What's A Good Method For Picking A Long-Term Stock In Today's Market?

Includes: KO
by: Patrick Lewis

Today's market makes it very hard to pick a good stock for the long term. Many factors, such as government stimulus, governments' lack of fiscal discipline, genuine market fear, and hype surrounding new technologies can all contribute to the confusion that arises when researching whether a stock can make a good long-term investment. There are a number of metrics such as trust in management, revenue growth, per-share earnings growth, dividend growth, and percentage of market saturation, to name a few, that can be reviewed to determine whether a stock is worthy of a long-term investment. I would like to discuss some ways to use these metrics to help an investor pick solid long-term investments that would help an investor sleep better at night, even during wild market swings.

I'd like to discuss some parameters around how I look at the market. I'm at a point where I have at least 20 more years before I will retire and leave the workforce to ply my fishing skills on the poor unfortunate fish of the world. All kidding aside, I tend to look at forever as a good time period to hold a stock. That doesn't mean I hold all of my stocks forever. Instead I follow the metrics that I used to pick a stock every quarter. Seeking Alpha does a phenomenal job of providing transcripts of quarterly earnings calls for most of the stocks that are traded over the counter in the United States. These calls, along with a company's website, traditionally have the numbers and information that most investors would need to evaluate how a company is doing. If analysts find it important enough to listen in on these calls, then it would be prudent for an individual investor to at least review the call transcript as well. Now that I've shown a great place to go to find some of the current information for a stock, I'd like to discuss some metrics that an average investor can use to evaluate stocks to buy for the long term.

Trusting management. I'm sure that a few people who read this article work for somebody else. Trusting management is a fundamental of any good workplace. If you or I are going to invest our money into a company, whose management we don't even know personally or professionally, then it would seem to make sense that an investor trust the individual running the company prior to investing in it. One of the best ways to look at how trustworthy the CEO of a company (or company President in some cases) is continues to be reading the CEO or President's letter within the company's Annual Statement or Annual Report. These documents are available at company websites, usually in the investor section. Read the letter, and ask the following questions:

1. Does the letter demonstrate that the CEO and company are friendly to shareholders? (look for statements about how the company feels about shareholder return, dividend increases, etc.)

2. Is the letter written so that anyone can understand it? (an investor may never understand all of the ins and outs of a particular business, but sloppy writing or rambling on with technical information by a CEO or President could indicate that the person signing it doesn't communicate clearly or have shareholder value in mind.)

3. Do you feel that this person is worthy of your investment and will do his/her best to grow the company and your investment over time?

The last question is most important. Think of how many geniuses are capable of solving the most complex problems but incapable of explaining the solution in a way that most people can understand. If I don't feel comfortable after reading a CEO's letter that he/she is doing everything that can be done to improve the business, with shareholders' interests in mind, I won't invest in the company. My thoughts are that this person is the face of the business, and will either make deals or hire the people that make deals. If I don't feel comfortable in my only interaction with this person (the letter), which is written and edited before I ever get to see it, then I'm not comfortable with investing in the company because I'm not really sure if my best interests are being considered by this person. I don't want say-so in the company, other than my shares' votes, but if the CEO or President can't relate to a casual investor, I'm not confident that my interests are being considered. That isn't to say that you will ever be able to completely trust a person that you only know through one (or a series) of written letters. Fortunately, we aren't talking about babysitting children; we are talking about an investment. CEOs have been involved in corrupt things, some of them in companies where the CEO's letters were not indicative of this. If the CEO seems trustworthy from the letter, the company still has to be followed in other ways in order to ensure that the company still is a good, long-term investment.

When looking at a company's financial numbers, one item to consider for long-term investment is increasing earnings. After all, if a company can't increase the money it takes in, then it will be more difficult to increase its per-share earnings, or bottom-line profits. Steadily increasing revenues are important because they demonstrate that the company's plan for growth is working. Where the earnings come from is important, but looking through the 10 years' worth of data (or even the past few years if the last 10 aren't available) is important to see if the company is just steadily growing revenues. Companies who on average grow their revenues in the upper single-digits or lower teens each year, in terms of percentages, can be good long-term investments.

