You've decided that investing in stocks might make sense. You like the idea of trading infrequently -- buying a stock in hopes of never selling. You're tired of making stock brokers a little rich, and you're thinking there might be a lot of long-term money in all this. But, of course, an investment approach that steers you into holding a stock for perhaps decades should make you awfully picky about which stocks to buy! Pick the wrong one, or few, and you might get very little return for a very long time.
Understanding a company's business is essential to successful investing. With that in mind, here are some guidelines for choosing high-quality stocks that you can buy and hold for years.
First, though, consider a basic philosophy:
As investors, we want to buy great companies at good prices.
It may seem obvious, but we want to hammer home the point that there are two requirements here. First and foremost, we focus on great companies. Price is secondary, but in no way is it unimportant. Overpaying for a great company may not be as fatal as overpaying for a garbage company, but it does not portend great returns.
Just the same, NOT selling a company when it has become absurdly overpriced can be just as bad a mistake. During the Internet bubble, it was silly for investors not to look at many of their tech holdings say, "Well, it doesn't get much better than that, folks," and move on.
Now, here are some specific criteria that make companies great:
- A sustainable competitive advantage
- Dominance in its industry
- An established track record
- Solid sales and revenue growth
- Great management
- A reasonable purchase (or holding) price.
Let's look at these in more detail.
1. The company must have at least one sustainable competitive advantage. The more, the better.
Companies with sustainable advantages are sheltered from competition. They have powerful brands, a deep-seated corporate culture, low-cost processes, de facto monopolies or standards, patents, or unduplicable distribution systems.
A sustainable competitive advantage is the fertile soil for creating long-term wealth. As Warren Buffett often quips, find a company surrounded by a wide moat filled with crocodiles, and you've taken the first step toward identifying a company worth owning for many, many years. Finding companies with at least one sustainable competitive advantage is another step toward locating stocks you'll want to hold for a long time -- maybe decades.
In looking at competition, be sure to take a wide view. The competitive landscape holds more than a company's head-to-head rivals. Competition also includes powerful buyers and suppliers, the threat of new entrants, and the threat of substitute products. Intel Chairman Andy Grove says: "Only the paranoid survive" in the business world.
But what exactly is a sustainable competitive advantage (SCA)? Here's a definition: It's is not only about doing it better (although that's certainly part of it), but it is also about doing it differently.
There are probably as many varieties of SCAs as there are great businesses. What they all have in common, however, is differentiation -- something that sets apart a company's product or service from the rest of the pack. More specifically, a product or service is differentiated when it is: 1) unique, 2) widely valued, and 3) rewarded for its uniqueness with a premium price.
2. A great company is often dominant in its given industry.
Think of how difficult it would be for another soft drink company to muscle in on Coca-Cola and PepsiCo. Or how much money it would take for a company to duplicate the distribution network of a pharmaceutical oligarch like Merck, Bristol-Myers Squibb, or Pfizer. Or to knock Google off its perch as a dominant search engine provider. The best companies are recognized within their industries as the best. The narrower the industry, the more dominant the company should be.
Note that in many industries, the company need not be dominant overall. For example, there is not one single pharmaceutical company that controls 50% or more of the total market, nor need there be. In restaurants it's the same: There's plenty of good competition among fast-food outlets. What one must control against is the potential for new or existing competition to come up and knock it off its perch.
3. Strong companies have strong track records.
This eliminates many kinds of companies, most notably newer ones. We must not assume that companies that have ascended to power recently will stay there forever, because a market changing that rapidly does not generally settle down all at once. We want a company to show that it possesses good economics through a full market cycle.
So how long is long enough? Ideally, you'd like to see a company go through an entire business cycle, to see how it reacts in both good times and bad. It's an arbitrary number, actually. But in any 10-year period, it's pretty much guaranteed there'll be one or two bad years, so you'll be able to see how the company operates in those economic environments, too. It's possible that a company that looks dominant in a period of economic expansion will collapse when a recession hits. If you make the wrong assumptions based on a period of prosperity, it might come back to haunt you later.
