Stock Selection Within Mutual Fund Portfolios

There are many competing theories of stock selection and most of them are right one time or another. Regardless of stock picking method or style, one should take into account the warning given by billionaire Warren Buffett, chairman and CEO of Berkshire Hathaway Corp. of Omaha, Nebraska, who said, "Nobody can hope to gain more than 25% per year for many years. It just can't be done." In other words, no style or method of stock picking works all the time.

The least risky way of picking stocks is to select cheap ones. We'll exclude penny stocks since in many cases they are so close to death or irrelevance that their risk is excessive. But cheap stocks, even if they fall to zero, have less to lose than expensive ones. Therefore cheap stocks bear less financial risk. It follows that if one buys a major company that is down on its luck and selling for a low multiple of its earnings per share, there's a good chance of profiting when the company recovers. Yet buying stocks that appear to be failing is counterintuitive. Most people don't want to put good money into a business other investors shun. Thus the strategy of buying these deep value stocks tends to be an extreme of the style of selecting businesses likely to be profitable.

A more conventional approach of investors is to select stocks of healthy companies that are selling for less than market valuations. This is the style of most so-called value investors. These investors seek out stocks with ratios of price to earning per share below market or sector average. These bargains exist for many reasons: companies' earnings may have failed to meet analysts' expectations, the stocks may just be dull or they may be in retreat because a large group of investors have moved out of the company's sector. The greatest investors in history, including Mr. Buffett, have been value investors ready to buy when other investors just yawn.

Alternatively, investors may take an interest in companies that are growing their earnings per share more rapidly than their peers. This is growth investing, a strategy that showed remarkable gains in the tech boom years of the late 1990s and that suffered badly in the correction that began in March, 2000 when the tech stock crash began. Growth investing requires faith in earnings projections. In the early years of the 21st century, growth investing, humbled by the fall to earth of tech stars like Nortel Networks, has been a less than stellar way to make money.

There are numerous other stock picking strategies and, for that matter, methods for investing in stock options, bond futures, mortgages, real estate and agricultural commodities. It is sufficient to say that all of them can work. The strategies vary from examining accounting and company management to ignoring those factors and merely dissecting lines that track price and volume of trading of financial assets. The wise investor, as well as the wise client, can assume that each style and each asset will have its day and diversify. Just as assets and insurance contracts can counterbalance one another, styles of asset selection may enhance one another. After all, knowledge is complementary. The wise financial planner is thus a conductor of a kind of orchestra made up of the assets the client may choose and the risks he faces. Knowledge and practice, judgment, instinct and intuition are needed to make those assets and risks play well together.