How To Identify Stocks For Long-Term Holding
From analysing fundamentals to business transparency, there are many factors to consider when investing for the long term.
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What ace do smart investors have up their sleeve when it comes to holding stocks for the long term? How do they identify the stocks that end up delivering great future returns? What quantitative and qualitative data do they factor in for boosting the probability of long-term profitability?
As much as it is tough to predict the outcome of stocks in the distant future (even the smartest of investors get it wrong sometimes), certain thumb rules help determine whether a particular stock is a reasonably sound long-term buy.
Here are some tried and tested strategies that can help you identify and buy stocks for long-term holding:
Fundamental analysis of stocks
A thorough fundamental analysis is critical to identify a stock’s future potential. The below factors provide an indication on how financially sound a company is, the intrinsic value of a stock and whether or not you should buy it.
● Earnings: A stock’s past earnings and earnings forecasts are important indicators of the company’s performance. If a company has posted rising earnings consistently in the past years and its revenue forecasts/forthcoming profit reports appear positive, its stock is worth contemplating. On the contrary, it’s better to steer clear of a stock with erratic earnings.
● Price/earnings ratio: The P/E ratio, calculated by dividing the share price by the earnings per share, is used to ascertain whether a stock is overpriced or under-priced. By comparing a stock’s P/E ratio with that of its competitors and/or industry, one can determine whether its valuation is attractive. A lower P/E ratio would make the stock a relatively attractive buy vis-à-vis its competitors/industry.
● Dividend: If a company has been consistent in paying dividends, it’s a pointer towards financial stability. Look at dividend payments over the past five years and you’ll get a picture of whether earnings are consistent enough for the stock to warrant investment. In fact, if you can look further back to perhaps 10 years that will give you an even better basis for your decision.
● Debt ratio: Calculated by dividing the total liabilities by the total assets of a company, the debt ratio indicates assets funded by debt. A ratio of more than one signifies a company’s liabilities surpass its assets and the company risks defaulting on debt in the event of interest rate increases.
● Current ratio: The current ratio is ascertained by dividing a business’s current assets by current liabilities and reflects its liquidity position, which helps assess the stock’s value vis-à-vis its current price. A higher current ratio, e.g., five, means the company can fund five times its liabilities, a positive indicator.
This boils down to going past the numbers game and looking at a stock’s intangibles.
● Scale: The bigger fish in the pond will have scale of operations, brand equity, resources to help growth, etc., which are likely to aid long-term returns.
● Innovation: A business with a history of innovation is likely to survive changing economic landscapes, whereas, as the past has shown us, companies that have failed to adapt have ultimately witnessed stagnation and their stocks have eventually become worthless.
● Transparency: A transparent company is a trustworthy one. Such companies will proactively provide ample information to investors with regard to company operations, performance, revenue, pricing and even business value. You can make better investing decisions in the case of transparent companies.
● Corporate governance: Good corporate governance, with a trustworthy management and board, helps build investor confidence and is a positive marker if you wish to invest in the stock for the long term.
Some other tips
● Avoid penny stocks: Some stocks with low value can be enticing because of the low price and owing to the perception there isn’t much to lose. Fraudsters also spread rumours about penny stocks and many buy by following the herd and regret their decision later. The belief that there isn’t much to lose when investing in penny stocks is grossly incorrect since a loss is a loss, whether arising from a penny stock or an expensive scrip. Penny stocks are highly volatile too, and therefore not a great investment option for the long term.
● Analyse, don’t assume: Never take a hot tip on its face value and invest your money without doing thorough analysis and your own due diligence. As much as following the herd is easy, others investment strategy and risk appetite may be vastly different from yours.
Holding stocks for the long term and generating profit from them requires rigour, thorough data analysis, patience and discipline. Whether you’re betting on a stock’s growth, value or dividends, back your strategy with analysis and be patient. After all, it takes more than a day to make money.