10 rules for picking stock winners

Listen to the experts if you want, but know that time will prove many of them wrong. Here’s what you need to know to make your own educated guesses.

By Harry Domash

As anyone who has tried can attest, consistently picking winning stocks is harder than it looks. Follow these 10 rules of thumb to improve your odds of success.

No. 1: Diversify

It’s tempting to load up on stocks in today’s hot industry or sector — for instance, energy or China stocks.

In days past, that strategy worked because once in favor, industries often remained strong for a year or longer. But today’s market, dominated by computerized trading, moves much faster. An industry could turn cold overnight.

Thus it’s important to diversify your holdings. Avoid investing more than 20% of your funds in any one industry or geographic sector.

No. 2: Ignore guru predictions

Everywhere you turn you’ll find some guru predicting which way the overall economy, energy prices, interest rates, the value of the dollar and numerous other factors are headed. History will prove half of these experts wrong, but you don’t know which ones.

Instead of trying to predict the unpredictable, focus on the fundamental outlook for your stocks. If you do a good job with that, the other factors won’t matter.

No. 3: Avoid cheap stocks

Sure, we all want to quit our day jobs — and the quickest way to do that is by loading up on a stock selling for pennies a share that soars to $100 or more. But the odds of hitting that home run are about the same as winning the lottery.

Stocks changing hands for less than $5 per share, often termed “penny stocks,” trade for those prices because most market players see fundamental problems ahead. Avoid stocks trading for less than $5 per share.

No. 4: Follow the big players

Because institutional investors such as mutual funds and pension plans generate huge trading commissions, they have access to information that you will never see.

If these big players don’t think they can make money on a stock, they don’t own it. Thus, it makes sense to piggyback on their efforts and avoid stocks that the institutions don’t want.

Institutional ownership, the percentage of a company’s shares owned by these big players, typically runs from 40% to 95% for in-favor stocks. Pick stocks with at least 40% institutional ownership. (You can see the institutional ownership on the MSN Money Company Report page.)

No. 5: Profitable

Some companies have exciting stories to tell but have yet to report a profit. For many such firms, profits are always just around the corner. Alas, in the end profits drive share prices. Perpetual money losers are apt to break your heart.

However, positive income isn’t enough. You’ll do best by sticking with companies that can finance growth from profits rather than by borrowing or selling more shares. Both of those alternatives diminish the value of existing shares.

You can use return on equity (net income divided by shareholders equity) to determine whether a firm is sufficiently profitable to finance growth. A firm can’t internally fund annual growth more than its ROE. For instance, a 10% ROE firm can’t internally fund more than 10% annual earnings growth.

To qualify as a growth candidate, most investors look for at least 15% expected earnings growth, and often more. Require a minimum 15% ROE, and increase that minimum for faster growing stocks. (Find ROE in the Investment Returns section of MSN Money’s Key Ratios report.)

No. 6: Cash generators

Thanks to flexible accounting rules, a firm can report earnings when, on a cash basis, it is really losing money. Thus, it’s necessary to check cash flow to confirm profitability.

Cash flow is the amount of cash that actually flowed into or out of a firm’s bank accounts. Since it must reconcile to bank balances, it’s not as easily fudged as reported income.

For this check, all you need to know is that cash is flowing in, not out. The price-to-cash-flow ratio will only be positive if that’s the case. So, insist on a positive cash-flow ratio (Find this in the Key Ratios section as well.)

No. 7: Low debt

From management’s perspective, there’s nothing wrong with borrowing money as long as borrowed funds can be profitably invested. For instance, it would make sense to borrow at 6% if a firm could use it to generate a 10% return.

Nevertheless, high-debt firms complicate life for investors. For starters, significant debt means that you’ve got to scrutinize financial statements to assure yourself that the firm has enough cash coming in to service its debt. Further, should interest rates rise, the higher debt-servicing costs will cut into earnings.

Rather than analyzing balance sheets and worrying about interest rates, for me it’s simpler to avoid high-debt stocks.

The total debt-to-equity ratio adds up both short- and long-term debt and compares that total to shareholders equity (also known as book value). Firms with no significant debt have zero ratios (shown as NA on MSN reports), and the higher the ratio, the higher the debt. Consider ratios below 0.5 as low-debt and avoid firms with D/E ratios above 0.5. (Look for the number under Fundamental Data on Money’s Company Report page.)

No. 8: Strong price chart

Weak share-price performance compared with that of the overall market signals that clued-in shareholders may be dumping their holdings ahead of bad news that hasn’t yet hit the wires. Consequently, you’ll do best buying stocks that are outperforming the market.

Relative strength compares a stock’s price performance to all U.S. listed stocks. A 90 RS means that a stock has outperformed 90% of all stocks over a specified period, while an RS below 50 signals that the stock has underperformed the majority of stocks.

Stick with stocks with minimum 75 relative strength over the last six months, and higher is better.

No. 9: Reasonable price

Rising share prices usually go hand in hand with strong earnings growth. However, fast growth attracts attention, everybody piles on and eventually share prices reach unsustainable levels.

The most widely used valuation measure is the price-to-earnings ratio, or P/E, which is the recent share price divided by the last 12 months’ per-share earnings. However, the historical P/E doesn’t mean much for a stock whose earnings might grow by 50% or even double this year.

For fast growers, the forward P/E, which is based on the current fiscal year’s forecast earnings instead of historical earnings, is a better choice.

While there’s no hard-and-fast rule, in my experience forward P/Es above 40 signal high risk. So stick with stocks with forward P/Es below that level. (Find this number under Earnings Estimates on the Company Report page.)

No. 10: Don’t check your stock prices at work

Stocks often make short-term moves for reasons unrelated to their long-term outlook. For instance, a mutual fund might be forced to raise cash to cover shareholder redemptions. Many times a stock will make a big move during the day and end up little changed by the time the closing bell rings.

Checking your stocks during the day will make you crazy and could cause you to sell your stocks prematurely. If you hold fast-moving “rockets,” check prices only once a day — after the market closes. For other stocks, once a week is enough.

These 10 rules of thumb will help you pick strong investment candidates. But they are not the final answer. You still need to do your due diligence and learn everything you can about your candidates. The more you know about your stocks, the better your results.