The next item that I measure are per-share earnings, or earnings. No company is going to increase earnings every year. 2008 and 2009 were some lean years for a lot of companies, and many saw earnings cuts. Just the same, some of those companies had record earnings in 2004-2007, or maybe even in 2010-2011. Earnings, if viewed over a long enough time period (remember forever) should be a relatively straight line. I personally prefer, as should an investor looking for a good long-term investment, that the earnings line have a positive slope, or be an increasing line. That means that I prefer that earnings steadily increase over a period of time. Steady earnings increases are better, but even some good companies can have choppy earnings. Take a look at the same, 10-year historical data that was used to evaluate the P/E. Look to see if the company's earnings are steadily increasing over time. Keep in mind that during recessions or bull markets, earnings can decrease or increase by larger-than-normal amounts. For a good long-term investment, a steady, upward trend over a long period of time is critical, because it will provide more steady returns on an investment. Remember, we want to be able to sleep at night! Companies like Coca-Cola (NYSE:KO), for instance, have a long history of steadily-increasing earnings. This allows them to continue to pay an increasing dividend, which is the next item that long-term investors should look for.

Dividends are a hot topic right now, especially with the endless chatter about the "fiscal cliff." Companies need not have a dividend in order for them to be considered good long-term investments. I have found, however, that companies that pay a dividend tend to be more stable, and good companies that pay a dividend actually have good long-term returns. I consider a dividend a good-faith return on investment by a company: I'm investing in the company, and the company is returning a portion of the profits it makes to me, the investor, on a regular basis. It's a bit of a thank-you from the company for trusting them with my money. Good, long-term companies that steadily increase their dividends are worthy investments. Good long-term investments should be stocks whose price will increase; a steadily increasing dividend is a sign that the company has been able to continually increase earnings, and is increasing its dividend as a token of gratitude towards shareholders. On top of that, if a company paid a 4% dividend in a year, and the markets were only up 3%, for example, the dividend helps to shield a long-term investment from a short-term period of bad price performance. And, steadily increasing dividends give an investor a "raise" every year, providing higher rates of return years down the road.

The percentage of market saturation, or share, that a company has is important. KO has a large market share, called a "moat" by Warren Buffet, and is not likely to lose it to its competitors any time soon. This market saturation gives it name brand notoriety, and ensures that companies like McDonald's (NYSE:MCD), who serve billions of KO products each year, want that specific name brand in their restaurants. This "moat" gives the company an ability to dominate a market and ensure stability in its revenues. This situation can give it an edge in new markets, because being the biggest thing and popular all over the region or world can make a product very desirable, which can then contribute to increasing revenues and increasing earnings. It doesn't ensure that a company can do what they want or charge what they want, but the "moat" edge over competition can truly help a company achieve steadily increasing revenues and returns.

Company debt is another important item to look for with any investment. Debt values can be found in the company's Annual Statement or Report, usually in the Financial Summary. Some companies, and most good, long-term investment companies, provide three- or five-year Financial Summaries. First consider if long-term debt is going up or down, and why. Secondly consider if short-term debt is going up or down and why.

The "why" is listed in the text of the Annual Statement, wherever the Financial Summary is described. If it isn't in the Annual Statement, the "why" is listed in the 10-K statement, which is on file with the SEC. An upward trend in debt is not usually a good sign unless important acquisitions have been made, or in a case of current times, interest rates are so low that companies are issuing low-interest bonds to provide long-term capital to take advantage of historically-low interest rates. Long-term debt requires recurring interest payments, and can hamper a company's profits and/or prevent them from paying or raising a dividend. Short-term debt, usually earmarked for a specific short-term purpose, is not as toxic to earnings, unless the level of debt significantly increases over the last reporting period (to the effect of a 100% or higher increase). The "why" for short-term debt should be explained in either the Annual Statement or 10-K. If reasons for debt aren't explained well, it could be an indication that the debt situation is negative to the company's business and might make the company a poor choice for a long-term investment. This being said, a very important point needs to be made: if debt goes up at a percentage rate (from the prior reporting period) less than the revenue and earnings percentage rates, then an increase in debt would NOT be a bad situation. Debt increases, for long-term debt, of 20% or higher over the last reporting period need to be looked into prior to investing in that company.

