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How to spot a long-term winner

14 July 2016

Picking stocks successfully is as much an art as it is a science. But successful investing is not about taking a punt on one or two shares; it’s about diversifying across a spread of companies and investments from a wide range of industry sectors.

The value of investments can fall as well as rise and you could get back less than you invest. If you’re not sure about investing, seek independent advice.

What you’ll learn:

  • How to pick shares which potentially offer the most promising investment opportunities over the long-term.
  • What to look for in a company that might suggest it's a long-term winner.
  • Which pitfalls you need to look out for.

Even for well-seasoned experts, the art of choosing which stocks to invest in can be a tricky task, especially given there is no shortage to choose from.

The trading hub that is the London Stock Exchange is itself home to more than 2,600 companies.1

But successful investing is not about picking just one or two shares; it’s about diversifying across a spread of companies from a wide range of industry sectors and other investments to ensure all your eggs are not in one basket.

Shares can be volatile and their values can fall as quickly as they rise. You may not get back any of what you put in. But over the long-term, returns have tended to beat those you can earn from cash. But remember, the higher the potential return - the greater the risk, and the past performance of investments is not a reliable indicator of their future returns; what’s happened in the past may not happen again.

If you are planning to create your own portfolio of investments, it is crucial you do your research and understand that investing is about being committed for the long-term, with a minimum five-year time horizon usually recommended.

But equally as important is having a very clear idea of what you want to achieve - for example are you looking for growth or income - or a combination of the two?

Income or growth

If income is your main goal, have a look at dividend-paying companies, which means firms that have in the past shared their profits with their investors through paying dividends. Pharmaceutical stocks for instance tend to have a reputation as decent dividend payers. Although always remember that dividends are not guaranteed. If a firm gets into financial trouble, it can reduce its payout or even cut it altogether, as some banks did during the financial crisis.

Growth companies on the other hand tend to reinvest their profits in a bid to help the business grow, by say expanding internationally, or developing new services and products.

But even if growing your capital is the main priority do not discount dividend payers altogether as you don’t have to take the cash. You can instead choose to reinvest the proceeds back into your portfolio, which could potentially have a major impact on your overall long-term total returns, given that you are boosting the base of your capital.

Picking stocks

Investing in companies you know and understand can be a good way to get started. Well-established companies with well-known brands are generally viewed as less likely to go off the rails and easier to analyse.

While identifying star performers isn't easy, look for companies with a combination of traits that make them possibly compelling investments.

Warren Buffett, the world’s best-known investor and billionaire has previously talked about seeking out firms with an “economic moat” by which he means companies which not only have a very strong brand, but have a competitive edge in their marketplace. Such businesses are typically protected from disruptive forces, such as being made obsolete by technological changes.

Other characteristics to look for are relatively predictable earnings that haven't tended to suffer too much in market downturns. In addition, look for companies with the ability to achieve high returns on investment without having to rely on excessive borrowing.

Cash generation is also vital as the amount of money a firm earns determines whether it can readily invest in new opportunities or reward shareholders with attractive dividends.

Doing your homework

Before investing, have a look at a firm’s website and check out its latest results, and how it views its prospects. But bear in mind, just because a stock has done very well in recent times, this doesn’t mean its fortunes will continue.

One way of assessing whether a firm is worth investing in is to check out what its price-to-earnings (PE) ratio is, which can be found by dividing a share value by the earnings per share over the past year. The theory is the higher the PE ratio, the better the investment looks. But a low PE may not mean a share is a bad bet but rather it’s undervalued by the market. To get a clear idea, compare PE’s of firms in the same sector.

If you are an income-seeker ensure that you avoid falling into any dividend traps. Firms in the main look at least to maintain, if not increase dividend payouts every year but many fail to achieve this.

Just because a firm is carrying a high payout, it does not mean it is a good investment. It can often be the case that a rise in the yield comes in the wake of a falling share price, and the firm may struggle to grow its dividend - it may even have to cut it.

Examining a share’s dividend cover will indicate how likely it is that a company will maintain, if not grow their payouts. You can find out a firm’s dividend cover by dividing its earnings per share (EPS) with its dividend per share (DPS). For example, if a group’s EPS is 100p and the DPS is 50%, then the cover total is two. The general rule of thumb is that a dividend cover of two or more represents a decent level of cover, although some groups, such as utility firms, well known for their reliable earnings can carry lower cover but are still viewed as steady payers.

Keeping track

If you are happy to build your own portfolio of individual shares, stay disciplined and leave emotion out of the equation. Just because a share looked like a good investment six months ago, this does not mean it will be now - realising when to sell is just as important as knowing when to buy. Also as time moves on, the make-up of your portfolio will inevitably change, as some companies will have flourished, while others unfortunately may have floundered. As such, keep an eye on your investments and ensure you rebalance by banking some profits and/or reinvesting in other shares to keep an allocation you are comfortable with. Investing in steady winners and maintaining a portfolio is not an easy undertaking so remember you can always pass the responsibility to a professionally-run equity fund, where a fund manager can do all the legwork and stock selection on your behalf.

Remember that sensible and successful investing is not about betting on one or two shares; it’s about diversifying and spreading your risk across a wide range of stocks and other investments from a wide range of sectors.

Always bear in mind that all investments can fall in value; you may get back less than you invest. If in doubt, or you need help with your investment choices, you should seek professional independent financial advice.

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