Many investors will buy a stock simply because someone told them to, without understanding how a business works. Others will simply buy because it has a low valuation multiple, such as the price-to-earnings ratio (P/E).
Both these strategies are a recipe for disappointing results. When looking for stocks to buy and hold for a decade or longer, there are fundamentals that matter much more than others.
Here is how I research a stock from scratch, utilizing three metrics -- revenue growth, business quality, and management -- to assess whether it is a business worth betting on.
NASDAQ: AMZN
Key Data Points
Betting on revenue growth
According to a study run by the Boston Consulting Group, if you own a stock for one year, the most important metric for expected forward returns is the starting earnings multiple, such as the P/E ratio. However, the best investors do not invest for one year, but a decade or longer, allowing them to enjoy years of multi-bagger returns.
When you look back on what drives stock returns over a 10-year period, revenue growth is the most important factor. Simply, you want to own the companies that will put up the highest levels of durable growth over a decade or longer, such as Amazon, Netflix, or other technology winners of the 21st century.
The best way to hunt for stocks that can deliver strong revenue growth in the future is to look for those growing quickly today. Then, it is important to analyze whether they are gaining market share in their sector, how large the business is today, and how large its addressable market is. A company with 50% market share in a $1 billion sector will have much lower growth potential than a firm with 1% market share in a $100 billion sector.
The latter is where the durable revenue growers can be found.
Image source: Getty Images
Business quality and moats
The second area that matters in analyzing whether a stock is worth owning is business quality. In other terms, investors will describe this as a competitive advantage or a competitive "moat" around the business.
A competitive advantage is important when hunting for durable growth stocks because it helps keep revenue and earnings growing over the long term. For example, a durable growth stock like Amazon has done so well for so long because of its superior value proposition for e-commerce delivery in the United States, which keeps customers around and spending more year after year.
When combined with market-share gains, a business with a high-quality competitive advantage can grow its earnings significantly over a decade.
Management smarts
The good thing about investing in growing, high-quality businesses is the cash that starts piling up on the balance sheet from the earnings and free cash flow they generate. The downside is needing a management team that will take care of your earnings as a shareholder.
Management teams are vital if one is to invest with a long-term time horizon, because one is entrusting them to act intelligently in deciding what to do with the earnings piling up on the balance sheet.
I personally like management teams that make decisions between two options. First, if there is ample opportunity to take cash and reinvest at a high return on invested capital (ROIC), they should do so to reinforce future earnings growth. Second, if there are no good opportunities for reinvestment, the cash should be returned to shareholders through repurchases or dividends.
In plainer terms, executives should either invest to grow if there is an intelligent way to do so, or else relinquish control of the cash and give it to the stockholders.
These three pillars -- revenue growth, business quality, and management's capital allocation -- help guide me in my stock investing decisions, and I think they can help you as well.
