Updated for 2020!
Hundreds of thousands of people search for terms like “stocks to buy today” or “best stocks to buy” or “top stocks for 2020” every single month.
The appeal is understandable, but most of the articles that pop up are ones quickly written by freelancers that often don’t even invest in the stocks they pitch. They’re just writing for one-time clicks and pageviews rather than doing serious research to provide value and establish long-term relationships with their readers.
The truth is, investing is hard, and building a portfolio of top stocks to buy that beat the market is something that even financial professionals have trouble doing consistently.
In fact, after fees, only about 15% of actively-managed funds outperform the S&P 500 over any lengthy period of time:
Chart Source: S&P 500 SPIVA
For the average non-professional investor, it’s even worse. As calculated by Dalbar Inc, and charted here by JP Morgan, the average investor barely beats inflation, and vastly underperforms the S&P 500:
Chart Source: JP Morgan Guide to the Markets
That’s mainly because investors tend to buy stocks or funds during market tops when they are expensive and all the news is good, and then sell stocks and funds after they crash, when they are cheap. They keep doing that over years and the returns end up being quite bad.
Meanwhile, value investors like Warren Buffett are building up cash during euphoric bull markets, because everything is expensive and very few stocks meet their strict investment criteria. Then when a stock market crash eventually occurs and top stocks are on sale everywhere, they deploy their cash hoard and snatch up the bargains of a decade.
However, there are plenty of independent, disciplined investors that build serious wealth in the market over the long term by following similar methods. It’s simple, but not easy, to stay focused and buy high-quality companies at reasonable prices on a consistent basis.
My favorite investing platform for holding these stocks is M1 Finance.
After using it myself for a couple years now, I see first-hand how much power its software gives for easily re-balancing individual stocks, and really helps me edge out extra gains. (See my disclosure policy here regarding my affiliation with M1.)
Investment Criteria for Top Stocks
Even though markets are hard to outperform, I think individual stocks can be a valuable component of an investor’s portfolio.
As I explained in my article about investor psychology, the most important thing you can do is find the right investment strategy for your unique needs and personality. You need a strategy that performs well, but also one that you’re comfortable with and that will entice you to invest regularly.
For many people, that’s index funds. In fact, I think most people should hold some index funds, and about 50% of my own money is in index funds.
But I think dividend growth investing is a good strategy for many hands-on people as well. This means investing in companies with 10+ years of consecutive dividend growth, sustainable dividend payout ratios, and solid growth prospects.
As a strategy, it provides more reliable investment income than index funds, gives investors an opportunity to learn about a variety of businesses, and turns on the “collector’s instinct” in a lot of people that can get them excited to invest more money.
While index funds can seem distant and vague, buying and holding a collection of hand-picked dividend stocks that grow their dividends every year at an exponential pace just “clicks” for a lot of people, and builds good investing habits. Dividend growth stocks as a group have statistically mildly outperformed the S&P 500 for decades too, which doesn’t hurt.
You can buy shares of companies, those shares produce cash dividends that grow each year, and you can reinvest those dividends into more shares or you can spend them.
Rather than just hoping the stock price moves up rather than down, dividend investors tend to pay attention to the underlying fundamentals of the company, including the growth and safety of their dividends, and watch for strong long-term performance. This helps build good investment fundamentals because they focus on company performance more-so than fluctuations in the daily stock price.
With that said, here are the 8 main criteria I used when selecting top stocks to highlight for this article:
Criteria 1: The company benefits from long-term trends and has little foreseeable risk of obsolescence.
Criteria 2: The company has above-average returns on invested capital and a durable economic moat to keep it that way.
Criteria 3: The company has a strong balance sheet, and solid historical performance during recessions.
Criteria 4: The company is a premium provider. They compete over quality, rather than just on price.
Criteria 5: The company generally has management with long tenures and a focus on long-term results.
Criteria 6: The company enjoys profitable growth. Not growth at all costs, but a combination of sustainable growth and value.
