Stock picking for long-term investors

History is filled with stories of great investors like Warren Buffett, who made his fortune following his mentor Ben Graham best known for his book "The Intelligent Investor: The Definitive Book on Value Investing" which is considered one of the most influncial books on investing. According to Graham, investors should always aim to profit from the market's irrationality rather than participate in it.

Now there are many ways to pick stocks, but for the purpose of this article, I will focus on how investors with a long-term horizon should pick stocks.

1.????Determine your investment objective/targets:

Every investor has his own goals. Young investors, in general, are more interested in increasing their portfolio in the long run by focusing more on growth stocks, as they anticipate they will earn money through capital gain when they sell their shares in the future. Growth stocks are those companies that are expected to grow their revenues and earnings faster than the market average. On the other hand, older investors are primarily interested in generating regular income in the form of dividend distribution.

Take your time to think about your investment goals, and depending on your goals, you will determine the type of companies you invest in. For example, investors interested in income will search for stocks with high dividend yields and cashflows to support those dividends; however, if the investors goal is growth, they will look at younger companies with a promising revenue growth prospect.

2.????Find companies you can understand

When buying a publicly traded company, you become a partial owner of this business. Therefore, understanding the business you are planning to buy is essential. Before you buy the stock, ask yourself whether you would trust yourself to take full ownership of the business and how you will assess how well the management is doing.

An easy way to find companies that you understand well, is to look around for the products and services you use daily and take a moment to look for the companies behind them. ?

3.????Determine whether a company has an economic moat

Warren Buffet promoted the term "economic moat", which refers to a business's ability to maintain competitive advantages over its competitors to protect its market share and long-term profitability. Like a medieval castle, ?the moat protects those inside the fortress from outside invasions.

After considering multiple companies and their competitors, you need to narrow the list to find companies with sustainable competitive advantages.

"The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage," Buffett said in a 1999 interview with Fortune. "The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors."

The moat can take different forms, such as scale, switching cost, unique brands, patents, and the network effect. Companies that possess such competitive advantages can prevail over their competitors in the long run.

4.????Determine the fair value of the company

After determining the list of stocks with solid competitive advantages, it is time to start looking at the stock price. Valuing a company can be a complex task. There are many factors to be considered, and there are many ways to evaluate the current stock price to determine whether it represents a fair price or not.

Here are a few:

• Price-to-earning ratio (PE): the PE ratio takes a company's share price and divides it by its earnings per share over the past year. Investors can find stocks trading for a reasonable price when their PE ratio falls below its historical average. This metric is best used for well-established companies with steady cash flows. Nonetheless, when the stock price trade below the historical average, there might be a good reason for the stock's low valuation, and a careful analysis behind the low valuation can help you avoid getting trapped with the stock that continues to languish or drop further after buying it.
• Price-to-sales ratio (PS): the PS ratio is more beneficial for companies at the growth stage and are not yet profitable. Again, buying below the historical PS average can be a bargain.
• ?Discounted cash flows model: To perform the discounted cash flows model, you need to estimate the future cash flows that the business is expected to generate in the future and discount them at an appropriate discount rate.

?5.????Margin of safety

The last step to stock picking is to buy companies trading below your estimate for a fair price. This is your margin of safety. In other words, if your valuation is wrong, you are preventing significant losses by buying well below your fair price. You might not need a wide margin of safety for a stock with stable earnings and a strong outlook. Taking 10% off your target price, and you'll probably be fine. On the other hand, you may want a wider margin of safety for growth stocks with less-predictable earnings. Aim for 15% to 30%, depending on how confident you are in your valuation. That ensures that if things don't go as expected.

If you follow the above steps and build a diversified portfolio of stock picks across several sectors, you'll be sure to find some winning investments.

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