There are many different ways to invest within a Stocks and Shares ISA. Some people like to invest in dividend stocks to generate income while others like to load up on penny stocks in the hope of generating explosive gains.
Personally, I try to find stocks that have the potential to generate strong, market-beating returns over the long run, but that don’t carry an excessive level of risk. With that in mind, here are three things I look for when selecting stocks for my ISA.
A long-term growth driver
Whenever I’m assessing a stock, the first thing I look for is a long-term growth driver. I’m looking for a trend or theme that’s going to help push the company’s revenues higher (such as digital transformation, the ageing population, etc)
If I can’t see a long-term growth driver, I almost always pass on the stock. Because I’ve found that companies that are growing tend to be better investments than those that are not.
Plenty of quality
If a company/stock meets the first criterion, the next thing I look for is ‘quality’. Now, quality means different things to different people. However, I typically define it is as a company with:
- A wide economic moat (meaning competitors can’t easily steal market share)
- A solid-track record in terms of top-line growth
- A high level of profitability (I look at return on capital employed or ‘ROCE’)
- A solid balance sheet
- A good management team
Why do I focus on quality? Because research shows that over the long run, high-quality businesses tend to be better (and less risky) investments than low-quality ones.
We can see this in the performance of the MSCI World Quality index. It has returned about 13.6% per year over the last 10 years versus 11.2% for the regular MSCI World index.
A reasonable valuation
Finally, I look for a ‘reasonable’ valuation. I acknowledge the fact that if a company is top class, it’s probably going to have a higher price/valuation than a company that’s a dud. Therefore, I’m willing to pay up for quality. I just don’t want to overpay.
So, for example, I might be comfortable with a price-to-earnings (P/E) ratio in the 20s or 30s if a company is world class. I’ll probably pass on a stock if the P/E ratio is over 100, however (not always though).
A stock I’ve been buying
What does this all look like in practice? Well, one stock I’ve been buying this year is Salesforce (NYSE: CRM). It’s a leading software company that specialises in customer relationship management solutions.
The big trend this business is benefitting from is digital transformation. With Salesforce’s solutions (which now include AI agents), businesses can potentially be far more productive and efficient.
In terms of quality, there’s plenty. Salesforce has a high market share, sticky customers, a founder CEO, a good track record in terms of revenue growth, a rising ROCE, and a solid balance sheet.
Finally, the valuation seems very reasonable. Currently, the P/E ratio is in the low 20s, which isn’t high for a world-class software company.
Now of course, this stock isn’t perfect. Today, Salesforce has quite a lot of competition – which is a risk.
Overall though, I see a lot of appeal (and believe it’s worth considering). To my mind, this stock has the potential to deliver attractive returns in the years ahead.
