How to pick stocks without getting burned

@Money June 5, 2012: 6:10 PM ET
stocks investments

(Money magazine) -- Anytime you seek to pump up returns, you take on risk. If everything collapses, it can leave a bad taste in your mouth. How else to explain that individual investors, burned in the financial meltdown, have continued to flee the U.S. stock market even as it has doubled?

Far better to exercise restraint. Rupal Bhansali, an international stock fund manager with an enviable long-term record, puts it this way: "Win by not losing. Paying attention to risk doesn't mean you have to give up on good returns."

During most bullish years she has trailed her competitors, but in bear markets she has lost far less. Her investors ended up with smoother, better returns.

Before Bhansali thinks about the upside a stock presents, she looks at the risks. Is the company carrying too much debt? Is the stock price so high that any sign of trouble spells disaster?"

"Paying attention to risk doesn't mean you have to give up on good returns," says Bhansali. "In fact, a strategy that keeps risks low can put more money in your pocket."

That's the advice this series on reducing risk and maximizing returns aims to provide.

In this story, you'll find a step-by-step approach to sifting through stocks to find ones that offer an extra margin of safety and potential for solid returns. Plus, seven low-risk stock picks.Part 2 does the same for stock mutual funds, offering up seven funds that will keep your money safe during stormy times. That's followed by advice on how to handle today's fixed-income market, a traditional safe haven that's grown risky in its own right.

Finally, you'll be warned about exotic, expensive products Wall Street is pushing as "safe." Forget them. Enough time, and the right mix of good, basic investments are all you need.

Step one: Start with a stable base

A bedrock principle of investing is that if you seek out higher returns, you must be willing to assume greater risk. When you're just dealing with stocks within a single market, though, the reverse may be true: "Over time the riskiest stocks actually have the lowest returns," says economist Robert Haugen, president of Haugen Custom Financial Systems.

Haugen is talking about a particular type of risk: the unpredictable up-and-down swings in stock prices. He found that between 1990 and 2011, the steadiest U.S. shares produced the highest returns, while the most volatile domestic stocks lost value.

So a good low-risk strategy starts with eliminating the shakiest stocks from consideration. At Finviz.com, you can rank stocks for free based on a specific measure of volatility called "standard deviation," which Haugen relied on for his research.

Standard deviation takes all the returns and losses that an investment produces over a period of time and measures how spread out they are. A high monthly standard deviation of, say, more than 75 would point to a stock that's likely to soar when it's up but nosedive when it's down.

To screen for this volatility measure and all other variables throughout this article, we chose to use Morningstar.com's premium online screening tool. While it costs $21.95 a month, you can buy a one-month subscription and cancel once you're done. And it allows you to compare a stock's risk characteristics against those of industry peers.

Step two: Focus on shares that can take the heat

Volatility measures the propensity of a stock to jump up and down. You're probably only worried about the downs. An easy way to focus on that is to search for stocks that performed better than their peers in bear market conditions.

For example, the retailer Wal-Mart (WMT, Fortune 500) and the media giant Viacom (VIA) both sport below-average standard deviations of less than 25 (they rank among the top quarter of all domestic stocks tracked by Morningstar in terms of stability).

Yet that doesn't tell the whole story. Wal-Mart has a high bear market rank -- its shares actually returned 20% in 2008, vs. the 37% drop in the S&P 500. Meanwhile Viacom's shares lost more than 50% that year.

Now, that is no guarantee that Wal-Mart -- or any stock with a good bear market track record -- will outperform come the next downturn. It's good to know, though, how certain shares behaved in past times of panic.

Morningstar's screening tool lets you do that by filtering out stocks with worse-than-average "bear market rank" among companies in various sectors.

Fund manager Bhansali, now at Ariel Investments, adds that there's a big benefit to sticking with bear market winners over the long run. With stocks that lose less in bad years, she says, "you don't have to play as much catch-up in good years."

Step three: Add an extra dollop of safety

For an added margin of safety, stick with stocks trading at price/earnings ratios that are below that of their average industry peer.

Now, you might not think of stock valuations as a gauge of safety, but low prices provide you extra cushion should the market suffer a pullback. After all, low P/Es are a sign that the market may have already punished these stocks, so theoretically there would be less room for the shares to fall compared with highfliers.

Also, the price you pay for a stock matters, since there's no guarantee it will continue to trade at or above those levels.

"One of the biggest risks you face as an investor is paying a price you'll never see again," says Keith Trauner, co-founder of GoodHaven Capital Management.