Criteria 7: The company is trading for a reasonable valuation. It’s a fair price for an exceptional company.
Criteria 8: The company is in my personal portfolio. I’ve researched and followed it for years, and understand its various nuances.
I didn’t directly include a dividend metric for this article, because I already have two popular dividend articles that I keep fresh with stock ideas:
Therefore, some of the companies in this article have rather low dividend yields, and that’s okay. The focus here is on total risk-adjusted returns.
When it comes to investing, nothing is for certain. There are no perfect stocks to buy, because there’s no way to see the future perfectly.
However, buying a diversified portfolio of high-quality companies at reasonable prices is among the most reliable ways to build wealth over the long-term.
7 Great Stocks To Buy and Hold
Here are seven companies that I think are trading at reasonable valuations that offer strong risk-adjusted returns over the next decade, and meet the above-mentioned criteria.
All of these are companies I actually own for the long-term. They’re ones I’ve researched for years, and some of which I have quite large positions in.
Some of these are likely to beat the market over time, while some may not. They have all beaten the market in the past. In terms of risk-adjusted returns, these are among the stocks I’m most comfortable holding through all market conditions along with my index funds. Always do your own due diligence before buying any company.
I published the first version of this article in 2018, and all 7 stocks that were selected outperformed the S&P 500 over the subsequent year. I recently updated this article for 2020, replacing three of the names with new ones, to try to identify some of the best stocks for 2020 and beyond.
#1) Brookfield Asset Management (BAM)
Brookfield Asset Management (BAM) is a Canadian financial firm you might not have heard of. It’s an asset manager that specializes in real assets like property, infrastructure, and renewable energy.
Their roots trace back over a century, when the company was an early developer and operator of infrastructure in Brazil.
Over the past 20 years, they have expanded into a global asset manager with over $500 billion in assets under management. They have diverse properties including gas pipelines, toll roads, data centers, solar farms, hydroelectric dams, and skyscrapers across five continents.
They hold the controlling stake in four publicly traded partnerships:
- Brookfield Property Partners (BPY)
- Brookfield Renewable Partners (BEP)
- Brookfield Infrastructure Partners (BIP)
- Brookfield Business Partners (BBU)
As a private equity firm, they make money in three main ways. First, they invest their own capital into a variety of real assets. Second, they collect money from institutional investors, invest that money on behalf of them into a variety of real assets, and collect performance fees from that capital. Third, they founded and hold large stakes in the above-mentioned publicly traded partnerships, from which they collect cash distributions, management fees, and performance fees called Incentive Distribution Rights (IDRs).
Here’s their full organizational chart. Click the image for a bigger view if you want:
Chart Source: Brookfield Investor Brochure
This structure gives them exponential growth, because in addition to their direct investments being extremely profitable, they are also benefiting from a major trend of increased institutional allocations into alternative assets, like private equity, real estate, infrastructure, and other high-performing low-liquidity investments. Brookfield’s private funds have consistently crushed benchmarks like the S&P 500.
Insiders own about 20% of the company. That’s massive insider ownership, easily an eleven-figure total, so their incentives are highly aligned with shareholders. The CEO, Bruce Flatt, has been with the company for 30 years, has been CEO for 15 years, and has overseen tremendous performance during his tenure so far.
If you invested $10,000 back in 2004, it would be worth $92,000 today compared to only $42,000 in the S&P 500 ETF, including reinvested dividends:
Chart Source: Y Charts
Despite Brookfield’s astounding results, they are not well-known and in my opinion they are still reasonably priced. Since they own cash-producing stakes in multiple partnerships and have a complex corporate structure, BAM tends not to show up well on stock screeners, and people looking at their financial statements for the first time wouldn’t see anything that stands out. In fact, they always look overvalued at first glance because their reported earnings tend to be choppy.
So, they tend to fly under the radar compared to a lot of top stocks that are household names.
The company positions itself well for recessions, because management builds up a fortress balance sheet, and then buys great assets for bargain prices from distressed sellers.
