10 rules for picking stock winners

By Harry Domash

As anyone who has tried can attest, consistently picking winning stocks is harder than it looks. Follow these 10 rules of thumb to improve your odds of success.

No. 1: Diversify

It's tempting to load up on stocks in today's hot industry or sector -- for instance, energy or China stocks.

In days past, that strategy worked because once in favor, industries often remained strong for a year or longer. But today's market, dominated by computerized trading, moves much faster. An industry could turn cold overnight.

• Video: Is your portfolio diversified?

Thus it's important to diversify your holdings. Avoid investing more than 20% of your funds in any one industry or geographic sector.

No. 2: Ignore guru predictions

Everywhere you turn you'll find some guru predicting which way the overall economy, energy prices, interest rates, the value of the dollar and numerous other factors are headed. 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 a good job with that, the other factors won't matter.

No. 3: Avoid cheap stocks

Sure, we all want to quit our day jobs -- and the quickest way to do that is by loading up on a stock selling for pennies a share that soars to $100 or more. But the odds of hitting that home run are about the same as winning the lottery.

Stocks changing hands for less than $5 per share, often termed "penny stocks," trade for those prices because most market players see fundamental problems ahead. Avoid stocks trading for less than $5 per share.

No. 4: Follow the big players

Because institutional investors such as mutual funds and pension plans generate huge trading commissions, they have access to information that you will never see.

If these big players don't think they can make money on a stock, they don't own it. Thus, it makes sense to piggyback on their efforts and avoid stocks that the institutions don't want.

Institutional ownership, the percentage of a company's shares owned by these big players, typically runs from 40% to 95% for in-favor stocks. Pick stocks with at least 40% institutional ownership. (You can see the institutional ownership on the MSN Money Company Report page.)

No. 5: Profitable

Some companies have exciting stories to tell but have yet to report a profit. For many such firms, profits are always just around the corner. Alas, in the end profits drive share prices. Perpetual money losers are apt to break your heart.

However, positive income isn't enough. You'll do best by sticking with companies that can finance growth from profits rather than by borrowing or selling more shares. Both of those alternatives diminish the value of existing shares.

You can use return on equity (net income divided by shareholders equity) to determine whether a firm is sufficiently profitable to finance growth. A firm can't internally fund annual growth more than its ROE. For instance, a 10% ROE firm can't internally fund more than 10% annual earnings growth.

To qualify as a growth candidate, most investors look for at least 15% expected earnings growth, and often more. Require a minimum 15% ROE, and increase that minimum for faster growing stocks. (Find ROE in the Investment Returns section of MSN Money's Key Ratios report.)

Continued: 5 more rules of thumb

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