The Key to Stock Picking Is to Prune First

The No. 1 question people ask me is, “Where’s the stock market going?” After I tell them that I haven’t the foggiest idea, they move on to No. 2: “How do you find good stocks?”

This is a question I’m happy to answer, but first, let’s get a few things straight. I define “good stocks” as ones that can be bought and held forever. Certainly, if a company changes management or a key product fails or severe competition develops, you can sell. But your objective should be to own stocks for the very long term.

The Standard & Poor’s Stock Guide, which is by no means complete, includes more than 10,000 stocks. If you spent just two hours analyzing each one and devoted all your waking hours to the effort, it would take four years to work your way through the list. (Talk about long-term investing!)

So in order to pick stocks worth even two hours of analysis (or quiet contemplation), you need to prune the list. You can do that in two ways:

* Identify companies yourself. Peter Lynch, the former manager of the Fidelity Magellan Fund, calls this technique “the power of common knowledge.”

In his 1989 book, “One Up on Wall Street,” Lynch, one of the nation’s greatest investors, describes how he stumbled “onto the big winners in extracurricular situations.” Specifically: “Taco Bell, I was impressed with the burrito on a trip to California; La Quinta Motor Inns, somebody at the rival Holiday Inn told me about it; Volvo, my family and friends drive the car.” One of his top discoveries came from his wife, who noticed L’eggs pantyhose in a grocery store.

In this same category are ideas gleaned from articles in newspapers and magazines--not about stocks, but about the history, management, strategy and performance of individual firms. I found Birmingham Steel Corp. this way, reading a piece years ago in the New York Times.

* Listen to others. Never, ever run out and buy a stock on a tip from a friend, or even someone claiming to be an insider. Listen to their suggestions; then, in a calm and leisurely fashion, do your own work. In other words, use advice as a guide, not as a catalyst for action.

Over time, you’ll get to know whose advice is valuable. I have. I have learned that of the hundreds of financial newsletters, most are stuck on the question at the beginning of this column, the one about where the market is going. If you ignore “timing” advice and concentrate on stock recommendations, you’ll find that some newsletters actually are worth what they charge.

For example, Charles Allmon, veteran editor of Growth Stock Outlook ([301] 654-5205), has been calling for a market crash for the last decade or so. Plug your ears to that stuff, but pay attention to the few stocks he suggests you buy.

Allmon has a phenomenal record for finding winners among boring companies that have low debt and consistent profits. Currently, he likes Harleysville Group Inc., a regional insurance company with a price-to-earnings (P-E) ratio of 10 (about half that of the average stock), and New Plan Realty Trust, a real estate investment trust that owns factory outlet centers.

The newsletter that’s the best value for the money ($165 for 24 issues) is the Dick Davis Digest ([954] 467-8500), whose editors cull ideas from other newsletters and brokerage reports and present them in 100-word excerpts.

A recent issue included write-ups on Sun Microsystems Inc. (recommended by the Ruta Financial Newsletter of Bronxville, N.Y.); Dollar General Corp., the discount chain (from Market Forecast of Elkton, Va.); Hannaford Bros. Co., a small supermarket chain (from UnDiscovered Stocks of Palm Beach Gardens, Fla.); Raytheon Co. (from Alpha-Omega Investment Newsletter of Los Angeles); and about two dozen others.

A small letter of which I’m particularly fond is Common Stocks, Common Sense, published by Ed Welles in Concord, Mass. ([508] 371-3023). Welles is a serious long-term stock picker, with a “value” (bargain-hunting) bent, who visits companies and studies their finances assiduously. His current list includes 21 stocks.

Core holdings include Smithfield Foods Inc., which produces hams; Wabash National Corp., truck trailers; Patterson Dental Co., equipment for dentists; and Mercury Finance Co., auto loans. Welles quotes Mercury’s chief financial officer as saying, “We try like hell not to do anything stupid.” That policy has produced 50 straight quarters of record earnings.

Quirky, expensive, irregularly published and brilliant is Outstanding Investor Digest ([212] 777-3330). The editor, Henry J. Emerson, conducts long interviews with some of the country’s best money managers, who are given the time and space to explain exactly why they’re buying particular stocks.

The April 30 issue included a talk with Bob Rodriguez of FPA Capital Fund, who extolled the virtues of MacFrugal’s Bargains Close-Outs Inc., which has since risen about 50%. Another choice, Arrow Electronics Inc., invites scrutiny today at just 10 times earnings.

In 1989, Rodriguez recommended Green Tree Financial Corp. and Nike Inc. to the newsletter’s readers. A $10,000 investment split between the two now is worth more than $200,000.

I also pay close attention to the newsletters of investment firms, especially when they publish lists of specific types of stocks, rather than scattershot recommendations. For example, Smith Barney Inc. has something called a “Ten Plus” list of companies that should outperform the market from mid-1996 to mid-1997. That’s too short-term for our purposes, but the list of 15 stocks contains some intriguing ideas: National City Corp. (Midwest banks), Sonat Offshore Drilling Inc., LM Ericsson (telecommunications) and Allstate Corp. (insurance, trading at a P-E of 10).

My favorite letter of this sort, Standard & Poor’s Investor’s Monthly, comes with my Fidelity Brokerage Services statement each month. The letter’s specialty is computer screening: That is, it takes the universe of stocks and selects only those that meet multiple parameters.

The current issue presents a list of stocks that rate at least four S&P; stars (out of five) for expected price appreciation, that have boosted their sales per employee by at least 6% a year for the last five years, and that have ratios of stock price to sales of 1 or lower per share, which means that investors pay $1 or less for every dollar of the company’s revenue.

At 52 stocks, the list is long. But you can further refine it by including only companies that S&P; rates B+ or better for “quality”--that is, stability of earnings and dividends over the last 10 years. That narrows the list to 16, including Avnet Inc. (electronic components), Briggs & Stratton Corp. (engines), Cardinal Health Inc. (pharmaceuticals) and Ryan’s Family Steak Houses Inc.

The Value Line Investment Survey ([800] 833-0046), a subscription service that monitors financial performance of thousands of companies and is available at libraries, provides a weekly set of screens as well. A recent issue listed stocks trading below book value, stocks with low P-Es, stocks with a high return on capital, with high dividend returns over the last five years and with high growth rates.

Finally, I mine mutual funds for stock advice--especially funds with small portfolios, a good track record and a history of holding stocks for a long time. To see what a fund owns, check Morningstar Mutual Funds ([312] 696-6000), a subscription service found at libraries, or Value Line’s new mutual fund service. Or read the statements of your own mutual funds, or call others and ask to get on their mailing lists.

One fund I check frequently is Parnassus ([800] 999-3505) in San Francisco. It’s a “socially conscious” fund, but more important, manager Jerome Dodson is a skillful value hunter. His current portfolio is headed by apparel maker Liz Claiborne Inc., Toys R Us Inc. and H.B. Fuller Co. (specialty chemicals).

If you use these sources well, you can boil down that list of 10,000 stocks. Then, by intense analysis--or even personal whim--choose companies you would like to join as a partner for the next 30 years or so.