question on our mind should be this: What kind of stocks make good long-term investments?

Here it’s important to keep the basics in mind.

Stocks are not pieces of paper. They represent ownership in a business.

With that in mind, we can say the following…

The best stocks for long term investing will be those companies that do the best over the long term.

Now, no one has seen the future.

So, how can you identify the companies that will do well in the long term?

How to Find the Best Stocks for the Long Term

Retail investors should not complicate the process of investing. If you want to build wealth over the long term in the stock market, you should follow a simple checklist that just works.

The good news is that such a checklist exists… and to get started, you need to follow only five steps:

#1 Debt

It’s always a good idea to start with debt levels of the company you are considering.

Ideally, the company should have little debt or should be debt free. Many fundamentally strong stocks have zero debt. You can check out thislist of debt-free companies.

Also, it’s a good idea to look for companies that are actively reducing their debt. As debt is repaid, the company has more cash left over to grow the business or pay higher dividends.

Here’s a list of the top companies reducing debt.

#2 Dividends

The fundamentally strongest companies have rock solid cash flows. They often share this cash with investors as dividends. The best companies usually have a long track record of dividend payments.

This is why these stocks are appealing to long-term investors.

In fact, during market downturns, dividend paying stocks are in even higher demand that usual. This is because investors prefer the safety of the cash flows that dividends provide over capital gains.

Check out the companies with the highest dividend payouts and the highest dividend yield stocks.

There are also excellent companies that raise their dividends every year.

In these stocks you get the best of both worlds: capital appreciation and rising dividends. They are called dividend growth stocks.

Check out the list of dividend growth stocks.

#3 Growth

Companies that maintain consistent sales and profit growth will always be in demand. Check for good growth in both revenue and net profit. The higher the better.

For large companies 15% consistent growth is very good but 12% is good enough. For midcaps and smallcaps the cutoff should be higher at 20% or more.

These stocks are usually not cheap but their valuations become more reasonable when the market falls. This is because profit growth combined with a falling stock price makes these stocks attractively valued from a long term perspective.

Fast-growing stocks get to this point sooner than slow-growing stocks. Unfortunately, these stocks tend to be overvalued at the start of the correction, so the downside can be significant. This is a risk investors have to keep in mind.

Essentially, it’s a waiting game with high growth stocks. If you invest too soon you may end up buying the stock before its valuation has corrected sufficiently.

But if you are patient, the stock market will present you with a golden opportunity to buy these stocks at a wonderful price. These stocks make great long-term investments.

Just remember to avoid companies that are growing their revenues but are struggling to grow the net profit. This risk is usually not worth taking.

Check out the list of fastest growing companies.

#4 Past Performance

Most investors get carried away with the future growth prospects of a company. They can tell you all the reasons why a company’s stock will go up because of some big upcoming corporate action.

But if you ask them how good the company’s past performance has been, you will get a quite different answer. This is what separates average long term investors from good long term investors.

While no investor makes profits in the past, it’s important to study it.

If the company’s financials have been poor in the past, you need to be absolutely sure the tide has turned and the future will be better. If not, then you would be taking a big risk investing in it.

Also, if a stock has done well in the past, then it’s worth checking out if it price movement was driven by fundamental reasons or by speculation.

If the reason was strong fundamentals, and those fundamentals are still intact, you could have a multibagger stock on your hands.

Check out this list of multibagger stocks.

#5 Return on Equity

The return on equity (RoE) is one of the best measures of a quality company. It’s the net profit of a company divided by its book value or net worth.

A high RoE along with low debt is a great combination to look for. Only a minority of listed companies have grown consistently over the long term with little or no debt while maintaining a RoE above 15%.

All great long-term stocks have good RoE, usually well above 15%. Just be sure to use it along with metrics like high growth and low debt.

If you rigorously filter out low RoE stocks, you will get a list of stocks with high RoE.

Conclusion

History is proof that some of the largest gains have come from investing in long-term stocks.

The 5 steps described above is enough to get you started on your long-term investing journey.

As you gain experience a long-term investor, you will look at other aspects too like the quality of the management, quarterly results,track record of dividends, stability of the margins, and more.

Consider all these points holistically. The best stocks for the long term are the ones that have a tick mark against all of them.

Do check out Equitymaster’s stock screener forBest Long Term Stocks in India.

Happy Investing.

Disclaimer: This article is for information purposes only. It is not a stock recommendation and should not be treated as such.

This article is syndicated fromEquitymaster.com.