Often, companies take on too much debt, their credit ratings drop, their interest yields get too high, and then when something unexpected hurts them, they go bankrupt or need to sell assets at fire-sale prices. Brookfield buys them, refinances them to much lower interest rates thanks to their high credit rating, and makes incredible returns as they hold and expand those assets. Often, they sell those assets during bull markets for much higher valuation multiples than they paid, so that they can recycle that capital back into other distressed assets.
For example, during the 2007/2008 financial crisis, Brookfield bought a variety of undervalued shipping ports, rail infrastructure, and other global assets from a firm called Babcock & Brown that ran into too much debt and got liquidated. These assets performed tremendously as the global economy recovered.
Back when Chile was a frontier market without much investor interest, Brookfield bought cheap electrical transmission assets, expanded them for over a decade, and sold them over a decade later for a 16% annually compounded return.
When Brazil ran into a huge recession during 2014-2017, Brookfield acquired all sorts of gas pipelines and toll roads from distressed sellers that needed to raise capital, and locked in long-term favorable pricing contracts indexed to inflation.
When North American midstream companies ran into major trouble in 2015-2018 due to energy oversupply and low prices, Brookfield bought energy transportation infrastructure on the cheap.
After solar developer SunEdison collapsed into bankruptcy from too much debt to fuel overly-aggressive growth plans, Brookfield swooped in and bought lots of attractively-priced solar and wind farms from them.
In early 2018 when the retail sector was under intense pressure from the existential threat of online retail, Brookfield bought out General Growth Properties, which has a lot of best-in-class properties and high occupancy rates. Some of this they will retain as retail, while other assets they will redevelop into other types of property.
The point is, Brookfield management consists of contrarian investors. They buy undervalued (but premium quality) assets during times of stress, expand them, and sell them for much higher valuations during bull markets.
Although Brookfield Asset Management only pays a 1.4% dividend yield, most of the returns come from capital appreciation over time. Their various partnerships, on the other hand, offer higher yields of 5-6% with a bit less growth.
I’ve been investing in Brookfield and/or their partnerships for 9 years, and collectively they are my largest individual portfolio holding.
BAM Economic Moat Rating: 5 out of 5
Brookfield has a globally diversified portfolio of real assets, including utilities, utility-like regulated monopoly infrastructure, premium buildings in world-class cities like London and Manhattan, and a large collection of hydroelectric dams. These are among the types of assets with the widest available economic moats. Being so globally diversified also reduces their reliance on any one nation’s economy or politics.
In addition, asset managers benefit from high switching costs, and BAM in particular does. Private equity funds typically lock in investors for many years. And as long as BAM private funds continue to perform well, institutional investors should continue to reinvest in them when they have the opportunity to do so.
BAM Balance Sheet Rating: 4 out of 5
BAM has plenty of liquidity, and much of its debt is non-recourse to the parent corporation, but due to its complex corporate structure with multiple layers of moderate leverage, it has a moderate investment-grade credit rating from most rating agencies.
#2) Enbridge Incorporated (ENB)
Enbridge is one of the largest midstream companies in North America.
They operate a vast pipeline network that transports oil and gas from where it’s gathered to where it needs to be to keep Canada and the United states powered and warm.
Although not without occasional incidents, pipelines are safer and more cost-effective for transporting energy than the main alternative, which is by freight train.
Enbridge has virtually no direct exposure to commodity prices; they make money strictly by transporting energy. However, prolonged periods of low energy prices can reduce production volumes of oil and gas, which eventually means lower volumes and lower revenue for transporters like Enbridge.
One of the things I like best about Enbridge is their large natural gas exposure alongside their oil exposure. While oil volumes face a growing long-term threat by electric vehicles (and it’s difficult to predict how long that change will take), natural gas is projected to be a significant energy source for decades to come.
