Worthwhile Stocks Don't Explode, They Grow
The Best Opportunities Combine Strength, Valuation, and Stewardship
When it comes to investing money, a common question for new investors is how to find good stocks to buy. To answer that, you should understand what a quality stock's characteristics are by investigating the underlying financials of the company that issued them.
One characteristic of a good stock is that it will be one you intend to keep for decades to help your family build wealth. Over time, this helps you enjoy a stream of passive income and profit from the tendency of corporate earnings to rise at a rise than the rate of inflation. Generally speaking, there are five aspects to look at before purchasing an individual stock.
Good Stocks Boast Strong Financial Statements
A share of stock represents a piece of ownership in a business. At its core, that is what investing is: buying equity (essentially loaning money) in an organization, in return for a share of the profits (or a promise of them).
As such, a strong potential investment has a balance sheet, income statement, and cash flow statement that prove the business is generating real money by selling real products or services—without fluffing their numbers with intangibles or writing-down the value of an asset. Good investments have also encountered economic storms and prevailed.
It doesn't do you much good if you own shares in a corporation that is a house of cards—a company that folds and tumbles the first time it experiences any significant macroeconomic stress. Famed investor Benjamin Graham once commented that this principle is the one most often violated by inexperienced investors.
Lulled into a false sense of security when times are good, they buy second and third-rate businesses at full valuations, then watch them fall apart when economic storms arrive. The economic cycle creates these storms, and there will always be the threat of one looming.
Additionally, you want the financial strength to be sustainable. You want products that don't change often, have barriers to entry, and have competitive advantages in the form of trademark protections and copyright licenses. Geographic monopolies are stable, and represent the idea Warren Buffett has called "moats."
In this respect, Dr. Jeremy Siegel at Wharton Business School undertook one of the longest-term academic studies of equity market results, proving that boring is almost always more profitable. Siegel suggested that good stocks are hardly ever the sexy investments everyone is chasing, but rather they are solid blue-chip companies that sell everyday mundane items that people always need or want—toothpaste, coffee, peanut butter, and alcohol are examples of this.
The patient investors that dollar-cost averaged into a company like Pepsi, or a family that regularly bought shares of Coca-Cola, and passed them down through the generations are the ones that turned single shares valued at $40 into more than $10,000,000.
Good stocks to buy, to put it another way, won't make you rich this year, next year, or 10 years from now. They will make your family richer over many years, spanning a time covering decades, harnessing the incredible power of compounding interest.
Good Stocks Have Stability and Valuation
Imagine you have $100,000 in savings. You are offered a choice. You can either buy:
- A piece of ownership in the world's largest retailer, boasting an earnings yield of 2.54% after taxes. The business, while successful, is so huge it will have a very difficult time growing profits quickly as there is already a location in every small town and backwoods corner in the nation.
- A sovereign bond backed by the full taxing power of the United States Government, yielding 5.49%. This represents 116% more profit for an investor. Even though the interest coupon won't grow over time, the bond will eventually mature and you can roll the proceeds over into something else. Meanwhile, you can invest that 5.49% in other assets if you want.
Both options represent a slower growth strategy, allowing for the continuous accumulation of wealth over time. However, a bond purchase matures and stops increasing in value, whereas the stocks continue to grow.
This is actually the choice investors experienced around two decades ago when buying stock in Walmart. Walmart has become the definition of a good stock to buy, minting countless millionaires from a network of stores that would take billions of dollars in capital expenditures to replicate.
In 2019, Walmart announced its 46th consecutive annual dividend increase, rewarding owners with more cash. Based on historical increases, Walmart's annual dividend for 2020 is expected to be $2.16 per share, up from $2.12 in 2019 (a $.01 increase per quarter, or $.54 per share, per quarter).
Over recent years, Walmart has an average annual dividend increase of 2.1%. Walmart has witnessed a price to earnings (P/E) ratio (price per share divided by the earnings per share) cover a wide range—in 2019, their P/E was 23.6.
This history of slowly increasing dividends, while stock price to earnings gradually lowers is a good indication of the value of Walmart stock over time.
Be Cautious of Over-Valuation
The Nifty 50 stocks are an index of 50 of the best-value stocks on the stock exchange in India (it's the benchmark of India's National Stock Exchange). During the 1960s, they were over-valued. For a decade thereafter, the owners of these overpriced-yet-excellent businesses suffered staggering losses relative to the major stock market indices.
However, within 30 years, they had actually beaten the S&P 500 and Dow Jones Industrial Average—even with several major bankruptcies along the way, because the surviving firms were such incomparable money-making machines.
When you entrust your money to another person, it is important that they have your best interest at heart. You could find the most profitable business at the lowest valuation—if it's controlled by managers not worried about shareholders, you'll have a hard time translating your equity into real-world cash profits.
Famed mutual fund manager Peter Lynch used to say investors should only buy businesses so good that any idiot could run them—sooner or later, one will. The good investments are well-oiled businesses that take leadership changes without flinching.
You should never forget that history books are full of otherwise promising companies that led to total devastation for the shareholders because of poor capital allocation decisions, strategic missteps, empire-building, or excessive executive compensation.
Tread carefully if you think you might be dealing with those who don't respect your capital. If the vice president is spending $6,000 on gold faucets or the CEO is using the corporate jet to fly his dogs to the family's vacation house, it's indicative of a deeper, morally-based problem. Conduct the necessary research and ask the hard questions before buying into any investment.