Opinion: How to pick stocks that will outperform for the next 20 years 

Published: Nov 10, 2015 7:59 a.m. ET

Find companies with worthy products or services and a high return on invested capital

Is it possible for investors to pick winning stocks on their own?

The investment-advisory and money-management industry says you can’t — it’s too complicated. But an adviser or manager could do it for you, of course.

As many mutual funds have relatively high management fees, you might be well-served by holding a few individual stocks in your retirement portfolio. That may seem like a radical idea, in light of all the advice not to do so, but some 401(k) plans are actually being changed to allow you to make your own investment choices within brokerage accounts.

In July, as part of MarketWatch’s Fixing the Market series, I discussed the long-term rise in stock-based executive compensation, whether it was a good thing and what investors might do to curb it. Gary Lutin, a former investment banker at Lutin & Co. who oversees the Shareholder Forum in New York, said at the time that investors seeking to hold shares of individual companies need to find ones that are likely to make “real profits for 10 or 20 years.”

Lutin agrees with the conventional wisdom that “index funds are the right way to secure the farm,” because of their low cost, diversification and good track record against most active fund managers.

But in an interview on Oct. 26, Lutin said: “If you want to go beyond securing the farm, invest in five to 10 stocks you are familiar with, based on their ability to compete in the production of goods and services for 20 years.”

Considering how fixated the financial media are on the day-to-day performance of the stock market and quarterly performance of companies, the idea of “going in” for 20 years might seem odd. But it can really pay off.

Nike’s long-term success

For starters, you will want to hold stock in a company that makes products you believe will remain popular, necessary or both, for a long time. For example, we recently discussed Nike Inc. because it had been 30 years since Marty McFly, in “Back to the Future Part II,” had traveled from 1985 to 2015.

McFly wore Nike sneakers in 1985 and bought new ones in 2015. It turned out that among S&P 500 stocks, Nike was the best performer for the 30-year period, with dividends reinvested. The stock returned an astounding 46,922%. This means a $10,000 investment made on Oct. 25, 1985, would have been worth $4.69 million on Oct. 20, 2015.

Anybody would have been hard-pressed to commit to any stock for 30 years in 1985. But even then, Nike had a commanding market position for athletic shoes in the United States, and it was pretty obvious that people would still need the types of products it was making for decades to come.

That part of the stock-selection process is something you will have to keep in mind, because looking at numbers underscoring historical financial success won’t tell you if a company’s products or services may fall by the wayside. But a long-term track record of success could indicate a strong management culture.

Return on invested capital

When Lutin of the Shareholder Forum suggested that investors should try to think decades ahead before making a long-term investment, he was encompassing many factors, including executive pay, and how a company treats its employees, customers and shareholders. But in an interview last week, he said investors should look at a company’s return on invested capital, or ROIC.

FactSet defines ROIC as earnings divided by the sum of the carrying value (not the market value) of a company’s common stock, preferred stock, long-term debt and capitalized lease obligations.

Ralph Segall, chief investment officer of Chicago-based Segall Bryant & Hamill, which has about $10 billion in assets under management, also has suggested ROIC is a useful metric for investors. In an interview on Oct. 30, Segall said that when analyzing companies for possible investments, his research team considers ROIC, “using a discount rate that is broadly market-driven.”

“We do not sort by industry or sector. We just use one cost of capital for all equities,” Segall said.

That’s an interesting statement, because some industries are more capital intensive than others, so it might not be “fair” to compare an auto manufacturer with Facebook Inc. for example, since one requires much more capital investment than the other.

Segall called ROIC “our North Star.”

“It helps us orient where we are and understand why we own something. We know we are going to be wrong about many forecasts. Quarterly earnings are random events. If stocks are going down, we need to know if we misunderstood these or if the market did, in which case it gives us an opportunity to add,” he said.

First, a ‘fair’ comparison

We thought it would be useful to look further at Nike and other apparel and footwear manufacturers, to see how their ROIC compared over longer periods. Since there are only six apparel manufacturers among the S&P 500, we expanded the list to the 19 included in the S&P 1500 Composite Index.

FactSet has five years of ROIC data for 18 of these 19 companies. For Michael Kors Inc. FactSet’s data goes back only three years, but for the past 12 quarters, the annualized average ROIC for the company has been a very high 46.5%. Still, the stock is down 40% over the past 12 months and its three-year return has been a negative 22%. This shows the fickleness of the fashion market. Concerns that slowing economic growth in China will lead to sliding sales of luxury handbags and similar items have weighed on the stock.

It’s easy to show that Michael Kors has achieved a very impressive ROIC, but predicting fashion trends is, at least for me, impossible.

Here are the 10 companies in the S&P 1500 apparel/footwear category with the highest annualized average returns on invested capital over the past 20 quarters:

Once again, Nike is on top with an average ROIC of 22.5% for the past five years through the end of its fiscal first quarter on Aug. 31.

Here’s how the same apparel/footwear companies’ stocks have performed, with dividends reinvested, through Nov. 6:

As you can see, the group fared best against the index for the 10-year period. This underlines how important it is to look at the numbers but also to really understand what’s going on with a company. For example, Ralph Lauren, the founder of Ralph Lauren Corp. announced on Sept. 29 that he would step down as CEO, although the company said he would “continue to actively drive the company’s vision and strategy as executive chairman and chief creative officer.” The stock rose 14% that day.

The point is not to bash Ralph Lauren’s accomplishments, but to emphasize that a company named after the founder and current CEO has quite a bit riding on his or her performance and personality.

It is critical that you, as an investor, really understand how popular and lasting a company’s products might be. If the company’s specialty is highly fashionable products, and you have little knowledge in that area, some caution is warranted.

Of course, one should also check to see how a company’s sales have fared, since a slow growth rate could point to a deeper underlying problem.

Here are sales-per-share growth numbers for the same 10 apparel/footwear companies over the past 12 reported months:

An ‘unfair’ comparison

Getting back to Ralph Segall’s comment that “we do not sort by industry or sector,” when considering ROIC, we’ve prepared another list that covers all industries.

Lutin said investors really should select companies “you understand and have confidence in,” before selecting stocks. If you are building a broad, diversified portfolio, he also said, “there is merit” to starting with highest ROIC, regardless of industry.

Here’s a list of S&P 1500 stocks, regardless of industry, with the highest ROIC over the past 20 reported quarters:

Here’s how these companies’ stocks have performed through Nov. 6:

There are many impressive numbers on the table above. Those companies could be a starting point for your own homework.

Finally, here’s how the 10 S&P 1500 companies, regardless of industry, have done increasing sales per share over the past 12 months:

There are two types of value investing. One way is to select stocks that you think are priced too low in relation to their intrinsic value. You’re hoping that somebody else will decide to pay significantly more for your stock in a relatively short time.

But the other type of value investing involves a much longer-term view. If you select companies that keep achieving high returns on invested capital and have products or services you believe will be popular or necessary for decades to come, then it may not matter so much whether you pay the lowest possible price for the shares.

“Price tends to converge on intrinsic value. That’s the foundation concept of Graham and Dodd and Buffet-style value investing,” Lutin said, referring to Benjamin Graham, David Dodd and Warren Buffett, the most legendary value investors.

“Sometimes you will pay 10% more than the current discounted present value, and sometimes you will pay 10% less. Over 20 years, if you do either, you’ll be OK if the company in fact competes successfully and continues to produce a decent ROIC.”