How to Pick Stocks for Long Term Investment
Read time: 10 minutes
Meme stocks, options and altcoins are fun to trade until you realize they make for terrible long-term investments.
Unlike chasing the next instant rocket, picking stocks for long-term investment requires a deeper understanding of a company’s investment analysis process and knowledge.
In this article, we’ll show you what to look for in stock, the qualities of a strong company and what you should avoid picking stocks for long-term investments. In this article, we define long-term investment with a timeline of 5+ years.
If you’re brand new to investing, make sure you read our:
- 5 Step Guide to Getting in the Stock Market — A Fundamental Guide For Beginners
- The Average Joe’s Stock Market Survival Guide — A Glossary Of Basic Terms Used In The Stock Market
- Invest In A Growing Industry
- Invest In Companies That Fit Your Risk Tolerance
- Invest In Companies With Strong Financial
- Factors To Consider: Cyclicality, Insider Buying And Others
1. How To Pick Long Term Investment Stocks: Invest In A Growing Industry
The first step in picking a stock for long-term investment: choose a growing industry that’s not at risk of going the way of Blockbuster (dying).
Why It Matters: When an industry grows, the companies inside the sector grow with it. On the contrary, If the companies in an industry are losing customers and their products are at risk of going obsolete, then it’s likely that their stock prices will also follow in its direction — down.
- One of the best examples of this is Netflix, the top-performing stock of the past decade.
- Since being founded in 1997, Netflix eliminated the need for DVDs and cable TV — sending many into bankruptcy oblivion.
Ask yourself before investing in a particular company:
- Are there any emerging industries/technologies that could wipe out this company?
- How likely is it that this company will be around in 5, 10 or 20 years?
Investing In Disruptive Industries
In pursuit of higher growth opportunities, investors will often look for emerging “disruptive” industries with high growth potential. These industries have their own set of risks that investors should look out for:
- In many cases, these companies may not be generating any revenue and are still developing their products.
- It could take several years to put a product into market and the stock could be highly volatile until then.
- Many companies at this stage are likely to fail.
According to hall of fame investor Warren Buffett, there were ~2,000 automotive companies in the 1900s. By 2009, only 3 publicly traded automotive companies were left in the US, and 2 had gone through bankruptcies.
Case Study: Investing in Tesla ($TSLA)
An investment in Tesla in 2010 would have made the investor 17,400% over 11 years — i.e. a $1,000 investment would have turned into $174,000.
During this period, Tesla had nearly gone bankrupt several times in 2017 and 2019 and its stock price had crashed more than 50%.
- It took Tesla more than 10 years before having its first profitable year.
- The bulk of Tesla’s stock returns came in 2020 where its stock had grown more than 8x.
The Tkeaway: Early-stage investments in disruptive industries is highly risky.
Then What Should You Do? When learning how to pick stocks for long term, it’s often safer to invest in growing industries that have proven themselves out — i.e. The companies are already making money, and there is a demonstrated need for the product in the market.
The best way to look for this is to find companies with growing sales and earnings, giving them a better chance of surviving recessions.
2. How To Pick Long Term Investment Stocks: Invest In Companies That Fit Your Risk Tolerance
The second step in picking a stock for long term investment is choosing a company with a market capitalization that’s appropriate for your risk tolerance.
Why it matters: Knowing a company’s market cap is essential to understand how risky it is. If you’re parking your money into a stick for the next 5+ years, you’d like some assurance that the company will still be around then.
Definition: Market capitalization is the market value of a company’s outstanding shares. This number is often used as an approximation to the total value of a company.
It is calculated by multiplying the stock’s market price and its outstanding shares, which is automatically calculated in most investing platforms.
Companies are often divided into 4 types of companies based on their market cap
- Micro-cap stocks — less than $300m in market cap (where you’ll find riskiest stocks and infamous penny stocks)
- Small-cap stocks — between $300m and $2b in market cap
- Mid-cap stocks — between $2b-$10b in market cap
- Large-cap stocks — greater than $10b in market cap
Here’s A General Rule:
- The higher the market cap of a company, the lower the risk.
- The lower the market cap of a company, the higher the risk.
Companies With Smaller Capitalization Have Two Common Traits:
- Faster Growth: These stocks will often see higher sales and earnings growth.
- Riskier: These stocks will often be more volatile and riskier than larger-cap companies.
In The Chart Below, We Compare The Performance Of ETFs:
- The iShares Russell 2000 — which tracks the performance of the 2000 small-cap stocks on the US stock exchange.
- The SPDR S&P 500 Trust — which tracks the performance of the largest 500 stocks (by market cap) on the US stock exchange.
Learn more: What Are These Indexes?
The Takeaway: Over the past 20 years, we can see that small-cap stocks have outperformed large-cap stocks. But small-cap stocks also fell harder during market crashes.
So what should you do? Diversify.
A common practice is to diversify your portfolio across companies with different market caps. By doing this, an investor can spread their risk across different companies and enjoy the benefits of growth and stability.
- Caution: Micro-cap and small-cap stocks may not fit everyone’s risk tolerance. Those that can’t afford big drops in their portfolio in the short term might want to stick with mid to large cap companies.
