Stock-Picking Tips for Your IRA

For example, buying and holding for one year, the top individual strategies over the entire period from 1955 to 1996 were:

• Buying stocks with the lowest price/sales ratio
• Buying stocks with market cap between $25 million and $100 million
• Buying stocks with the lowest price/book value ratio
• Buying stocks with the lowest price/cash flow ratio
• Buying stocks with the highest price change over the previous year

Conversely, the worst strategies were:

• Buying stocks with the highest price/earnings ratio
• Buying stocks with the highest price/book ratio
• Buying stocks with the highest price/cash flow ratio
• Buying stocks with the highest price/sales ratio

And the very worst strategy was buying those stocks that had declined in price the most over the prior 12 months.

O'Shaughnessy combines some of these metrics to arrive at systems that have performed very well over time. In fact, he started a couple of mutual funds that use his approach. They have subsequently been sold to another manager and are now part of Hennessy Funds. I have a small investment in the (HFCGX Quote)Cornerstone Growth that has definitely outperformed the market over the last several years.

Another similar approach to the market was outlined by Joel Greenblatt in his book, The Little Book That Beats The Market. He uses another valuation metric, enterprise value/EBIT, along with a return measure to rank stocks, and posts the results on his Web site. He claims a back-tested 35% annual return for his system, but I have not followed it over the last year or so, and I don't know what recent real-life results have been.

The point is that these quantitative approaches use what has worked in the past and will help you take the emotional response out of the investment equation. When someone asks if you own Google(GOOG Quote), you will smile, knowing that a portfolio full of stocks with valuation characteristics similar to Google is almost certain to disappoint over time. It sure has a great story though.

In the next and final installment, I will get more specific about what investment approach I actually use in my own personal IRA.