Six Signs a Stock Might Be a Good Long-Term Investment

Successful Stocks Tend to Have Certain Characteristics

Glasses set on top of a stock report
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When you buy a stake in a firm, there's no way to truly know how the shares will perform. When I invest, I don’t think about whether a stock will rise or fall a year from now, because it has nothing to do with the task of building wealth as I see it.

What does interest me is gaining as much ownership as I can in a broad array of companies I respect and that I trust will grow over time. I look at it as making money by owning part of a company, not by renting stocks. That said, I spend time looking for the types of stock I want to own, then waiting (maybe even years on end) for them to be selling at a price that I think is worth it. I then buy them and sit on them. 

The checklist below is broad and high level. It provides a basic survey of some of the things that I look for when searching for companies I want to own. Keep in mind that the checklist can't promise success. Truth be told a company could possess all of these traits and still go bankrupt due to an event that's not on any normal radar. Still, the features offered here are a good place to begin when trying to choose the assets you want churning out earnings for you for years to come.

Key Takeaways

  • When you buy a stake in a firm, there's no way to truly know how the shares will perform, but there are a few signs that suggest it might do well in the long term.
  • A company may have staying power if it has high returns, and if there are buyers loyal to its products or services.
  • The price of stock can make or break a good deal when it comes to value in the long term.
  • For clues about a company's health, look to how well it treats its shareholders, and if it has been able to survive tough stretches in the past.

You Can Easily Describe How it Makes Money

You might be shocked to learn how many new investors risk their hard-earned money buying stock in a company that they don’t know that much about. You should be able to explain in no more than a few sentences, in simple terms, how it creates its profits. You should also be able to talk about the major cost inputs. For instance, if you're thinking about buying stocks in a tire maker, the cost of rubber will be a factor. If you’re looking to invest in freight or shipping, the cost of fuel is going to matter in how you assess a deal.

Learning about the inner workings of a company is not that hard, and with a bit of research you may be able to narrow your choices. All public stock abides by sets of rules in place to inform people for this very reason. You should be able to access balance sheets and many other public filings that can tell you about a firm's cost structure, its cash flow, its major suppliers, business plan, and much more.

It Generates High Returns on Capital

Whether or not a company can create returns for its long-term owners over many decades will depend on one metric more than others: its return of capital (ROC). This is a way to measure how much profit a company can make compared to the amount of money that shareholders and others invest into it. Simply put, it tells you well it turns cash into profit.

The best models produce high returns without the need for a lot of, or any, borrowed money. Instead, they churn out cash that the owners can extract without harming the core workings. In fact, one way to think of healthy returns is as a failsafe against taking on too much debt, because why borrow when there's cash coming in?

In this era of the rise of tech stocks, many experts claim that ROC can tell you much more about a firm than how well it turns a profit. In some cases, high ROC may act like a sort of "moat" against tech stocks, and measure how well they can adapt to changes in their industry.

Its Products or Services Are Competitive

Most people don’t care which brand of screw they pick up at the local hardware store or which farmer grew their corn. They do care, on the other hand, whether a store carries the brand of candy bar or soda they prefer, or whether a local discount merchant sells the brand of toothpaste or mouthwash they've been using for years.

When buyers are highly loyal to a product or service, they are willing to pay more (for what may amount to the nearly the same thing), and the manufacturer or service provider can charge higher prices. This leads to a feedback effect: The firm grows larger, becomes better at scaling, produces more, brings in greater profits, and has more surplus cash flow. That surplus cash flow allows a firm to pay for more marketing and innovation which, in turn, drives brand loyalty even more. And the cycle repeats. But it might take years.

That said, this is a cycle that can produce a great deal of wealth for those who have the patience to stick to their stocks for along time, through the ups and downs that may come with the stages of the cycle, or with market changes.

Management Works to Keep Shareholders Happy

Good companies are often in the habit of returning surplus cash to their owners. It may come in the form of clever share repurchase plans, or a healthy dividend plan (such as one that grows at a rate far in excess of the broader rate of inflation).

In other words, you want to invest in people who have your best interest at heart. You want them to nurture a culture that measures success by how the firm does for you, the owner, not to mention how they treat others who may have even more at stake, such as the people who work for them.

Though it's not a common way to measure the value or future worth of stocks per se, you can tell a lot about a firm's staying power through its culture, and how it treats the people it employs. If it is willing to invest in perks for their workers (like superb health plans), it points to faith in their future earnings, as well as current cash flow to spare.

More than a few times in my career, I’ve come across a firm that had great figures on the balance sheet, only to find out that the people at the top were taking advantage of their owners. This can take many forms, like obscene options grants, paying execs much more than they were worth, or making strange deals with suspect "partners" (such as forming a deal that turns out to be a ruse for paying into a friend's side gig).

Shares are Priced Fairly

Even the most solid and highest earning stock on the market can make for a bad investment if you pay too high a price for it. Many would argue that price is the factor that stands out above all others in the long run. This is because even a lousy business bought at a cheap price can result in high earnings and wealth in the right context. The perfect scenario would be to find a company that you trust and respect, that happens to be selling stock at a fair price.

If you're new to the market, you may not know how to tell if a stock is priced fairly. Frankly, this is something that even seasoned traders struggle with. The reason for this has to do with the fact that a stock's value itself can be tricky to pin down. A stock's price, though it may rise or fall over time, is always expressed as a simple dollar figure. It's value, on the other hand, will differ based on what you hope to get out of it. A stock priced at 50 cents per share that just went public (and trending wildly up), may have a great deal of value for a day trader who wants to take a risk on a fledgling IPO. But if you invest with the aim of long term growth, this same stock at 50 cents a share might not present that much value to you because there is too much risk.

Experts can spot a bargain stock by tying its value down to other figures. You can do as the experts do: Compare price to sales, earnings, returns, cash flow, book value, or any number of metrics, so long as you know the context.

It Can Survive When Times Are Tough

Without a doubt, there are times when storms will arrive in the market. Often, these storms will provide no warning before showing up and wreaking havoc on your bottom line. The market is marred and shaped by ups and downs, and those that stand to win (or lose) the most are those that invest in these extremes.

One way to protect against this risk is to shift how you invest to focus on companies that are strong enough to survive even the darkest days. They should be able to maintain prices to some extent without having to issue stock at deep discounts. (If so, it could amount to you having to sell off your shares in exchange for a bailout.)

Sure, these types of stocks might grow a little on the slow side, or provide a mere fraction of the thrill you might get from others, but you'll be glad you put your trust (and your money) in them when the maelstrom is raging all around you.