It’s easy to get emotional about stocks, especially when markets behave like roller-coaster rides.
That’s why it’s a good idea to stay disciplined in your approach to stock selection. It sounds simple, but the fact is that ignoring short-term gyrations and holding an array of quality stocks for the long term is a time-tested, successful strategy for serious investors.
Of course, it’s important to make sure that stocks do not represent your entire investment portfolio. You need to have an appropriate allocation of assets, with stocks complemented by other asset classes, such as bonds.
With that in mind, some of the most attractive stocks for your portfolio are those that provide dividend income (though keep in mind dividends may be increased, decreased, or eliminated at any time without notice), while providing the potential for long-term growth.
Individual investors who want to own stocks might be best served by owning a basket of at least 20 to 25 of these stocks, selected from a variety of industries and countries, including Canada, the U.S. and western Europe. An alternative is to own mutual funds that follow a similar approach. This is to ensure adequate diversification, which does not guarantee a profit or protect against loss, but has proved over time to be very prudent.
In identifying quality companies, here are four key characteristics to look for.
Operation in attractive industries. You might find that certain industries are particularly appealing because they have high barriers to entry, low capital intensity and beneficial types of regulation. At the same time, it might be best to avoid highly cyclical industries that are overly dependent on a strong economy to produce good growth opportunities.
Strong competitive position. If a company doesn’t command a leadership position within its industry, it should offer other competitive strengths that could help it sustain long-term profitability. Typically, companies with a strong “franchise” or a special niche tend to generate higher returns on capital.
Experienced management teams. Companies led by strong management teams that have a track record of success are most likely to be deploying the firm’s capital in ways that will consistently generate attractive returns for shareholders.
Solid financial positions. Keep your eye on companies that have historically demonstrated consistent growth in sales and earnings, while maintaining a solid balance sheet and strong cash flow. While these stocks typically will decrease in value during inevitable market declines, they may be in the best position to bounce back when markets recover.
After you’ve determined that a company is of high quality, you still need to buy it at the right price. To assess whether it’s attractively valued, look at such traditional valuation approaches as comparing a stock’s price-to-earnings ratio (P/E) to its historical P/E range and to that of its peers. Then there are a number of other, more sophisticated measures and tools that can be employed. Check with your financial adviser to learn more.
Be prepared to periodically add or remove stocks to maintain proper industry weightings, adjust foreign content, reflect rating changes or take advantage of new opportunities. But avoid being too reactionary, by making changes based on short-term setbacks or expectations. Remember that a long-term focus and systematic process may be your most valuable guiding principles.
Past performance is not a guarantee of future results, but it’s safe to say that investing in quality companies at attractive prices has historically been a successful way for individual investors to own stocks over time.
Deborah Leahy is a financial adviser with Edward Jones and member of the Canadian Investor Protection Fund.