In a recent article, I explained how I pick stocks for the long-term. To recap, I look for leading companies with high-quality attributes in growth industries. This approach doesn’t guarantee success. However, it has helped me pick some great long-term winners such as Apple, Microsoft, and dotDigital Group.
Today, I’m adding a little more insight into my stock-picking process by highlighting five key questions I ask when analysing a stock. These questions help me identify the best shares to buy for my portfolio.
Does this company have the potential to be bigger in five or 10 years?
This is a ‘big-picture’ question I always ask at the start of my stock analysis. The reason is that investing, at its core, is pretty simple. If you invest in a company that’s able to grow substantially over time, and invest for the long term, there’s a good chance you’ll make a profit.
If the company isn’t likely to be materially bigger down the line, I’m generally not interested in investing in it.
What’s going to drive revenues higher?
My next question digs deeper into the growth story. Here, I’m looking at ‘why’ the company might be bigger in five or 10 years’ time.
Is the company operating in a high-growth industry? Or is it poised to benefit from a dominant structural trend that’s likely to provide tailwinds? I need to know that, going forward, there’s a clear growth driver.
Does the company have a competitive advantage?
If I’m happy the stock has strong growth potential, I then look to see if it’s a leader in its industry with a strong competitive advantage. Without a competitive advantage, the company may not be a good long-term investment as competitors may steal market share.
Is this a high-quality company?
Answering this question involves taking a deep dive into the company’s financials. Here, I look at revenue and earnings trends, return on capital employed (a key measure of profitability), the balance sheet (I like low leverage), and the dividend track record.
Is the valuation reasonable?
Finally, I examine the valuation and look to see if it’s ‘reasonable’. I focus on that word as I’d rather pay a higher valuation for a great company than a lower valuation for an average company.
I’ve found that ‘cheap’ stocks are often cheap for a reason. As Terry Smith said in his annual letter to investors last year: “Markets are not perfect but they are not totally inefficient either and most of the stocks which have valuations which attract value investors have them for good reason — they are not good businesses.”
Of course, I don’t want to pay a sky-high valuation for a stock. That would increase risk. My goal is to make sure I pay a valuation that still provides room for share price upside over the long term.
Finding the best shares to buy
Asking these questions doesn’t guarantee stock-picking success. Even a rock-solid investment thesis can be obliterated by a black swan event, such as a global pandemic.
However, I find that asking these questions helps me identify top companies that have substantial growth potential. And that gives me a good chance of earning strong returns over the long term.