Chart Source: ENB Investor Day Presentation, December 2019
While renewable energy is projected to take a larger and larger market share of new energy projects, natural gas is taking market share from coal. Compared to coal, natural gas produces much less carbon dioxide, and doesn’t produce high levels of noxious pollutants like mercury. In addition, Enbridge does have a small portfolio of renewable energy assets and plans to increase it over time.
In recent years, the company made a series of acquisitions and consolidations to streamline their business model. Specifically, they acquired Spectra Energy (which gave them their big boost in natural gas exposure), and then bought out several master limited partnerships that they had large stakes in, bringing all of this into the parent company.
Enbridge currently trades at an EV/EBITDA multiple of less than 7x, and has 25 years of consecutive annual dividend growth:
Chart Source: ENB Investor Day Presentation, December 2019
With about a 6% current dividend yield, a dividend payout ratio below 65% of distributable cash flow, and solid dividend growth expected going forward, Enbridge offers a high likelihood of strong overall returns for the next decade.
ENB Economic Moat Rating: 4 out of 5
Enbridge is essentially a regulated monopoly.
Their Canadian gas distribution system is a utility, while its longer-distance pipelines are regulated backbone infrastructure for North American energy transportation. Enbridge has long-term contracts with most of its customers.
However, Enbridge’s exposure to oil may be safe for a while, but faces eventual existential risk from electric vehicles. And as Enbridge grows its renewable energy portfolio, it will be competing in an area that it has fewer advantages in. Lastly, political opposition has delayed some of their planned pipelines in recent years.
ENB Balance Sheet Rating: 4 out of 5
Enbridge has one of the highest credit ratings in the midstream industry, but took on a lot of debt when they acquired Spectra Energy a couple years ago. Enbridge has since reduced its debt/EBITDA ratio from 7.0x down to about 4.5x in a short period of time by selling non-core assets, which puts them back near the lower range of oil/gas infrastructure companies.
Going forward, the company plans to maintain its debt/EBITDA ratio in the range of 4.5x-5.0x and keep its strong credit rating. Now that deleveraging is done, they have more flexibility for growth and returning capital to shareholders.
#3) Alphabet (GOOGL)
If I had to buy just one mega-cap stock today, out of Apple, Microsoft, Amazon, Google, Alphabet, Facebook, Visa, J.P. Morgan, Berkshire Hathaway, Johnson and Johnson, and so forth, it would be Alphabet.
Alphabet now has arguably the strongest balance sheet of any company in the world, with over $120 billion in cash-equivalents and just a token $4 billion in debt. In addition, they are still growing earnings and EBITDA at 15%+ per year.
Chart Source: F.A.S.T Graphs
As the F.A.S.T Graph above shows, Google’s enterprise value per share (black line) has been well-justified by its fundamental EBITDA growth (blue and orange lines).
Alphabet operates their core Google website, as well as Youtube, and the has a host of other platforms including Android, Google Adsense for other websites, Google Maps, Google Cloud, and so forth. They are also launching Google Stadia for cloud-based gaming, have some of the leading technology in driverless technology, and are among the top tier researchers in quantum computing.
As a website creator for a decade now, literally half of Alphabet’s existence as a company, I’ve used multiple parts of Alphabet’s portfolio of services and have seen first hand how they have grown over this time.
Google was led for a while by its co-founders, but recently, Google CEO Sundar Pinchai was promoted to being the CEO of all of Alphabet, as the co-founders continue to step back from the company.
Alphabet should probably initiate a small dividend soon, like Apple and Microsoft both have. They generate enough free cash flow that paying a small yield would not impact their R&D efforts or affect their competitiveness in any way. Under the new leadership of Sundar Pinchai, I suspect this will happen within the next few years, but we’ll see.
GOOGL Economic Moat Rating: 5 out of 5
With both Google and Youtube, Alphabet absolutely dominates the global search market in both text and video. With Android and other portals for reaching users, they further diversify their reach and ensure continued interaction with their platforms. Their ad network on various websites benefits from the network effect; as more publishers and advertisers use the network, it increasingly becomes the standard to use online. Most major websites have Google ads on them.
