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Ten Rules for Picking Better Stocks 

Picking winning stocks is harder than it looks. Here are 10 rules that will improve your odds of success. You can find all of the numerical data mentioned here in Yahoo’s Key Statistics report (finance.yahoo.com).

#1. Diversify
It’s tempting to load up on stocks in today’s hot industry, for instance technology. In days past, that strategy worked because in-favor industries often remained strong for a year or longer. But now, everything changes faster. A hot industry could turn cold overnight.

Thus, it’s important to diversify your holdings. Avoid investing more than 20% of your funds in any single industry.

#2. Ignore Gurus
Everywhere you turn you’ll find pundits predicting energy prices, interest rates, the value of the dollar, and more. History will prove half of these experts wrong, but you don’t know which ones.

Instead of trying to predict the unpredictable, focus on the fundamental outlook for your stocks. If you do that right, the other factors won’t matter.

#3. Avoid Cheap Stocks
Stocks changing hands for less than $5 per share, often termed “penny stocks,” trade for those low prices because many market players see problems ahead. Cut your risk by avoiding penny stocks.

#4. Follow Smart Money
Thanks to the huge trading commissions that they generate, institutional investors such as mutual funds are privy to information that we never see. Institutional ownership, the percentage of a company’s shares owned by these big players, typically runs upwards of 40% for in-favor stocks. Piggyback on these savvy investors’ research. Avoid stocks with less than 40% institutional ownership. 

#5. Profitable
Strong earnings growth is what drives share prices up. Return on Equity (net income divided by shareholders equity) measures how fast a firm can grow by reinvesting profits rather than resorting to borrowing or selling more shares to raise the needed cash. The way the math works, a 10% ROE firm can’t internally fund more than 10% annual earnings growth. Most professional money mangers require a minimum 15% return on equity, and you should too.

#6. Follow The Cash 
Cash flow is the amount of cash that flowed into, or out of, a firm’s bank accounts. Since it must reconcile to bank balances, it’s not as easily fudged as reported income. Stick with positive (operating) cash flow stocks.

#7. Low Debt
Firms carrying high debt loads are more likely to run into problems than low-debt firms. The total debt to equity ratio compares the total of short- and long-term debt to shareholders equity (book value). No debt companies have zero ratios (shown as ‘NA” on Yahoo), and the higher the ratio, the higher the debt. Avoid stocks with total debt/equity ratios above 0.5 and lower is better.

#8. Strong Price Chart
Weak share price action might be your first clue that insiders are dumping a stock ahead of upcoming bad news. Stick with uptrending stocks, meaning that they are trading above both their 50- and 200-day moving averages (average closing price over specified period). 

#9 Not Overpriced
Fast moving stocks eventually attract too much attention. Everybody piles on and the share prices reach unsustainable levels.

The most widely used valuation measure is the price/earnings ratio (P/E), which is the recent share price divided by the last 12-month’s per share earnings. However, for fast earnings growers, the forward P/E, which is calculated using the next fiscal year’s expected earnings, is more meaningful. Avoid stocks with forward P/Es above 30, and lower is better.

#10. Don’t Overreact 
Stocks often make short-term moves for reasons unrelated to their long-term outlook. Checking your stocks too often will make you crazy and could cause you to sell too soon. If you hold fast moving “rockets,” check prices only once a day, after the market closes. For other stocks, once a week is enough.

These 10 rules of will help you make better decisions. But they are not the final answer. You still must do your research. The more you know about your stocks, the better your results.

published 4/25/10

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