3 Key Things to Look for in a Long-Term Investment

Over the years, I have found that there are three main qualities to look for in a company to establish whether or not it is a good long-term investment.

That said, these points may not be applicable to everyone's investing strategy. Indeed, you may have your own criteria before making a long-term investment (we Fools all have our own individual opinions -- that's what makes us Motley). Nonetheless, based on my experience, these qualities are the most telling, and it never hurts to have another view on the matter.

Point 1: Cash is king
MasterCard (NYSE: MA  ) is good at what it does, it generates predictable recurring revenue, and it has strong cash flows. Many competitors have tried in vain to compete with the global dominance of MasterCard and peer Visa, but the top dogs are too well-established and well-known. Still, this has not stopped companies like eBay's PayPal from trying to capture market share, although these attempts have so far been limited.

Indeed, low costs, recurring revenue, and and a near absence of capital spending mean that MasterCard is highly cash-generative and will likely continue to be for so long as it's around. Consider the firm's cash conversion ratio for the last five years. For those unfamiliar with the metric, the cash conversion ratio is calculated as cash flow from operations less capital expenditure divided by EBITDA. It's extremely helpful in determining how much of EBITDA the company converts into cash. The higher the "cash conversion," the better.

 

2009

2010

2011

2012

Average

Operating Cash Flow

$1,380

$1,700

$2,680

$2,950

--

Capital Spending

$139

$151

$177

$218

--

EBITDA

$2,410

$2,910

$3,690

$4,200

--

Cash Conversion Ratio

51%

53%%

68%

65%

59%

All dollar amounts in millions. Source:MarketWatch.com.

On a four-year basis, cash conversion has averaged 77% of EBITDA, which comes down to a combination of high gross margins and low capital-spending demands.

What's more, at the end of the second quarter, MasterCard's current assets covered total liabilities twice, and for the first half of the year the company produced an annualized return on capital employed of 28% and a return on assets of 37%. This would be like receiving a 37% interest rate on savings.

This strong cash flow is allowing the company to buy back stock without digging into cash reserves. During the first half of this year the company had a free cash flow of $2.5 billion, repurchased $2 billion of stock, and paid $150 million in dividends. 

Point 2: With age comes experience
There are many other companies that exhibit similar characteristics -- Coca-Cola (NYSE: KO  ) , for example. The Coca-Cola brand itself was only recently surpassed by Apple as the most valuable brand on the planet after 13 years at the top spot.. Indeed, Coca-Cola and Diet Coke hold the top two spots for the best-selling beverages in the world. 

Coca-Cola's historic performance is extremely impressive and indicates how the company will perform in the future. Since the beginning of 1970, Coke's stock has returned 4,416%. Meanwhile, the S&P 500 has returned around 1,500%, and inflation would have turned the purchasing power of $1 in 1970 to $6.14 today -- a 514% gain. Moreover, Coke is diversified, with an extensive list of products in its company's stable, from water to Vegitabeta. The company leans on its brands, as each one has its own market, meaning that one or even several of the drinks brands could fail without taking the whole company down with them. These brands and their individual followings have been built up over time.

So, based on Coke's historical performance, its diversification, and its experience as the worlds largest beverage company, I believe the company's stock will continue to outperform both the market and inflation for decades to come.

Point 3: Flexibility
My final point is flexibility. A company that is going to be around for a long time needs to be flexible, change with the times, and have a history of changing to meet consumer demands. IBM (NYSE: IBM  )  is the perfect example.

IBM has consistently shown that it can change with the times, giving me confidence that the company will be able to survive, continue to make money, and return cash to shareholders for many decades to come.

For example, according to IBM's 1992 annual report, 52% of the company's $64.5 billion in revenue then came from hardware sales. However, times have changed, and so has IBM. During 2011, 20 years on, only 18% of IBM's $107 billion in annual revenue came from the sale of hardware, while 56% of revenue came from services.

IBM can trace its roots back to the 1880s. The company has soldiered through two world wars, the dot-com bubble, several serious recessions, and a depression. IBM joined the Dow Jones Industrial Average back in 1932, which is extremely impressive, considering the fact that the average time for a company to stay in the S&P 500 is only now only 15 years.

IBM's success lies in its drive to be the most innovative tech company around. Indeed, the company has migrated from a hardware-focused company back in 1994 to an IT services-focused company today. Furthermore, IBM's Thomas J. Watson Research Center is producing some of the most advanced technology the world has ever seen, including the Watson supercomputer.

Foolish summary
All in all, a strong cash flow, experience ,and history of changing with the times are, in my opinion, three key factors that point to an extremely good long-term buy-and-forget investment. 

If a company has a history of meeting all these points, it is likely that it will continue to do so, outperforming its peers over the long term and giving investors' portfolios a strong backbone.

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  • Report this Comment On October 14, 2013, at 5:06 AM, mrplow2000 wrote:

    If your strategy is long term investment (and for most amateur investors this should be the case!) this tool is a great way to check up on the fundamentals of any stock - with a long term view. Note the price isn't even displayed (it's accounted for in the metrics).

    Coca-Cola Company

    http://simplistickr.com/KO

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