Stock picking secrets -- By Kathy Kristof

Billionaire investor Warren Buffett looks for value when he buys stocks. Peter Lynch, the investment guru who once headed Fidelity's giant Magellan stock fund, sought companies with strong growth prospects. Both have been wildly successful, showing that stock-picking success can be achieved from different angles. Indeed, there is no one right way to pick stocks.

Knowing the basics of stock picking is a fundamental skill that all serious investors need to have, One relatively basic method, used in variations by many professionals, is to combine the growth and value strategies prescribed by Buffett and Lynch: Look for steadily growing companies that are selling at reasonable prices, suggests Judy Vale, a portfolio manager at Neuberger & Berman in New York.

Looking at Fundamental Indicators of Value

Exciting and volatile markets warrant a dull approach to investing — an approach that involves asking a lot of questions about the company’s fundamental business, then doing a little mathematical analysis, Vale says. So how do you do it?

While there are no hard-and-fast rules, many professional investors screen companies based on a number of factors, including growth in sales and earnings, cash flow, and net profits. They also look at how profits compare with total assets — a ratio better known as return on assets.

These figures are important because the future value of a company’s shares is likely to hinge on its ability to grow and prosper. Growth in sales and earnings is a mathematical reading of demand for a company’s products and services. Meanwhile, a company that’s earning a substantial amount on assets — Vale’s standard requires more than a 1 percent return on assets for a financial services concern and more than 8 percent for non-financial businesses — has proved it knows how to deploy its resources in effective ways.

In terms of cash flow, look for whether the company is generating more cash from operations than it’s spending. That tells you if the company is earning enough on its business to finance future growth without resorting to borrowing or issuing more stock either of which can prove detrimental to existing shareholders.

Finally, try to determine whether the company has a product or provides a service that’s unique and difficult to copy. If it does, it’s likely the company will remain a market leader for a longer period of time. What products are hard to copy or unique? There are a wide variety, but they would include products that require formulas that are under patent protection for long periods, those that require unique technical skills, or those that require a great deal of capital to produce — such as cars and air planes, for example.

If the company makes it through that gauntlet, its stock is analyzed to determine whether the price is cheap or dear. Often that analysis hinges on the price-to-earnings (P/E) ratio, which is a measure of how the company’s stock price compares to its per share earnings. A company that earns $2 per share annually and sells for $20, for example, would have a P/E ratio of 10. This company’s stock price is equivalent to ten times its annual earning per share.

When looking at this ratio, what investors must keep in mind is that there is not one right P/E ratio for all companies. Instead, each company has a normal P/E range. When the company's stock price breaks out of that range, it’s time to ask why. If the company’s stock price is higher than normal compared with earnings, it can be an indication that its stock price is too high. Or it can indicate that the company is primed for unusually fast growth. Likewise, when a company's P/E is low, it can mean either that bad times are setting in or that the company's stock price is a bargain.

The rule of thumb for considering the price of growth stocks that have broken out of their normal P/E ratio is this: The stock is still a good buy if the P/E is at or below the annual growth rate of the company’s earnings. In other words, a stock that normally sold for fifteen times earnings might be a legitimate bargain when selling for twenty times earnings if its profits were growing by 20 per cent or 25 per cent per year.

Take caution about narrowing your stock choices based on Value Line’s timeliness rankings. Sometimes the top-ranked companies are all clustered in just a few industries. If you aim to diversify properly — a requisite for anyone who wants to reduce his or her risks — you have to keep an eye on the industry groups you’re choosing and make sure you choose stocks in many different industries.

Once you’ve chosen a stable of stocks to buy, all you need to do is keep an eye on your selections to make sure you didn’t select poorly. Doing that periodic analysis will help you determine when you ought to sell — and when it’s time to buy more shares in the companies you like the best.