A Step By Step 5-Point Checklist to Become a Good Long Term Investor in the Stock Market

Has the recent stock market correction spooked you?

The sudden shift in market sentiment from overwhelmingly positive to cautious has given many investors a lot to think about. Stocks that were going up, suddenly reversed their direction.

Short term traders, already unhappy due to the increase in the capital gains tax and STT, faced sharp losses, especially in the F&O segment.

This is why we at Equitymaster, always favour long term investing.

It allows an investor to sleep peacefully at night knowing they don't have to constantly check the stock price every morning.

Also, long term investing in fundamentally strong stocks can potentially maximise returns while keeping risk under control.

On the other hand, the stock market is not a kind place for speculators and gamblers.

Those who don't understand the fundamentals of the listed companies they're trading in will end up losing their money.

Here's what one of the greatest investors of all time had to say about this...

• 'The stock market is a device for transferring money from the impatient to the patient.' - Warren Buffett

In volatile market conditions like we are experiencing now, this quote should be on the top of your mind, dear reader.

When you become a long term investor, you put yourself in a position to beat the market. This is because the stock market rewards those who successfully apply the rules of long-term investing.

So, if you are ready to take the plunge as a long-term investor, the first question on our mind should be, what kind of stocks make good long-term investments.

Here's it's important to keep the basics in mind. Stocks are not pieces of paper. The represent ownership in a business.

The best stocks for long term investing will be those companies that do the best over the long term.

So how can you identify the companies and industries that will do well in the long term? After all, no one has seen the future.

In this article, we attempt to light the way for long-term investors with a 5-point, step-by-step checklist.

Read on to know how you can put yourself on the path to becoming one of the top long term investors in the Indian market.

5-Point Checklist for Long Term Investors

#1 Start with Debt

It's always a good idea to start with debt levels of the company you are considering.

Ideally, the company should have little debt or should be debt free. Many fundamentally strong stocks have zero debt.

You can check out this list of debt free companies.

Also, it's a good idea to look for companies that are actively reducing their debt. As debt is repaid, the company has more cash left over to grow the business or pay higher dividends.

Here's a list of the top companies reducing debt.

#2 Check the Dividends

Next, you should check the dividend payout.

The fundamentally strongest companies have rock solid cash flows. They often share this cash with investors as dividends. The best companies usually have a long track record of dividend payments.

In a stock market downturn, dividend paying stocks are in high demand as investors prefer the safety of the cash flow that dividends provide over capital gains.

These stocks can also provide good dividend yields during a market crash. This is because they tend to fall initially along with the rest of the market. But as soon as their yields become attractive enough, investors jump in and buy them.

This means high dividend paying stocks have an in-built stop loss.

Check out the companies with the highest dividend payouts and the highest dividend yield stocks.

There are also excellent companies that raise their dividends every year.

In these stocks you get the best of both worlds: capital appreciation and rising dividends. They are called dividend growth stocks.

Check out the list of dividend growth stocks.

#3 Is the Company Growing Fast?

Companies that maintain good sales and profit growth during a stock market downturn will always be in demand. Check for good growth in both revenue and net profit. The higher the better.

For large companies 15% consistent growth is very good but 12% is good enough. For midcaps and smallcaps the cutoff should be higher at 20% or more.

These stocks are usually not cheap but their valuations become more reasonable when the market falls. This is because high growth increases per share earnings at a fast pace. This combined with a falling stock price makes these stocks attractively valued.

Fast growing stocks get to this point sooner than slow growing stocks. Unfortunately, these stocks tend to be overvalued at the start of the correction, so the downside can be significant. This is a risk investors have to keep in mind.

Essentially, it's a waiting game with high growth stocks.

If you invest too soon you may end up buying the stock before its valuation has corrected sufficiently.

But if you are patient, the stock market will present you with a golden opportunity to buy these stocks at a great price.

Also, remember to avoid companies that are rapidly growing their revenues but are struggling to grow the net profit. The risks in these stocks are usually not worth taking.

Check out the list of fastest growing companies as well as the top growth stocks in the market.

#4 Past Performance: Ignore it at Your Own Risk

Most investors get carried away with the future growth prosects of a company. They can tell you all the reasons why a company's stock will go up because of some big upcoming corporate action.

But if you ask them how good the company's past performance has been, you will get a quite different answer. This is what separates average long term investors from good long term investors.

While no investor makes profits in the past, it's important to study it.

If the company's financials have been poor in the past, you need to be absolutely sure the tide has turned and the future will be better. If not, then you would be taking a big risk investing in it.

Also, if a stock has done well in the past, then it's worth checking out if it price movement was driven by fundamental reasons or by speculation.

If the reason was strong fundamentals, and those fundamentals are still intact, you could have a multibagger stock on your hands.

Check out this list of multibagger stocks.

#5 Return on Equity: The Secret Sauce

The return on equity (RoE) is one of the best measures of a quality company. It's the net profit of a company divided by its equity, i.e., its book value or net worth.

A high return on equity along with low debt is a great combination to focus on when looking for stocks with the best fundamentals. Only a small minority of listed companies have grown consistently over the long term with little or no debt while maintaining a RoE above 15%.

All great long-term stocks have good RoE, usually well above 15%. Just be sure to use it along with metrics like high growth and low debt.

If you rigorously filter out low RoE stocks, you will get a list of stocks with high RoE.

Conclusion

We have often heard stories on how investing in share markets have led to unbelievably high returns.

Investors are fascinated by multibagger returns that fundamentally strong stocks keep on delivering.

But the most important aspect of investing is often ignored, i.e., the time horizon. History is proof that some of the largest gains have come from investing in long-term stocks.

The key to finding the best long-term stocks is to look at all the aspects of the company. You need to look at the growth opportunities for both revenues and profits, quality of the management, financial performance, track record of dividends, and much more.

Consider all these points holistically. The best stocks for the long term are the ones that have a tick mark against all of them.

Finally, we suggest you check out our stock screener for Best Long Term Stocks in India.

Happy investing!

Disclaimer: This article is for information purposes only. It is not a stock recommendation and should not be treated as such. Learn more about our recommendation services here...