Picking Stocks for the Long Haul

The key to successful long-term investing is getting the big picture right. You need to figure out how the economy is going to evolve and what sectors and industries will benefit from these changes.

Though you could buy funds to take advantage of these big trends, you'll make more money by focusing on individual stocks. This is what the most successful investors do, and the strategy I follow for our new Zacks service, Strategic Investor.

How do I know which stock to buy? There are 3 specific characteristics that allow to identify the companies with the most upside.

1. Valuation is Paramount

Once I've identified a company that looks poised to benefit from a big trend, I immediately look at the P/E ratio to if matches 3 key criteria:

• The current price is attractive relative to future earnings. After all, I'm not investing on what the company has done in the past, but on the assumption it will be profitable in the future.
• Future earnings will be higher than current earnings. A stock that is growing earnings at 15% per year is cheaper relative to future earnings than one that is forecast to grow slowly (e.g. 5% per year).
• As low as valuation as possible, all else being equal.

Conversely, I will avoid the stock if:

• The expected growth rates are very high, because they have a nasty habit of not coming through. (I always ask myself if the long-term growth rate expected is reasonable or not.)
• Both the long-term growth rate and the P/E are both very high. This goes double if almost all the companies in the industry have high expected long-term growth rates and high valuations.

Understand, however, that given a choice between a low valuation and a high growth rate, I will choose the low growth rate. The reason being that low expectations are easier to beat. Furthermore, low expected long-term growth rates and low P/Es are a good indication that the trend you have identified is not one that the market is already anticipating.

The P/E ratio is the most important of the valuation metrics, but it is not the only one. Also look at the Price to Book, Cash Flow, Revenues and Dividends among other measures.

To seriously outperform the market over time, it is not enough just to be right about a trend, but you have to be right when most people are wrong!

2. The Company Must Also Be Financially Strong

Valuation and growth is not the end of the story, however. I also want to know the company is fiscally strong.

A clean balance sheet means that a company will have the resilience to weather storms, and the flexibility to take advantage of future opportunities.

Key measures I look at are:

• Ratio of Long term Debt to Equity
• Current Ratio
• Fixed Charge Coverage

3. The Zacks Rank Tells Me When to Buy

The Zacks Rank is a very useful timing tool, especially since the long run is a collection of many short runs.

• This timing indicator alerts me to when it is a good time to buy a stock, allowing me to focus on stocks that are both attractive from a long and short-term perspective - a win-win situation.
• The Zacks Rank also alerts me when the future is no longer as a bright as it once was, taking the emotion out of sell decisions.

This is the process we follow at the Zacks Strategic Investor: Find the trend. Zero in on companies that will benefit from it. Then assess and monitor their valuation, fiscal strength, and Zacks Rank potential.

If you think that our process makes sense, the next few hours mark the perfect time to take full advantage of it. You can get the trends, the companies, and the specific moves with savings and bonus reports. I recommend that you look into this special opportunity now because it ends Saturday night, September 26.

Click here for more details about the Strategic Investor.

Sincerely,
Dirk van Dijk, CFA

With more than 25 years of experience as an analyst and portfolio manager, Dirk is Zacks' Chief Equity Strategist. He regularly authors market strategy reports and articles, and appears on many investment TV programs. He also manages the new long-term investing service, Strategic Investor.