What to look for in safe stocks

While no stock is perfect, you can certainly set yourself up with a portfolio of relatively safe stocks if you incorporate a few guidelines into your stock analysis.

If safety is a priority, consider these four benchmarks:

1. Steady, growing revenue: Look for companies that grow their revenue steadily year after year. Erratic revenue tends to correlate with erratic stock prices, while consistent revenue is more common among stocks with less volatility.
2. Lack of cyclicality: Cyclicality is a word that describes how economically sensitive a business is. The economy goes through cycles of expansion and recession, and cyclical companies typically perform well in expansions and less well during recessions. For example, the auto industry is cyclical because people buy fewer new vehicles during recessions. On the other hand, utilities aren't cyclical because people always need electricity and water.
3. Dividend growth: A good way to gauge a company's long-term stability is to take a look at its dividend history, if it provides a dividend. If a company has rarely (or never) cut its dividend and has a strong history of increasing its payout, even in tough economies, that’s a great sign. A Dividend Aristocrat is a stock that has increased its dividends for at least 25 consecutive years, so a list of those stocks would be a good place to start.
4. Durable competitive advantages: This could be the most important thing to look for. Competitive advantages come in several forms, such as a well-known brand name, a cost-advantaged manufacturing process, or high barriers to entry in an industry. By identifying competitive advantages, you can find companies likely to maintain or expand their market share over time.

Red flags that a stock is less safe

On the other hand, there are some telltale factors that indicate a stock is a less safe investment:

• Penny stocks: There's no set-in-stone definition of a penny stock, but the term generally refers to stocks that trade for less than $5 per share. While not all the stocks that meet this description are bad investments, nearly all are cheap for a reason. It's a common myth that trading penny stocks is a great way to get rich; it's more likely to have the exact opposite effect.
• Dividend cuts: If a stock has a frequent history of slashing or suspending its dividend during tough times, that could be a sign that it's not a stable business in all economic climates. However, many companies prudently suspended dividends during the COVID-19 pandemic. But if a stock didn't have to halt its dividend during this time, that’s a great sign of stability.
• Declining or unstable revenue: Most U.S. companies took a revenue hit from the pandemic, but safe stocks will trend back to relative stability over the long term. If a company's revenue is frequently up one year and then down the next, it's tough to make the case that it's a stable business. Consistently declining revenue is an obvious sign of an unsafe stock, but unstable revenue can be just as worrisome.
• High payout ratio: This one applies only to stocks that pay a dividend (some great companies don't). If a company pays a dividend, check out the stock's earnings per share for the past 12 months and compare them to the dividend paid. If the dividend represents a high percentage of the earnings (say, more than 70%), that could be a sign that the dividend isn't sustainable.

The recipe for investing in safe stocks

If you're looking to invest in "safe stocks," the above list will get you started. But before you begin, remember these two caveats.

First, one of the best ways to make your portfolio safer is to diversify. As we’ve said, no stock is completely safe from volatility and competition, so by finding relatively safe stocks and spreading your money across a bunch of them, you're giving yourself much more of a safety net than if you just purchased one or two.

Second, the stocks mentioned here (and any others that seem safe) aren't necessarily “safe” over short periods. Even the best-run companies experience short-term price swings, and this has been especially apparent during the COVID-19 pandemic. Don't worry about stock prices over days or weeks, but keep your focus on which companies are most likely to do well over the long haul. And, when it comes to safe stocks like these, short-term share price weakness can make for excellent long-term buying opportunities.

Essentially, the recipe for safe stock investing is to find stable companies, buy a bunch of them, and hold on for the long haul.