When it comes to picking stocks for the long term, there are many different approaches investors can take. Some investors like to go for ‘value’ stocks, which are those trading below their true value. Others like to invest in ‘growth’ stocks, which are those growing faster than average.
My own personal stock-picking strategy combines growth, ‘thematic’, and ‘quality’ approaches. In other words, I look for companies benefiting from big, powerful growth themes that also have the high-quality attributes billionaire investor Warren Buffett looks for in a business.
I’ve found this approach has the ability to generate powerful returns over the long term. Here’s a look at my strategy in more detail.
Picking stocks: my first step
Whenever I’m analysing a company, the first thing I do is look at its long-term growth potential. I look to see if it’s in a high-growth industry and whether it’s poised to benefit from a dominant long-term growth theme.
Companies in higher-growth industries generally have a better chance of generating sustainable revenue growth. This is what you want as an investor as it tends to lead to long-term share price growth.
Some examples of higher-growth industries include online shopping, electronic payments, and cloud computing. All of these industries are set to grow by at least 10% per year in the next five years.
I like industry leaders
Next, I look to see if the company has a sustainable competitive advantage (an edge over its rivals). I’m looking for companies that are leaders in their industries.
A competitive advantage is one of the first things Warren Buffett looks for. That’s because, without this, a company may not be able to protect its profits.
A focus on quality
After identifying leading companies in higher-growth industries I then look at the financials. Here, I look for:
A good revenue growth track record. I like to see growth of 5%+ per year over the last five years as well as forecast growth of 5%+ for the next few years.
Consistent growth in earnings per share.
A high return on capital employed (ROCE). This measure of profitability is one of the first metrics Buffett looks at. I like to see an average five-year ROCE of 15%+.
A strong balance sheet with low debt.
Strong cash flows from operations.
A good dividend growth track record.
Occasionally, I’ll invest in a company that’s not yet profitable. But not very often. I’ve found that by focusing on companies that are already profitable, risk is reduced significantly.
Finally, I look at the valuation. I don’t like paying a sky-high valuation for a stock. However, I’m not afraid to pay more for a high-quality company. Plenty of stocks I buy have P/E ratios in the 25-30 range. As Buffett says, it’s better to buy a fantastic company at a fair price than a fair company at a fantastic price.
Picking the best stocks
Overall, I think this is an effective way of picking stocks for the long term. I use this strategy to find stocks of all sizes in multiple different markets. In recent years, this approach has delivered strong results for me. Some examples of my winners include Apple (+200%), dotDigital (+650%), and Keywords Studios (+130%).
In 2021, I’ll continue to use this approach to pick out top stocks to invest in.
Edward Sheldon owns shares in Apple, dotDigital and Keywords Studios. The Motley Fool UK owns shares of and has recommended Apple. The Motley Fool UK has recommended dotDigital Group and Keywords Studios. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.