All of this advertising revenue allows Alphabet to spend on super long-term research and development projects, similarly to what the normal function of a government is for (with like NASA or military R&D). Alphabet can put billions of dollars into quantum computing or driverless car testing, for example, without caring that it may not create new revenue for a decade. This gives Alphabet a serious advantage in the technological arms race.
One area where Alphabet has faced considerable competition is cloud computing. Amazon and Microsoft have proven to be stronger than Google, so far, at gaining cloud computing market share.
GOOGL Balance Sheet Rating: 5 out of 5
With over $120 billion in cash-equivalents and virtually no debt, Alphabet sets the standard for what constitutes a fortress balance sheet.
With their cash hoard and a modest issuance of debt, they could easily buy most of the companies in the world outside of the top 25 largest ones. Or, if they face an impact to their profitability, their cash hoard can fund their operations for quite a long time.
#4) HDFC Bank (HDB)
HDFC Bank is the largest private bank in India. It is celebrating its 25th year since being founded in 1994, and now has over 5,000 branches and a robust online business throughout India.
India is set to overtake China as the world’s most populous country, and still has very low (but rising) per-capita GDP. As a large emerging market, it has one of the highest GDP growth rates in the world, and is set to become one of the world’s largest economies by the 2030s.
HDFC stock is available as an ADR on the NYSE under the ticker HDB. You can see below, with data since its inception on the public markets, how fast its earnings are growing relative to a large U.S. bank like J.P. Morgan Chase:
Chart Source: Y Charts
Besides all of the normal risks that come from operating a bank, HDFC Bank’s stock has two key risks.
First of all, it is expensive, with a blended P/E ratio of just over 30 at the moment. However, with earnings growing at roughly 20% per year, it actually has a rather attractive PEG ratio, which was a metric popularized by Peter Lynch that compares the valuation of a company to its growth rate.
Second, India is very reliant on oil imports, and whenever oil becomes expensive, their trade deficit widens, which tends to hurt the currency. If you’re an American or European investor, for example, then you don’t really care how HDFC Bank stock performs in terms of Indian rupees; you care how it performs in dollars and euros. If the rupee weakens vs those currencies, your returns could be reduced. On the other hand, if the rupee strengthens vs your home currency, it’s a tailwind.
Personally, I think having a stake in India as part of a diversified portfolio, and letting it run for the next couple of decades, is a smart thing to do. I like the INDA ETF, but I also like HDFC Bank stock, particularly.
HDB Economic Moat Rating: 4 out of 5
HDFC Bank has built up significant economy of scale within India, which gives it operational advantages over competitors. In addition, banks tend to have annoying switching costs, meaning that once customers pick a bank, they don’t change too frequently.
HDB Balance Sheet Rating: 4 out of 5
HDFC Bank maintains strong creditworthiness, but as a bank in an emerging market, it can be subject to more severe currency fluctuations or other crises compared to what is historically normal for developed markets.
#5) Starbucks Corporation (SBUX)
After many years of market-crushing performance, coffee-giant Starbucks has transitioned from being a growth stock to a value stock.
In recent years they’ve lowered their forward growth guidance, albeit still with rather large growth rates, and boosted their dividends and share buybacks. In other words, less focus on investing in growth, and a greater focus on giving money back to shareholders.
That gives it some short-term headwinds and a healthy reduction in valuation multiples, but over the long-term they’re likely poised for strong returns once again from the combination of moderate growth and a high shareholder yield. Some growth investors have rotated out of this name while value and dividend investors have rotated in.
With a saturated market in North America, Starbucks is focused on expanding in the rest of the world, with an emphasis on China. With China’s massive 1.4 billion population and growing middle class, Starbucks management expects to eventually have more Starbucks locations in China than the United States.
If that ends up being true, that’s a lot of money to be made.
Chart Source: Starbucks Oppenheimer Consumer Conference 2018
Starbucks is also moving up the quality chain with Reserve Roastery locations.
