When you invest in the stock market, you may generally have a long-term outlook on the stocks you purchase. It is common to expect that over several years, the stocks will appreciate significantly, thereby delivering substantial returns. However, this is not always guaranteed because it is impossible to predict how stock prices will move — whether over the short term or the long term.
So, if you want to invest in the equity market, you need to know how to pick stocks for long-term investments. This is quite different from how to pick stocks for short-term trading, which involves using technical analysis.
Let us begin with the basics.
The secret of how to choose stocks for the long term - Fundamental analysis
Fundamental analysis is the process of evaluating the fundamental financial metrics of a company to identify its true worth or value. Once you determine the intrinsic valuation of a company using fundamental analysis, you can compare this value with the prevailing market price. This will help you identify if a stock is overvalued (where the market price > the true value) or undervalued (where the market price < the true value).
As for how to pick stocks for the long term using fundamental analysis, the consensus is to choose stocks that are undervalued. This is because, with time, when the market realises the true value of the company and a correction occurs, such undervalued stocks will gain value, thereby resulting in capital appreciation for the investor.
How to choose the top stocks for long-term investments - Key strategies
While fundamental analysis forms the core of how to choose stocks for the long term, you need to have some practical and actionable strategies to help you with this. Here are some tips that you can use to identify potentially good long-term investments in the equity market.
Check the P/E ratio
The P/E or price-to-earnings ratio is a shortcut to company valuation. It measures the current market price of a company against its Earnings per Share (EPS). A high P/E ratio means that investors are paying much more for the stock than its earnings warrant. This is a signal that the stock may be overvalued. Ideally, you must choose stocks with a low P/E ratio to benefit from potential future gains when a market correction occurs.
Look for dividend-paying stocks
Another way to pick stocks for long-term investments is to look for companies that regularly pay out dividends to shareholders. Generally, established companies with years of experience in the market tend to pay dividends more generously because they are stabler than companies in the growth phase. While this strategy may not focus solely on long-term capital growth, it gives investors the benefit of regular income.
Analyse the company’s earnings
Many investors tend to adopt a myopic view and look into the current earnings alone. However, if a company has had a good run this year because of extraordinary events, it may be difficult to sustain this momentum over the long term. To pick the best stocks for long-term investing, you need to look for consistent growth in earnings, which may translate to capital growth over the years.
Beware of value traps
A value trap is a share that appears to be undervalued and, therefore, attractive to buy. However, this low valuation may be misleading because it could stem from actual inefficiencies in the company rather than incorrect market perception. This means that when you invest in a stock that is a value trap, it may never increase in value with time. To avoid such stocks, evaluate the company’s profitability, debt structure and operational efficiency.
Evaluate the company’s management
Another important aspect of how to pick stocks for the long term is to look into the management of the companies you are interested in. Entities that are managed by a robust team of professionals have a higher chance of performing better over the long term. Inefficient management, on the other hand, could lead to underperformance, financial losses and even litigation issues — all of which may result in a decline in the stock price.
Perform sectoral analysis
Sectoral analysis is another crucial part of learning how to choose stocks for the long term. This is because even if the company is poised to perform well, the stock may not be a good investment if the sector it operates in has poor long-term prospects. To evaluate a sector, you need to look into quantitative aspects (like historical performance and valuation metrics) as well as qualitative aspects (like regulatory, economic and regional trends).
Look at the big picture
Beyond company-specific factors and the sectoral outlook, you must also look at the big picture and study economic trends. If a recession is around the corner, the markets may decline, making it an unfavourable time to take a long position in any stock. However, if the economy is booming, you can use the strategies outlined above to choose stocks for the long term and invest in them.
Conclusion
The strategies on how to pick a long-term stock, as outlined above, can help you get started with investing in the equity market. That said, you need to keep in mind that these tips can only improve the chances of choosing stocks that have the potential to deliver high returns. In the equity market, however, there is no guarantee. If the market moves unfavourably, you may lose a significant portion of your capital.
You can offset some of this risk by diversifying your portfolio and investing in bonds alongside your equity investments. This way, even if some of the stocks you have invested in do not perform well, the gains from the bond market can minimise such losses.
