How to Pick Stocks: One Manager's Approach

Editor's note: Many of you have asked us: "How do I get started picking stocks?" There's no one way, so we've asked some of our contributors to outline the basics of their approaches. This week money manager Jeffrey Bronchick, for his weekly TSC Buysider column, describes how his firm picks stocks. Upcoming we have a series on the topic by our (once) full-service broker Andrew Greta. Please let us know what you think and what more we can do to help you become a better do-it-yourself investor.

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One of the more irritating things about the investment arena is how nothing is really carved in stone. Nearly every theme, style of analysis, computer-generated program or mechanical approach to investing inevitably creates the seeds of its own demise as it drowns from overpopularity or some basic change in the inputs, which renders the model silly, if not financially dangerous.

Nonetheless, within the caveat of retaining intellectual flexibility, it is clearly to one's advantage to approach stock-picking with a consistent tint in one's glasses. Unfortunately, it can take some time and some money to develop an approach that blends with your temperament, tolerance for risk and the amount time you are willing to commit to investing. Here's our way at Reed, Conner & Birdwell.

Our overall approach is fundamental, long-term and value-oriented, which essentially translates into the following:

We are price sensitive and risk sensitive. A great idea is not a great idea if it is widely recognized and grossly overpriced. We want to pay a great price for a decent company, or a decent price for a great company.

While ideally we would like to be Warren Buffett, the reality is that a two- to three-year time horizon is about how far we can confidently look into the future. It also helps narrow the list of potential stocks; if there is not a sense of fundamental (versus price) momentum at the company, then let's focus where there is some.

That said, we are searching for companies that, somewhat obviously, are "undervalued." This can show up in a number of different guises -- which I will go into later -- but intuitively what we are attempting to do is to value the amount and growth of the "free cash-flow" that a company can reasonably expect to generate in the future, and/or determine the value of the company's business to another competitor or a financial buyer.

We generate stock ideas from both left-brain and right-brain thinking. On the right, analytical side, we screen for stocks using some very basic valuation principles, and our efforts can very easily be duplicated on some reasonably priced software from places like Value Line, Zacks and a number of online screening services.

What we are seeking are lists of stocks that fit our criteria, which we then use as a basis for further research. Desirable traits for us include steady earnings and sales growth, debt below 50% of total capital, five-year returns on equity greater than 16%, stable or improving operating margins, and companies that generate more cash flow than they spend in capital improvements. You then overlay valuation criteria, which might include a low price-to-sales ratio, a price-earnings ratio within 1.2 times the past five-year growth rate, and/or a price-to-cash-flow ratio less than 12.

What you are trying to do is generate lists of potential ideas that at least on the surface appear to be reasonable businesses selling at reasonable prices. It also helps to look at other people's lists of stocks, as long as they are consistent. For example, we love to look at Value Line's list of stocks that get its lowest ranking, 5, for worst-expected performance. It is a great start to find solid companies that have gotten clobbered in the short run. We have found the list to be a indicator of when a stock has hit bottom.

The beautiful thing about the investment business is that the left side of the brain can also produce wonderful ideas. These ideas must be given equal weight to those developed in a more mechanical fashion, the caveat being that they are subject to the same valuation criteria. Left-side ideas come from everywhere, from trips to the supermarket to see the obvious discounting on contact lens solutions (saved us some pain in Bausch & Lomb a few years ago) to an article in American Demographics on the popularity of flexible work schedules (long-term growth for temporary employment companies) to an offhand comment from a salesman sitting next to you on the airplane about disk drives piling up in a warehouse in San Francisco. The key point is that they can all be a basis for further research and should not by itself be the reason to call your broker and plunk some money down.

So now you have a list of stocks culled from the left and right sides of your brain. Narrow the list to 10 names, call the companies (phone numbers in Value Line or here on TheStreet.com in the company quote area) and ask for investor relations.

Request a basic packet of an annual report, 10K, proxy statement and the last few quarterly reports. Sit down on a Saturday and read.

Do you understand the business? Does the chairman's letter seem to indicate that he/she understands the concept of running the business for the benefit of the shareholders? If there have been problems, are they glossed over or dealt with in an up-front manner? Check the proxy and see how much stock is owned by management and the board, and how the management is being compensated. Is the business consistent or is it very cyclical? What probability would you attach to the company's achieving its goals for the next three years, using Coke as a proxy for 90% and a semiconductor manufacturer 15%?

We do a very detailed spreadsheet and look at 10 years of financial history, but in 20 minutes you can get a basic understanding of how the company has been growing sales, operating cash-flow and earnings; how stable gross and operating margins are; whether net operating cash-flow generally exceeds capital expenditures; and whether the footnotes indicate faster or slower growth than what is reported. While a degree in accounting is not necessary to be a successful investor, taking a basic night course in financial statement analysis at a local college is probably worth its weight in gold.

When you have "done the work," and understand what the risks are in the company, and it still makes sense to you, pull the trigger and don't be swayed by friends, CNBC or Wall Street Journal headlines. You must expect to make mistakes, but by focusing on a limited number of stocks that you understand well, you can help limit mistakes to tolerable losses. And, in our opinion, avoiding bad mistakes is 75% of being a successful investor.