The first Starbucks Reserve Roastery opened up in their hometown of Seattle, and it has been extremely profitable. It’s a 15,000 square foot, beautifully designed location that is like the Willy Wonka of coffee. Customers spend 4x as much there compared to what they spend at a normal Starbucks because they offer a variety of premium foods and drinks along with a high-end visual setting that makes it a destination.
After the success of their first Reserve Roastery, they opened a flagship 30,000 square foot Reserve Roastery in Shanghai, China, which has been another smashing success. It makes about 10x as much money as a standard Starbucks location through a combination of higher prices and more customers. Third, they opened one in Milan, Italy, which was a daring move considering Italy’s reputation for coffee culture. Nonetheless, that location has been very popular as well. Then they opened in Chicago, New York, and other major cities.
Each Roastery location generates profits equal to several normal locations due to their large sizes and high prices, and most major cities around the world can probably support at least one premium location of this type.
SBUX Economic Moat Rating: 4 out of 5
Starbucks has a globally powerful brand, and its massive scale gives it massive bargaining power with its suppliers. This is slightly offset by the fact that customers have low switching costs. If Starbucks makes a major misstep that hurts their brand, customers can easily switch to other coffee shops.
SBUX Balance Sheet Rating: 4 out of 5
Starbucks has an interest coverage ratio of well over 40. They run a very lean operation that produces tremendous amounts of free cash flow that covers their debt interest expense many times over. Their book value is very low, because the company generates very high returns on invested capital compared to their assets. Their excellent debt/income ratio is less than 1x, meaning they could pay their long-term debt off with about one year’s worth of net income.
However, Starbucks has been borrowing a bit more lately, and credit ratings agencies have mildly downgraded its credit rating. This currently prevents the company from having a score higher than 4.
#6) Carnival Corporation (CCL)
Carnival is the world’s largest cruise operator. Nearly half of all people who will cruise in 2020 will be on Carnival ships, including their various wholly owned brands.
Besides their core Carnival brand, the company has Princess Cruises, Holland America Line, Searbourn, Costa Cruises, AIDA, and P&O Cruises. They have exposure to North America, Europe, Australia, and Asia. Asia in particular likely represents a big portion of where new cruise demand will come from over the next decade.
The cruise industry basically operates as an oligopoly, dominated by Carnival, Royal Caribbean, and Norwegian. Most other cruise brands are owned by one of these three. This is an industry where brand names and operational efficiency matter; it’s not just a commodity transportation service.
Arnold Donald, CEO of Carnival Corporation, gave an interview in Chief Executive magazine, and he had this to say when asked about potential disruption to the cruise industry:
We’ve seen disruption in the hotel and transportation industries with Airbnb, Uber and Lyft. How concerned are you about disruption in the cruise industry?
The beauty of the cruise industry is that it’s tiny. We’ll maybe sail as an industry 30 million people this year. There are 1.4 billion travelers a year, with over half a billion vacationers a year on the planet. The city of Orlando attracts something like 70 million tourists a year. Las Vegas sees 40-something million. Venice does 24 million or 25 million The entire global cruise industry is the size of one major tourism city, and not even that in some cases. So, we’re so tiny. Therefore, when you say disruption we’re not anywhere near a mature industry. We’re underpenetrated in every market in the world. We’re capacity-constrained because there are only so many shipyards. The most the industry can grow in a year is 7 percent off a small base. It will be tough for anything that involves being on the ocean, that requires a vessel, to be instantaneously disruptive because there’s limited shipbuilding capacity.
Besides the upsides, Carnival has three big risks for investors.
The first is that it’s a highly-cyclical consumer discretionary stock. During recessions, fewer people can afford to take vacations and cruises, so Carnival and other cruise operators have to cut costs and sacrifice margins to keep ships full.
The second is that they are somewhat vulnerable to fluctuating energy prices, even if they can pass some of it on to their customers or protect themselves via hedging strategies.
