Characteristics Good Stocks Share
The Best Opportunities Combine Strength, Valuation, and Stewardship
When it comes to investing money, a common question I'm asked is, "How do I find good stocks to buy?" To answer that, we need to examine what a good stock looks like in the first place. Please understand that from here on out, we won't be talking about stock trading—buying shares at one price hoping to sell them at a higher price in the short-term (which should be defined as any time period less than five years )—but rather, putting together a portfolio of individual common stocks that borrow the best practices of low-cost index funds.
This is a portfolio that you intend to keep for decades to help your family build wealth, enjoy a stream of passive income, and profit from the tendency of corporate earnings to rise at a rate faster than inflation. Generally speaking, there are three key things to look at before purchasing an individual stock.
1. Good Stocks to Buy Boast Strong Financial Statements Resulting From Selling Real Products and Services to Real Customers
A share of stock represents a piece of ownership in a business. At its core, that is what investing is: buying equity in a productive asset so you can enjoy the profits generated by the enterprise. As such, a great firm, by definition, has a strong balance sheet, income statement, and cash flow statement that prove the business is generating real money by selling real products or services—not hope, not some future development, not some turnaround story. It is capable of weathering the 1-in-600-year storm, such as the Great Depression.
After all, it doesn't do much good if you own 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 in his writings 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 the storms of life arrive.
The storms will come. You have to be prepared for them.
Above and beyond this, you want the financial strength to be sustainable. You want products that don't change often. You want barriers to entry. You want competitive advantages in the form of trademark protections and copyright licenses. You want geographic monopolies. You want what 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 to buy are hardly ever the sexy investments everyone is chasing, but rather solid, blue chip companies that sell mundane items such as toothpaste, deodorant, cola, bleach, chocolate, candy, cookies, jam, peanut butter, coffee, ice cream, cheeseburgers, insurance, jet engines, tobacco, and alcohol.
In other words, despite the success of high-profile, exciting businesses, such as Microsoft, which made its investors obscenely rich in the decades following its IPO, most of the money earned by business owners is generated by the prosaic. It's not the hot tech company issuing new shares, it's the person who dollar cost averaged into a company like Pepsi, or a family that regularly bought shares of Coca-Cola, passing them down through the generations, turning a single share costing $40 into more than $10,000,000.
Good stocks to buy, to put it another way, won't make you rich this year. Or next year. Or in three years. They will make your family richer over many years, even decades, harnessing the incredible power of compound interest.
2. Goods Stocks to Buy Must Be Available at Reasonable Valuations
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 percent 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 percent. This represents 116+ percent more profit for you, the 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 percent in other assets if you want.
This is actually the choice investors experienced roughly 15 years ago when buying stock in Walmart. Walmart is a fantastic business. It is the very definition of a good stock to buy, having minted countless millionaires over multiple decades from a network of stores that would take billions upon billions of dollars in capital expenditures to replicate.
In 2018 it announced its 45th consecutive annual dividend increase, rewarding owners with more cash. Its annual dividend for 2019 is expected to be $2.08 per share, up from $2.04 in 2018. This results in a 2 percent increase.
Over the past five years the company has an average annual dividend increase of 5.11 percent. Despite its advantages, even this fantastic company couldn't escape the fact that price is paramount. When investors get irrational, be it about stock prices or tulip bulbs, crazy things happen. As such, Walmart has seen its price to earnings in a wide range, coming down to a more reasonable 19.72 in December 2018.
Had you bought the shares at the nosebleed valuation, you'd have had to wait a long time—many, many years, in fact—for that overvaluation to burn off. On the upshot, there is still an argument that finding good stock to buy is more important if your time horizon is 10+ years. In this case, the discount retailer was such an incredible company that with dividends you would have ended up compounding around an 18 percent return annually over the past three years.
The same thing happened with the so-called Nifty 50 stocks back in the 1960s. For a decade thereafter, the owner of these overpriced-yet-excellent businesses suffered staggering losses relative to the major stock market indices. Within 30 years, they had actually beaten the S&P 500 and Dow Jones Industrial Average even with several major bankruptcies along the way, all because the surviving firms were such incomparable money-making machines.
3. Good Stocks to Buy Are Run by Shareholder-Friendly Managers
More than a decade ago, I wrote an article called 7 Signs of Shareholder Friendly Management. Little has changed since that time. When you entrust your money to another person, it is important that they have your best interest at heart. You could find the best business, at the lowest valuation, and if it's controlled by crooks, you'll have hard a time translating your equity into real-world cash profits you can save, spend, reinvest, gift, or donate.
Famed mutual fund manager Peter Lynch used to say investors should only buy businesses so good that any idiot could run them because sooner or later, one will. The good news is that investors frequently tolerate mismanagement for only so long. The best businesses can withstand a lot of abuse so it can make sense buying into a firm that is poorly run if the core economic engine is intact.
Even still, you should never forget: history books are full of otherwise promising companies that led to total devastation for the owners because of poor capital allocation decisions, strategic missteps, empire building, excessive executive compensation, abuses of power, and other sins. Tread carefully if you think you are 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, moral problem.