4. Pick companies with solid sales and revenue growth.
The top large-caps have revenue measured in billions of dollars. When you weed out those with slow or no revenue growth, you're left with a select group of survivors. We want big companies, and we would like them to be in industries that have promising futures, evidenced by above-average growth today.
Again, though, there are no hard limits -- and you should be wary of any company that consistently says it's going to grow at rates of 15% or more. Be even more wary of a company that is growing at slower rates than its competition.
That leads us to ask:
- Will the company be more relevant or less relevant in the future as it is today?
- Does the company compete in an industry that will support growth?
- Does the company have lots of options to grow?
Sales growth is the most fundamental indication of an expanding business. While net profit growth is also important, it can be the result of cost-cutting measures rather than pure business growth. Cost-cutting is all fine and well, but we want to isolate a company's ability to sell more and more of its stuff year after year. And that's exactly what sales growth tells us. This metric is easy to calculate. Using a company's income statement, simply divide the current year's sales by the previous year's sales and subtract one.
5. Demand best-of-class management.
We won't know everything about a company, and sometimes managements that the public thinks are fantastic turn out to be anything but (example: Enron). Still, you want to own companies run by managers who are honest and who show above-average skill at increasing the value of people's investments in good times and in bad.
More than 40 years ago in his investment classic, Common Stocks and Uncommon Profits, Philip A. Fisher wrote, "The success of a stock purchase does not depend on what is generally known about a company at the time purchase is made. Rather, it depends upon what gets to be known about it after the stock has been bought."
Fisher's approach was to buy the truly exceptional growth company that, ideally, could be held forever. He summed up the process of finding these types of companies in his well-known "15 Points." These characteristics, in his words, were "to distinguish the relatively few companies with outstanding investment possibilities from the much greater number whose future would vary all the way from the moderately successful to the complete failure."
Using the seven Fisher Points on management quality, here are some characteristics of great management, with their associated Fisher Point number:
- Unquestionable integrity (Point 15)
- Commitment to new product development (Point 2)
- Outstanding labor and personnel relations (Point 7)
- Outstanding executive relations (Point 8)
- Managerial depth (Point 9)
- Long-range outlook on profits (Point 12)
- Open communication with investors (Point 14).
6. A reasonable purchase (or holding) price.
We'd like to be able to buy a company that approaches 60% of our calculation of its intrinsic value and sell it as it approaches 100%. Some companies might grow and NEVER make it to 100% -- the prospects for future business might be improving along with the stock price. To make such determinations, an investor requires a firm understanding of a company's underlying business and future prospects.
Well, that about does it. We can take these new criteria and tape them on the wall or on the fridge or some other convenient place, like, for example, our neighbor's back.
In the short term, the investing community can hammer any individual stock. Expect the stock price of even the company you most believe in to get cut in half at some point. Often, the sell-off will be unwarranted; Mr. Market is just playing games with your short-term emotions.
Keep your wits about you. If the stock has a rapid run up, or begins to drop in price, pull out these criteria and read them again. Do you see problems or issues in the financials that you missed before? The market may simply be telling you "I'm manic!" -- but it may also signal that there is something very, very wrong.
We suggest that you ignore the short-term wanderings of stock prices. Focus on the much harder and more rewarding task of accurately assessing a company's future based on its present financial standing, its managerial strengths, and the scope of its opportunities in the years ahead.
In your search, Fool, you must ask yourself:
- Are this company's products likely to fulfill needs in the future even better than they did in the past and as they do today?
- Does management have the vision and administrative skills to continue its outstanding performance?
- How much opportunity for growth around this planet (and, hey, maybe other worlds someday) is there for this company?
These are extremely difficult questions to answer. But to the best of your ability, you'll want to try. You may get a few wrong. But, remember, one great company compounding market-beating growth over the next four decades for you can pay down your losses many times over.