After looking at some metrics to evaluate for a company, we should look at how to pick a "reasonable" price at which to buy a good, long-term investment. Even though it is a long-term investment, it is still very important to not overpay for something.

If an investor looks at a stock over a long enough period of time, its P/E ratio becomes a constant number. This happens because long time periods tend to smooth out market swings, averaging the highs and lows of stocks to a manageable number. There are a number of ways to look at P/E: forward, trailing twelve-months , and current. I do things a little differently, which I'll explain next.

Historical data is a pain to go through. There is so much data available for any stock that an investor can go bonkers trying to assess it. I make P/E simple by looking at a specific point in time. I choose the last trading day of the year, and for a couple of reasons: First, most companies close their business year on December 31. The last trading day of the year represents the last snapshot of the company's stock price as of that date. Second, because per-year earnings often coincide with the close of business on December 31, that last trading day is a "mark" that can be used to apply the stock's price at the end of the year to its earnings for that same year. I understand that since earnings haven't been reported yet for the year/Q4 that the last-trading-day price of a stock isn't a true measure of what the market feels about that stock's earnings. There are some companies who follow the Federal Government's fiscal year, or a different period, but that's just the point I choose. As long as you are consistent by using the same date across each stock, the date really doesn't matter. When using yearly earnings, I have found that December 31, works best for me, and to ease my data gathering, that's what I choose.

Accumulating many years (at least 10) of P/E ratios using the method of last-trading-day price and full year's reported earnings can allow an investor to get a good idea of what a historical P/E of the stock could be. It is very important to use at least 10 years to help smooth out market peaks and valleys. Historical daily stock prices are available from websites like Yahoo! Finance and historical earnings can be looked up on websites like CNBC or InvestorsHub. I especially like CNBC because in the quarterly earnings section of the earnings tab for a stock, the site displays the next year's projected quarterly earnings, which can be added to make the next year's total expected earnings. The next year's projected earnings can be used, with the historical P/E that's been generated, to determine whether a stock is "cheap" or "expensive" as compared to next year's expected earnings. This method requires that an investor believes that the company will meet the projected next-year's earnings.

Because we are investing for the long term, and have looked at long-term trends, it should be easier to avoid worry about short-term swings in a stock's price or market. Good companies that have trustworthy management or increasing revenues, earnings, or dividends tend to perform with more stability through short-term market and economic swings. That doesn't mean that an investor should "invest-and-forget." Investors need to follow their investments and make sure that during whatever review period they choose, their stock is performing as expected. Quarterly reviews after earnings releases or simply following the news weekly about a stock are two good methods for tracking long-term investments. A lot of websites that have portfolio-tracking features also deliver news stories related to ticker symbols. These sites can be used to channel delivery of information that an investor can use to track long-term investments. When a company is underperforming and the outlook over the long-term is negative, an investor can evaluate the stock using the metrics measured here and determine if the stock should be sold or continue to be held. The time period of "forever" mentioned earlier is relative; the assumption is made that a stock will continue to perform as it has historically only to allow a point at which to measure current price and future ability to go up in value. It doesn't mean that investments should not be followed.

In summary, there are a number of metrics that should be considered for any long-term investment. Trust in management, revenue increases, earnings increases, dividend increases, market saturation, and debt, among others, are important factors that can give a long-term investor an idea as to how a business is performing. Digging this information up can be challenging, but the rewards of finding it and using it to make investment decisions can be the difference between making good long-term investments or bad long-term investments. Very few, if any, companies exhibit all of the traits that are mentioned in this article. If a company matches a few of the traits mentioned, it has a much higher likelihood of being a good, long-term investment. By analyzing this information and using historical P/E ratios, an investor can choose a good, long-term investment and buy it at a reasonable price. I've personally used this process to help me sleep at night when investing for my family's future well-being and found that it works for picking good, long-term investments.

Disclosure: I am long KO. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.