Get Rich Slowly

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How to Pick a Stock
The moral for the intelligent investor is to avoid second-quality issues in making up a portfolio, unless for the enterprising investor they are demonstrable bargains. --Benjamin Graham

For most investors, selecting individual stocks is unnecessary if not inadvisable. The vast majority of people who try to pick stocks learn that they are not as good at it as they thought; the luckiest ones discover this early on, while the less fortunate take years to learn it. A small percentage of investors can excel at picking their own stocks. Everyone else would be better off getting help, ideally through an index fund.

If, nonetheless, you decide to invest part of your money in individual stocks, how should you go about looking for the best ones? You can use websites like finance.yahoo.com and morningstar.com to screen stocks. And you should take a patient, craftsman-like approach. Many of the best professional investors first get interested in a company when its share price goes down, not up. Christopher Browne of Tweedy Browne Global Value Fund, William Nygren of the Oakmark Fund, Robert Rodriguez of FPA Capital Fund and Robert Torray of the Torray Fund all suggest looking at the daily list of new 52-week lows in the Wall Street Journal. That will point you toward stocks and industries that are unfashionable or unloved and thus offer the potential for high returns once perceptions change.

By checking "comparables," or the prices at which similar businesses have been acquired over the years, managers like Oakmark's Nygren and Longleaf's O. Mason Hawkins get a better handle on what a company's parts are worth. For an individual investor, it's painstaking and difficult work. Start by looking at the "Business Segments" footnote in the company's annual report, which typically lists the industrial sector, revenues and earnings of each subsidiary. (The "Management Discussion and Analysis" may also be helpful.) Then search a news database like Factiva, LexisNexis or ProQuest for examples of other firms in the same industries that have recently been acquired. Using the EDGAR database at sec.gov to locate their past annual reports, you may be able to determine the ratio of purchase price to the earnings of those acquired companies. You can then apply that ratio to estimate how much a corporate acquirer might pay for a similar division of the company you are investigating. By separately analyzing each of the company's divisions, you may be able to see whether they are worth more than the current stock price. Longleaf's Hawkins likes companies whose stock is trading at 60% or less of the value at which he appraises the businesses. That helps provide the margin of safety that Graham insists on.

Most leading professional investors want to see that a company is run by people who, in the words of Oakmark's Nygren, "think like owners, not just managers." Two simple tests: Are the company's financial statements easily understandable, or are they full of obfuscation? Are "nonrecurring" or "extraordinary" charges just that, or do they have a nasty habit of recurring? Hawkins looks for corporate managers who are "good partners"--who communicate candidly about problems, have clear plans for allocating current and future cash flow, and own sizable stakes in the company's stock (preferably through cash purchases rather than grants of options).

At Vanguard Primecap Fund, Howard Schow tracks "what the company said one year and what happened the next. We want to see not only whether managements are honest with shareholders but also whether they're honest with themselves." (If a company boss insists that all is hunky-dory when business is sputtering, watch out!) You can listen in on a company's regularly scheduled conference calls even if you own only a few shares. To find out the schedule, call the investor-relations department or visit the company's website.

Robert Rodriguez of FPA Capital Fund turns to the back page of the company's annual report, where the heads of its operating divisions are listed. If there's a lot of turnover in those names in the first one or two years of a new CEO's regime, that's probably a good sign; he's cleaning out the deadwood. But if high turnover continues, the turnaround has probably devolved into turmoil.

Graham wants you to realize that when you buy a stock, you become an owner of the company. Its managers, up to the CEO, work for you. Its board of directors must answer to you. If you don't like how your company is being managed, you have the right to demand that the managers be fired, the directors be changed or the property be sold. So how should you, as an intelligent investor, go about being an intelligent owner? In its proxy statement, a company discloses details about the compensation and stock ownership of managers and directors, along with transactions between insiders and the company. The intelligent owner will vote against any executive-compensation plan that uses option grants to turn more than 3% of the company's shares outstanding over to the managers. And you should veto any plan that does not make option grants contingent on a fair and enduring measure of superior results say, outperforming the average stock in the same industry for a period of at least five years. No CEO ever deserves to make himself rich if he has produced poor results for you.