The third is that their ROIC is a bit below my normal threshold for what constitutes a “top stock”. However, under the current CEO’s leadership, the company has been steadily improving its ROIC, and that rate of change is very important for forward investor returns if the trend continues.
However, Carnival is currently quite cheap with a P/E ratio of below 12, compared to its long-term average of over 17.
Chart Source: F.A.S.T. Graphs
The chart above shows that if Carnival was trading at a P/E multiple of 15, it would be where the orange line is, and if it was trading at a P/E multiple of 17, it would be where the blue line is. There has been a significant disconnect between fundamentals (blue and orange multiples of earnings) and the stock price (black line) since 2017.
However, it’s certainly possible that we’ll see another big leg lower, if there is a U.S. recession in 2020 or 2021.
CCL Economic Moat Rating: 4 out of 5
As described above, the three major cruise operators control most of the global market, and shipbuilding capacity is limited. Once a fleet of ships is owned, the sunk cost is very large, and it’s challenging for new competitors to enter the industry.
However, Carnival has had some public relations disasters in the past, including a capsized ship, a sanitation problem due to an engine room fire, and other mishaps. In luxury and semi-luxury industries, brand strength and consumer perception are important and also fragile.
CCL Balance Sheet Rating: 4 out of 5
Carnival has an A- credit rating, which is surprisingly high for such a capital-intensive industry. Carnival has much lower debt ratios than Royal Caribbean and Norwegian,
The company has a healthy debt/income ratio of about 1.5x. In other words, it would take about a year and a half to pay off their long-term debt if they focused all of their net income on doing so.
#7) Discover Financial Services (DFS)
Discover Financial Services was spun off from Morgan Stanley in 2007 and currently operates a lean online bank as well as two significant payment networks.
The company owns the well-known Discover brand, which is one of the four main credit card networks along with Visa, Mastercard, and American Express.
Over the past decade, Discover has built up an online bank as well, with a diverse range of offerings including checking accounts, savings accounts, personal loans, student loans, and home equity loans to consumers with high credit scores.
They also own the Pulse payment network (an interbank electronic funds transfer network) and Diner’s Club International (a charge card brand).
Discover is widely accepted in the United States, but not nearly as accepted internationally as Visa, Mastercard, and American Express. This is a downside for obvious reasons, but also is a source of potential growth for the company if they can push outward internationally like the other three main card networks.
Importantly, Discover is both a bank and a payment network. Visa and Mastercard focus purely on operating payment networks, and do not carry any credit card loans on their own books (the issuing banks do, like JP Morgan, Bank of America, and others that issue Visa and Mastercard credit cards). Discover and American Express, in contrast, are combined payment networks and banks, and thus operate the payment networks and hold the loans on their own books, so they take on credit risk but earn substantial interest income from this lending activity.
Discover has been exceptionally well-managed. David Nelms served as CEO from 2004 until 2018. The new CEO, Roger Hochschild, was previously the president and chief operating officer (COO) from 2004-2018. The two of them oversaw Discover’s transformation from a small spin-off credit card company to a more diversified bank.
Here, for example, is a snapshot of Discover’s transformation from when it went public in 2007 until ten years later in 2017:
Chart Source: Discover Financial Services 2018 Annual Shareholder Meeting
The numbers have continued grinding higher in 2018 and 2019, on top of this first decade of explosive transformation.
Hochschild has been with the company since 1998 and still is a fairly young executive. These long tenures help ensure that management is aligned with shareholders with a focus on long-term performance rather than quarterly results. For a second-tier card network like Discover in terms of market share, it’s important to have exceptional management.
Discover consistently has the highest consumer satisfaction among credit card issuers. Their customer service is industry-leading, and has been responsible for their high rates of customer retention.
It’s important to note that Discover might be the most volatile company on this list of seven stocks to buy (competing with Carnival) due to their large credit card loan portfolio. Credit card debt has among the highest default rates out of various types of debt during economic recessions, but allows the bank to generate upwards of 20% annual returns on equity during most normal years, which is outstanding.
