Some Rules for Successful Selection of Stocks

Marlene Smith bought stock in a discount food store because she shopped there and was impressed with the company’s high-quality merchandise and low prices. In just over five years, Smith’s shares quadrupled in value. Not long after she sold the stock, the company’s share price began to languish.

Smith, who asked that her last name be changed for this article, admits that she knows nothing about the stock market.

What did Smith know about successful stock picking that thousands of investors didn’t?

Rule 1: Buy companies you know.

Smith was aware that the quality of the retailer’s goods had begun to deteriorate.

“It’s the Peter Lynch Rule,” says Hugh Johnson, chief investment officer at First Albany Corp. in New York, referring to a former Fidelity Investments mutual fund manager whose stock-picking prowess became legendary. “Only buy stock in companies you understand.”

For many Americans, this strategy translates into investing in companies that make or sell the goods they buy.

A doctor, for example, has made a killing investing in drug companies, while a housewife with young children doubled her money with stakes in toy and children’s entertainment concerns. A computer hacker has generated gratifying profits by investing in software companies. Similar stories abound.

However, experts stress that the Peter Lynch Rule is only a first step in evaluating what stocks to buy. Those who fail to consider additional investment rules are as likely to lose money as make it.

Rule 2: Buy quality.

There are several ways to define a quality company, experts maintain. The first is to look at its balance sheet. A summary of the company’s sales and earnings--available in annual reports--should show consistent growth in earnings and dividends.

Beware of debt, says Charles Allmon, editor of Growth Stock Outlook in Chevy Chase, Md. Cash-rich, debt-free firms are ideal, Allmon says in a recent newsletter.

A third test is market share, according to Johnson. If a company’s products are among the three best sellers in that field, you’ve probably got a winner. The exception is when market share is volatile or declining. If a company went from No. 1 to No. 3, investors should start to worry.

Rule 3: Identify companies that are likely to benefit from long-term demographic shifts and trends.

Some of the trends that may help shape the investing landscape over the next several years include the aging of America, the need to rebuild the nation’s infrastructure, international privatization and environmental concerns, according to Johnson.

Other experts believe that the current baby boom and what’s perceived as a return to more traditional values will also have an effect on investors.

The types of investments these trends suggest include stock in health care and drug companies, engineering and construction firms and international stocks and bonds. Firms that make strollers, car seats and baby clothes could also be big winners in coming years.

Rule 4: Trust your instincts.

Many individuals believe that they’re too unsophisticated to invest alone. Consequently, they turn to brokers and investment advisers to make their decisions for them. While advice from a professional is often helpful, investors need to weigh the suggestions with the same care that they’d weigh a stock tip from their brothers-in-law.

Rule 5: If you don’t feel comfortable, don’t do it.

There are many reasons for this rule of thumb. First and foremost is that brokers don’t always have their client’s best interest at heart.

Some unscrupulous advisers will persuade clients to buy investments--such as high-load mutual funds--that pay the adviser the biggest fees and may or may not be good for the investor.

Others might simply choose stocks that don’t suit the client’s investment horizon or risk tolerance.

Even when advisers are honest, brilliant and successful, customers need to ask ample questions about the risks and rewards so that they don’t lose sleep over details that make them uneasy.

Rule 6: Diversify.

Don’t put all your investment dollars in the stock market. Spread your money around in investments that offer different risk and rewards.

Certificates of deposit, real estate and bonds are other options. That way, you’re not likely to find that all your investments have declined in value at the same time.

Assuming you’ve taken this first step at diversification, take a second look at your portfolio and consider diversifying again.

The money you have in the stock market, for example, should not be invested solely in one company. Spread your stock market money among companies in different industries on the theory that even when some stocks languish, others might soar.