10 rules for picking stock winners

No. 6: Cash generators

Thanks to flexible accounting rules, a firm can report earnings when, on a cash basis, it is really losing money. Thus, it's necessary to check cash flow to confirm profitability.

Cash flow is the amount of cash that actually flowed into or out of a firm's bank accounts. Since it must reconcile to bank balances, it's not as easily fudged as reported income.

For this check, all you need to know is that cash is flowing in, not out. The price-to-cash-flow ratio will only be positive if that's the case. So, insist on a positive cash-flow ratio (Find this in the Key Ratios section as well.)

No. 7: Low debt

From management's perspective, there's nothing wrong with borrowing money as long as borrowed funds can be profitably invested. For instance, it would make sense to borrow at 6% if a firm could use it to generate a 10% return.

Nevertheless, high-debt firms complicate life for investors. For starters, significant debt means that you've got to scrutinize financial statements to assure yourself that the firm has enough cash coming in to service its debt. Further, should interest rates rise, the higher debt-servicing costs will cut into earnings.

Rather than analyzing balance sheets and worrying about interest rates, for me it's simpler to avoid high-debt stocks.

The total debt-to-equity ratio adds up both short- and long-term debt and compares that total to shareholders equity (also known as book value). Firms with no significant debt have zero ratios (shown as NA on MSN reports), and the higher the ratio, the higher the debt. Consider ratios below 0.5 as low-debt and avoid firms with D/E ratios above 0.5. (Look for the number under Fundamental Data on Money's Company Report page.)

No. 8: Strong price chart

Weak share-price performance compared with that of the overall market signals that clued-in shareholders may be dumping their holdings ahead of bad news that hasn't yet hit the wires. Consequently, you'll do best buying stocks that are outperforming the market.

Relative strength compares a stock's price performance to all U.S. listed stocks. A 90 RS means that a stock has outperformed 90% of all stocks over a specified period, while an RS below 50 signals that the stock has underperformed the majority of stocks.

Stick with stocks with minimum 75 relative strength over the last six months, and higher is better.

No. 9: Reasonable price

Rising share prices usually go hand in hand with strong earnings growth. However, fast growth attracts attention, everybody piles on and eventually share prices reach unsustainable levels.

The most widely used valuation measure is the price-to-earnings ratio, or P/E, which is the recent share price divided by the last 12 months' per-share earnings. However, the historical P/E doesn't mean much for a stock whose earnings might grow by 50% or even double this year.

For fast growers, the forward P/E, which is based on the current fiscal year's forecast earnings instead of historical earnings, is a better choice.

• Video: Is price to R&D the new key ratio?

While there's no hard-and-fast rule, in my experience forward P/Es above 40 signal high risk. So stick with stocks with forward P/Es below that level. (Find this number under Earnings Estimates on the Company Report page.)

No. 10: Don't check your stock prices at work

Stocks often make short-term moves for reasons unrelated to their long-term outlook. For instance, a mutual fund might be forced to raise cash to cover shareholder redemptions. Many times a stock will make a big move during the day and end up little changed by the time the closing bell rings.

Checking your stocks during the day will make you crazy and could cause you to sell your stocks prematurely. If you hold fast-moving "rockets," check prices only once a day -- after the market closes. For other stocks, once a week is enough.

These 10 rules of thumb will help you pick strong investment candidates. But they are not the final answer. You still need to do your due diligence and learn everything you can about your candidates. The more you know about your stocks, the better your results.

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