However, Discover consistently passes Federal Reserve stress tests every year. The Fed analyzes the company to ensure they have enough capital to withstand an extreme recession similar to what happened during the 2007/2008 global financial crisis. Although their credit card loan losses would be substantial, the company makes up for it by having less leverage and extra capital reserves compared to other types of banks. Indeed, they held up quite well during the 2007/2008 financial crisis even though it was a rough time for them.
Discover generally trades at low stock valuations, which makes its share buybacks very lucrative. It’s one of the companies where I think share buybacks actually make a lot of sense for shareholders. The company has reduced the number of shares outstanding from 543 million in 2011 to 359 million today by buying back 5-8% of their shares back each year. This boosts earnings per share (EPS) growth at a much faster rate than company-wide net income growth.
The company has grown its dividend for 9 consecutive years, and currently pays a 2% dividend yield with a low payout ratio below 25%.
DFS Economic Moat Rating: 4 out of 5
Credit card networks naturally have very wide economic moats due to the network effect. The more cardholders that want to use the card, the more merchants there will be that are willing to accept the card as payment. And the more merchants that accept the card there are, the more users will be happy to use the card, creating a virtuous cycle. This is somewhat mitigated by Discover’s relatively low international acceptance.
Banks also naturally have high switching costs; once consumers put their money in they rarely go through the hassle of switching. Discover’s lean online banking business allows it to give some of the higher interest rates in the industry, which combined with its top-notch customer service should help it retain and grow market share.
DFS Balance Sheet Rating: 4 out of 5
Discover’s high concentration in credit card lending makes it susceptible to economic recessions, meaning under the current business model it will never have a fortress balance sheet that gives it a 5/5 rating.
However, Discover has conservative lending standards and very high levels of capital reserves to cover projected loan losses during a recession as severe as the 2007/2008 financial crisis. In addition, they generate much higher returns on equity than banks that focus mainly on mortgage lending.
Asset Allocation vs Hot Stock Selection
Asset allocation, meaning the long-term strategy for how you invest in various asset classes, is more important for most investors than individual stock selection.
Focusing all your time on trying to pick the top stocks usually results in missing the forest by looking for the trees.
Getting the big questions right, like how much of your net worth should be in domestic equities, how much you should invest in international stocks, how much to invest in bonds or precious metals, how reliably you re-balance your portfolio, and how consistently you save money to invest, are likely to generate the bulk of your returns and portfolio growth compared to spending a lot of time looking for the top stocks to buy.
Everyone has that colleague at work that talks about how their portfolio did this quarter, or about some hot stock they recently bought. You know the type of guy. Ten years later he’s still talking about trading a couple thousand bucks in stocks around but is he rich yet?
It doesn’t matter what stocks you pick if you don’t a) diligently put capital to work month after month with a high savings rate and b) focus on long-term results and building wealth.
There are some highly-skilled traders out there that make a lot of money in the short term by devoting their full-time job to it, but most of the people who get rich from the stock market are people with day jobs that diligently save and invest money every paycheck.
They keep buying and holding dividend stocks, index funds, real estate, or other high quality assets with a focus on long-term results.
And as I said before, I’m in favor of buying individual stocks, at least for some people. I think it’s a valuable practice to be able to understand and value a business, and evidence shows that some value-oriented strategies with a long-term focus do indeed outperform the broader market.
But it’s important not to get obsessed with it, or concentrate too heavily in any individual hot stock.
My purpose for writing this article is to point out the problems with short-term thinking and hunting for hot stock tips, while also indeed giving some real ideas for stocks to buy.
If you approach investing with a disciplined savings rate, proper investment criteria, and reasonable expectations, you can do well.
Some stocks to buy on the list are high-valued fast-growing companies, while others are under-valued moderate-growth value stocks. But these are all real cash-producing companies with market-beating historical returns, superior returns on invested capital, and wide economic moats, that don’t rely on much speculation for good returns going forward.
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