5 Possible Signs of a Long-Term Investment

When I started to invest in the stock market, I was overwhelmed at first. Seeing a lot of opportunities but as always never enough money to buy whatever you want. Therefore, I narrowed the field of interesting companies based on my investment strategy. It is tough when your first investment is virtually losing after conducting research carefully. You could also have experienced this and it will test you as an investor.

However, I decided to focus primarily on the long-term. In the short-term, there are many factors that affect the stock market. You could ask yourself the following after learning the unpredictability of the stock market over a shorter period; How can I find a good long-term investment? There are many ways to get there and we will find out together.

Keep focused on the fundamentals

Experts in investing prefer to look at the fundamental factors of a company to decide if it qualifies as a good long-term investment or not. An important aspect is the financial health of a company and whether their stock is trading below their actual value. Below, I summed a few factors that can help you determine the value of a stock.

• The consistency of dividend When a company’s earnings are predictable, they are able to pay and raise their dividend. They also show financial stability by paying and raising their dividend towards shareholders. You can look back 10 years to see how consistently a dividend was paid by a company to estimate its stability.
• Making improvements In the past, growth companies didn’t give their shareholders dividends because their expenses were close to or exceeded their earnings. In today’s market, it is different because some companies prefer to reinvest and stay competitive instead of paying dividends. It is with the frame of mind that investors will be rewarded through stock price appreciation, which leads to a greater return of investment.

I believe you are either getting better or getting worse. When the latter happens, it will be difficult to catch up with competitors if you don’t acknowledge the fact you have to improve. Other companies won’t stand still and will take (a part of) their market share.

• Look at the Price to Earnings ratio (P/E) This ratio compares the share price of a company with its earnings per share. Companies and investors use this ratio to compare it with other companies and/or past P/E ratios of its own company. You could ask yourself what a high or low P/E ratio is. Luckily, with a few clicks, we know what an average P/E ratio in an industry is.

It depends partly on the sector what a high or low P/E ratio is. For example, if a company has a P/E ratio of 11 while their industry has an average of 15, this is an indication the company has a good valuation. However, it is always beneficial to look at the average P/E ratio of a company for over 10 years. I learned the following; if a company has a P/E ratio of 18, an investor is willing to pay $18 for $1 of the current earnings.

For example, a price/earnings ratio of 100 is often high and could mean that the company is overvalued. However, it can also mean that they expect high growth in the foreseeable future. When this is the case, it is beneficial to look at their forward P/E estimate. Some individuals prefer to look at the trailing P/E because it’s based on facts and forward P/E is based on a forecast.

• Stability of earnings The economy experiences ups and downs. When the economy is strong, it is more likely companies report good earnings. If the economy is experiencing difficulties companies are also more likely to feel this in their earnings. I always try to look if a company often beats its earnings estimate and has rising earnings. A company that often fails its estimates and comes back on its future guidelines is more likely to be perceived as unreliable and experience difficulties moving forward.
• Watch out for value traps I have talked about factors you should look for and what you must avoid is even more important. A value trap is an investment that looks great because of a low valuation such as a cheap Price to Earnings ratio, Price to Book ratio, and Price to Cash Flow ratio. A company becomes a value trap when they aren’t producing material improvements, the ability of innovation, experiencing higher costs, and/ or ineffective management.

A successful and profitable company can also become a value trap when they are unable to continue to generate revenue and profit growth. This can happen because of competitors taking (a part) of their market share, a lack of new products and services, rising costs, and management issues.

Identifying a Value Trap

There are some ways to identify a value trap which is a company that seems a bargain and after your purchase only becomes cheaper. You compare their current numbers with their past performances of several years. For example, a company with a P/E ratio of 10 compared to the overall industry which has a P/E ratio of 14 looks an attractive valuation. However, if the company’s P/E ratio has a 5 year average of 15, their current P/E ratio could be an outlier.

Takeaway

There are many ways to find a good long-term investment and we are lucky to have a possibility to know more with a few clicks. However, it is important to identify red flags and be careful as an investor when trying to find a good long-term investment. I believe when the fundamentals of a company are good it is easier to invest your money and hold for the long-term. Thinking in this way makes it more likely to find a wonderful company at a good price. Warren Buffett said the following about this;

It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price

Thank you for reading and I wish you a nice day.