Taking Inventory of Ways to Pick the Best Stocks : Finance: An investment executive focuses on the two theories for selecting securities in his Anaheim speech.

There is a great debate among money managers about how to pick the best-performing stocks.

One theory, a trusted tenet of finance professionals since the early 1960s, is that stocks that are more volatile than the market as a whole are the best performers.

The other theory, published earlier this year as a challenge to the first, is that long-term performance depends not on volatility, but on company size and the ratio of book value to market price.

Money managers don’t necessarily have to choose between the two, said Roger C. Gibson, an author and president of Pittsburgh-based Gibson Capital Management Ltd. He spoke to an audience of investors and financial planners from around the nation who are in Anaheim this week for the annual convention of the International Assn. of Financial Planners.

Gibson pointed to the example of the Pacific Mutual Investment Fund, which uses the first theory to choose stocks. But the Newport Beach-based fund’s stocks also happen to conform to the second theory. “It’s as though the money manager intuitively screened” for the second theory’s requirements, Gibson said.

The volatile-stock theory was developed by William F. Sharpe, a retired Stanford University professor who won the 1990 Nobel Memorial Prize in Economic Science for his ideas. It is also known as the “beta” theory, beta being the variable that stands for a stock’s volatility relative to the market.

But Eugene F. Fama and Kenneth R. French, two business professors at the University of Chicago, published a paper in February saying that the beta theory has not proved itself. They examined thousands of stocks over 50 years and found no link between relative volatility and long-term returns.

Instead, they theorize that investments that have outperformed the market are in smaller companies and those with low prices relative to their book values, which is the value at which a company lists its assets on a balance sheet.

Share prices tend to fall faster than book value when a company is having trouble, Gibson explained, so a small gap between the two numbers is a sign of health.

Whether the Fama/French theory unseats Sharpe’s is, obviously, of great importance to companies whose shares could be bought or sold as a result.

Gibson said he does not foresee an overthrow of the earlier theory.

He also offered some advice and predictions for his audience:

* Don’t assume that a stock that has hit its low point will increase its price. “Markets have no memory,” he said.

* Capital markets lead the economy, not the other way around.

* By the time a story is printed in the Wall Street Journal, it’s too late to react. Prices have already adjusted.

* Capital markets will become more efficient because of technological advances. The Morningstar newsletter, which tracks the performance of mutual funds, is now available on computer disk, for example.

* Portfolios will become more broadly diversified, as investors increasingly think globally.