But looking at the market cap alone isn’t the only aspect to look at when learning how to pick long-term investment stocks. In some cases, the market cap could even be deceiving — i.e. in circumstances when companies with zero revenue get sent to ridiculously high market caps and valuations.
3. How To Pick Long Term Investment Stocks: Invest In Companies With Strong Financials
The third step in learning how to pick long term investment stocks is choosing a healthy company at its core — with strong financials — the lifeblood of a company.
This section can be its textbook, but here are some common metrics to look at when analyzing a company (sorry if you hate numbers).
Look For Earnings Growth
In the long run, stock prices are driven by profits and earnings — after all, one of the primary goals of a business is to generate profits. When analyzing a company, one way to look for long-term investments is to look for:
- Profitable companies
- A history of consistent earnings growth
To find how profitable a company is, use free tools like Atom, which pulls and displays financial data in easy-to-read charts.
But if you only look for profitable companies, you could be missing out on opportunities found in growth stocks — which are often losing money from re-investing their sales back into growth.
In the case of analyzing an unprofitable growth stock, investors should look for shrinking losses with a focus on another metric: sales growth…
Look For Sales Growth
If a company doesn’t generate any sales, it can’t make any profits or pay its expenses. This is why you want to see companies that are consistently growing their sales.
- Look for a history (the longer the better) of consistent sales growth.
- Avoid companies with declining or fluctuating sales.
Also Consider Seasonality: When looking at sales, we have to look at it from a year-over-year perspective — i.e. Comparing the same period from one year to the next.
In specific industries, sales might be higher in different seasons (i.e. retail/e-commerce companies will see higher sales during the holidays).
To better understand a company’s growth, we would consider the increase in the one set of months compared to the same months in the previous years.
Use The Altman Z-Score To Pick Stocks For Long Term Investment
The Altman Z-Score is a number derived from a formula — which shows the financial health of a company and the risk of it going bankrupt.
Here’s how to interpret the number:
- Below 1.8 — the company is in the “distress zone” and has a higher chance of bankruptcy.
- Between 1.8 and 3 — the company is in the “grey zone” and has a moderate chance.
- Above 3 — the company is in the “safe zone” and has a much lower chance of bankruptcy.
The higher the number, the safer you are.
When learning how to pick stocks for long term, in many cases, it’s rare to find a company that meets all these criteria in a positive way. We’re flipping through as many stones (companies) as possible to find the best opportunities when it comes to investing.
Looking at the numbers is only half the story. The other half requires understanding the story behind the numbers and what’s driving the numbers.
4. Factors To Consider: Cyclicality, Insider Buying and Others
Just a couple of things to consider when you pick stocks for long-term investment…
How Cyclical Is The Industry?
If you’re trying to pick long term stocks, you might want to avoid cyclical companies. These companies fluctuate alongside economic cycles of expansion and recessions.
- If the economy expands, these companies perform better.
- If the economy contracts, these companies perform worse.
Examples Of Cyclical Industries: oil, housing, construction. Most commodity-based industries (i.e. oil, gold, lumber) are cyclical. Any companies involved in the extraction, production and distribution of these commodities are cyclical.
Why It Matters: They’re often not “set-it-and-forget-it” investments. Unless you’re actively following the market, it’s often better to leave these alone.
In the chart below, we have a stock chart of the S&P Oil & Gas Exploration & Production ETF, which has exposure to the largest oil and gas companies in the US. If you had invested early in the mid-2000s, your investment would only have swung up and down over time.
Can One Single Event Destroy The Company?
When it comes to learning how to pick stocks for long term, it’s impossible to eliminate all risks. Otherwise, you’d be investing in US government bonds to earn 1% of your money.
And when it comes to picking stocks for the long-term, you also want to avoid companies where their success relies on a few key events.
Example: Biotechnology companies — whose futures rely on FDA approvals in the drug development process. Approval can send its stock skyrocketing, but failure to get permission can send its stock crashing.
Why It Matters: This makes them difficult to rely on for the everyday long term investor, who’s unlikely to have much knowledge of the biotech industry. These stocks tend to be highly volatile and have a higher chance of failure.
In the stock chart below of Sorrento Therapeutics, a biotech company that develops therapies for cancer, we see that the company had a roller-coaster decade in trying to push its drugs through FDA approval. An investment for the long-term wouldn’t have gone far.
Are Insiders Buying Long Term Investments?
When analyzing a stock, one thing to consider is what insiders/management teams are doing with their shares.
Why It Matters: There are many reasons why someone would sell a stock but typically, only one reason they would buy: they think it’s going up
- Look for: Insiders that are buying stock in the company.
- How? One tool to use is OpenInsider — where you can easily search a company, and see what insiders are doing.
While insider selling shouldn’t be taken as a negative sign, be careful when many insiders are selling at once.
If the management team owns a large portion of the company’s shares, their incentives are aligned with the company. The better the company does, the more they’re compensated.
With all this information, you’re now slightly more qualified on how to pick long term investment stocks. Next up, subscribe to our investment and stock newsletter to receive the latest market trends, news and analysis.