How to identify good long-term investments

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CMC Invest

23 October 2023

Key points

  • You don’t have to pick stocks for long-term investing – many people are content to hold broad-based passive funds and ride out market volatility.
  • Investors often look at company fundamentals such as P/E ratios and dividend history to identify what they think are the best stocks for long-term investing.
  • Industries less impacted by economic cycles are often looked to for long-term investments.

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Important: This information is for guidance purposes and may become out of date at any given time. It is not investment advice. Investments can rise and fall in value. We won’t make an assessment of whether the investments you choose are appropriate or suitable for you. If you are unsure of the suitability of any investment, investment service or strategy, you should seek independent financial advice. Capital is at risk.

You know your risk tolerance and time horizon. You’ve determined your financial goals and you’re starting to think long term.

This is a good idea. While no investment is ever guaranteed to generate a return and past performance is never a guarantee of future results, history tells us that markets trend upwards over longer periods of time.  

Investing for a longer period – five or more years – gives the market more time to “do its thing” and for the impact of compounding to work its magic on your money.

Many investors are content to invest for the long term by utilising broad-based passive investment products. But what if you want to try and outperform the wider market by selecting individual stocks to hold for 5+ years? Here are some of the considerations investors often make when looking for long-term investments.

Remember, allocating a greater proportion of your portfolio to individual assets carries more risk and, of course, that when you invest, your capital is at risk.

Pay attention to company fundamentals

Imagine you ran a small bakery. How well your bakery does financially will depend on a few factors. How good are your cakes? How expensive are they? How popular is your shop?

All these factors would impact your business’s fundamentals. They’d impact factors such as your profitability, revenue, and growth projections.

Let’s say you make great cakes and sell them at a premium price – your bakery’s fundamentals would probably look attractive to an outside investor.

Long-term investors look at public companies in the same way, addressing their fundamentals to forecast how successful the business will be.

A couple of fundamentals are often singled out when investors are looking for stocks that can be held for a long period.

P/E ratio – The price/earnings (or P/E) ratio of a stock is calculated by dividing its market price by its earnings.

When a stock has a high P/E ratio it shows investors are willing to pay more for exposure to its earnings.

Generally speaking, higher P/E ratios suggest companies are overvalued. Lower P/E ratios may suggest a company is undervalued and could therefore be an attractive long-term purchase.

However, a high P/E ratio could also indicate that investors are willing to pay more for a stock because they believe it will continue to deliver attractive earnings. And this could mean owning the stock is an attractive long-term proposition.

A lot has been written on what the “optimal” P/E ratio is for public companies. This differs depending on industry and country, so make sure you research and use this ratio in context.

Dividend history – Dividends are a portion of corporate earnings that are paid out to shareholders.

If a company has a long history of paying a dividend and increasing this payment over time, it likely suggests it has a strong financial position. And this bodes well for the long term. Remember, dividend payments may also decrease if there is a drop in the company’s revenue.

Think about the broader economy

If you’re investing for the long term, you’ll want to think about how the stocks you buy will be impacted by the global economy. A lot can happen in five years – think about the sudden effect of events like the Covid-19 pandemic or the US subprime mortgage crisis.

It’s a good idea, therefore, to understand what kind of stocks you’re purchasing.

Defensive stocks – Defensive stocks are those that generate consistent earnings and revenues regardless of the economic environment and are normally attractive in times of economic distress.

They can therefore be attractive to long-term investors since they can deliver steady results over time, meaning there’s less worry about what the economy will look like in five years’ time.

Sectors that are often said to be defensive include:

Healthcare– the global population is aging – particularly in developed economies – meaning demand for care will likely remain high.

Consumer staples – even during times of economic uncertainty, people will likely still purchase essential goods.

Utilities – essential services like water, gas and electricity will also likely always be in demand.

Cyclical stocks – Cyclical stocks are those dependent on economic conditions to deliver revenues and earnings.

Companies like automakers and airlines can be cyclical stocks – when there’s economic uncertainty, people are less likely to buy cars and travel. By contrast, when times are good, people want to spend their disposable income and treat themselves to discretionary purchases.

While cyclical stocks are seen as the opposite to defensive stocks, they can also form part of a long-term investment portfolio.

Holding these stocks long term can help “ride out” some of the volatility associated with them during less favourable market conditions. It’s important, however, that you adequately research companies you’re investing in and understand what economic factors may impact stock performance.

Stick to what you know…

As noted above, finding attractive stocks to hold for many years requires a careful assessment of company fundamentals and how the business will react to economic movements. This can take time and require significant knowledge.

Even investment gurus like Warren Buffett shy away from investments they don’t understand. Buffett himself is even a great proponent of using low-cost index funds when investors lack the time and/or knowledge to do their own research.

Holding a stock for more than five years requires discipline and that’s harder to keep when you’re surprised by how an asset performs. If you’re unsure whether an investment is suitable for you, you should always seek out independent advice.