How to Pick Stocks

ARE YOU tired of hunting frantically for tomorrow's hot stocks? If so, you should consider investing in undervalued stocks and waiting patiently for their market prices to rise. Many of the professional stock pickers who have done best in fair markets and foul alike are known as value hunters. They believe that the only sound investment strategy is to buy a stock when it is selling below the company's true value. Then they wait perhaps for years for other investors to recognize this value and bid up the stock's price. To succeed with such a strategy, you will need discipline and a willingness to buck the prevalent opinion of the Wall Street herd. As a small investor, you might think you just cannot compete in a stock market dominated by large financial institutions. But there is a sound reason why amateurs like you can humble the institutional investors. Because so many of them have to concentrate on safety and the ability to sell out quickly if they have to, they choose their stocks largely from among 500 or so of the nation's biggest and best known companies.

Professional managers are reading and hearing the same good or bad news about the same stocks at the same time, so they often buy and sell in a pack. This makes investing in the institutions' relatively few favorites increasingly risky for the rest of us: the bottom could drop out of stocks that fall from favor. But individual investors do not have to worry about causing market turbulence or justifying their stock picks to a fickle clientele. They can go prospecting in a market of 7,000 or so stocks that most of the institutions ignore and few, if any, analysts bother with. As a class, these shares produce the biggest profits. The Leuthold Group, a research firm that follows the historical performance of financial markets, tracks such "neglected" issues in its study of stocks with less than 30% institutional ownership. It also follows "royal blues," stocks most heavily owned by institutions. For the years 1985 through 1988, Leuthold's overlooked issues rose 157%, while the institutional favorites climbed 66%.

Before you make your stock selections, learn what investment analysts the ones who have the best records of forecasting and picking winners think will happen in the market. You can get a reasonable idea of that by reading the financial press and investment advisory newsletters.

If you want to develop winning stock strategies, it is wise to follow certain guidelines:

Scout for stocks owned by fewer than five big institutional investors. These shares, while risky, often tend to rise faster than others. You can find out how many institutions hold an issue by looking it up in Standard & Poor's Stock Guide, which all brokers and many libraries have.

Also, search for stocks whose prices are low relative to their earnings. Newspaper stock tables show the price/earnings ratios based on the previous 12 months' earnings. For a better guide, use the ratio based on analysts' estimates of future earnings. You can find such estimates in The Value Line Investment Survey. Or ask your broker to send you Standard & Poor's stock reports for specific companies.

Look also for shares of well established firms that have high dividends relative to stocks in general, notably relative to stocks of companies in the same industry.

One popular strategy among small investors is to concentrate on issues selling for $3 or less. These cheap thrills can be fast growing small companies. Another tactic is to try to catch a fallen star, a stock that has fallen victim to bad news. You can spot these unfortunates in daily newspaper lists of stocks reaching 52 week lows. To find out whether the company is reeling from only a temporary setback instead of a terminal problem, look for long term debt that is not greater than 40% of the company's total capitalization and less than 10% of annual sales. Aggressive new management, significant cost reductions and the introduction of potentially profitable products are other signs that the corpse may be coming back from the grave.

Sometimes you can find hot stocks on Wall Street by making a cool evaluation of the people, products and services you encounter on Main Street. Many successful small investors discover that personal experience leads them to stock market winners. For example, your children might direct you to a new fast food chain that is packed with hungry youngsters. Perhaps the firm's stock is worth a nibble. Or you might detect a changing pattern in sales at your job. An investment opportunity may be behind it.

Investing in what you know firsthand lets you exploit two of your best assets your experience and your own good judgment. But do not invest without first finding out more facts. Superb products and services can come from poorly run, unprofitable companies. And a close encounter with a single product tells you nothing about a firm's other lines of business. They may not be so terrific. In other words, use your experience, but do not let it over impress you. You should do the same kind of research you would do with any investment. For example, does the company have cash hoards, real estate, oil reserves or other assets that might catch the eye of a takeover artist or make the market take a second look? The most convenient source of answers is usually The Value Line Investment Survey.

Ask a stockbroker for a copy of the firm's latest annual report, or write the company for one. Look for steady growth in revenues and net income over a five year period. See how current assets compare with current liabilities, and hold out for close to a two to one ratio in favor of assets.

Also, see how the company measures up to others in the same industry. You can find reliable comparative data in Standard & Poor's annual industry surveys. One of the key figures to compare is return on equity. If your firm's return is lower than that of its competitors, beware. The company probably is not being managed as well as it might be.