Step four: Go with the healthiest ingredients

The financial crisis showed that in addition to the risks of owning volatile shares, there's also the possibility that the underlying companies you own could falter or go bust. Lehman Brothers was the extreme example. But for every Lehman, there are plenty of examples of once-dominant businesses, like Eastman Kodak, that lose their market share and mojo over time.

So, while volatility is important, "you can also lower risk by seeking fundamentally strong businesses that won't ever need to be carried off the field," says Trauner.

How? Look for companies that are stronger than their industry peers in three basic areas: First, go with businesses that have lower-than-average debt on their books relative to their total market value, since that gives them a greater margin of safety than their competitors in case the economy or business goes bad.

Long-term debt at Exxon Mobil (XOM, Fortune 500), for example, represents just 6% of its total stock market value. The debt of many companies stands at around 50%.

But Tom Forester, manager of the defensive-minded Forester Value fund (FVALX) -- the only stock fund that made money in 2008 -- says that depending on the sector, you should demand much less borrowing. For instance, he would look for industrial companies with debt levels below 20% to 30%.

Second, make sure any company you're thinking of investing in is a big generator of cash -- in other words, after paying its bills each month and meeting other obligations, the business has money left over.

In a financial statement, this is known as "free cash flow," considered an indicator of safety because this money can be used for anything -- to reinvest in the company for growth, pay down debt, and cover emergencies.

The best-performing companies generate just under 6% of their market capitalization in cash each year -- yet the industrial giant United Technologies (UTX, Fortune 500) throws off more than 7.5%, thanks in part to its below-average debt and a steady stream of aerospace and defense contracts.

Finally, you'll want to focus on companies with better-than-average profit growth, since, after all, a stock's performance is ultimately tied to the underlying company's earnings potential.

Step five: Fortify your recipe

Robert Zagunis, manager of Jensen Quality Growth (JENSX), which is in the MONEY 70, says there's another key ingredient all healthy businesses share -- high "returns on equity."

Return on equity, or ROE, is a measure of profitability with a twist. This figure takes net income and divides it by all the money that shareholders have put into the firm, including reinvested earnings. The idea is to see how efficient a business is at turning shareholders' money into profits.

Zagunis adds that ROE is useful because it reinforces the other good traits that solid businesses share: "When a company can perform at a high level for many years in a row, that return on equity compounds and creates cash flow." And with that cash flow it can pay down debt and invest in future growth, he says.

The Jensen fund isn't so much interested in what a company's ROE is in any given year. The fund's managers want to own businesses that have a record of consistently producing high profits, even in downturns like 2008.

So the fund screens for stocks that have produced at least 15% ROE every year without fail for a decade -- a screen that takes a universe of more than 3,000 U.S. stocks and winnows it to fewer than 200. You'll find companies like Emerson Electric (EMR, Fortune 500), whose products range from motors to electric tools to testing equipment.

Step six: Add a sweetener

No low-risk screen would be complete without dividends, which serve as a cushion for periods when share prices slump. That doesn't mean you should favor firms with the absolute highest yields. Sky-high yields can actually be a sign of danger if they result from stock prices cratering.

Safety seekers are better off with firms that have consistently raised their payouts, no matter what the size of the dividend is.

Rising payments are a sign that a company's financial health keeps improving, and it's "a way for management to show they prioritize shareholders and have confidence in future earnings," says Zagunis.

Ned Davis Research found that over the past 30 years, dividend growers have returned an average of 10.4% annually, compared with 9.4% gains for basic dividend payers and 1.5% for nonpayers.

Four of the stocks you see below, which are examples of shares that meet all of the above-mentioned screens -- Emerson, Exxon, Wal-Mart, and the health care equipment maker Becton Dickinson (BDX, Fortune 500) -- are members of the S&P 500 Dividend Aristocrats index, companies that have boosted payouts for at least 25 straight years.

Low-risk stocks: The picks

These seven stocks passed all of our strict safety standards.

Becton Dickson (BDX, Fortune 500): This medical equipment maker has raised dividends for 25 straight years.

  • Sector: Health care
  • P/E: 11.8
  • Yield: 2.4%
  • ROE: 25%
  • Standard deviation: 17.8

Emerson Electric (EMR, Fortune 500): This conglomerate seeks to be first or second in all its businesses.

  • Sector: Industrials
  • P/E: 11.6
  • Yield: 3.4%
  • ROE: 22%
  • Standard deviation: 27.9

Exxon Mobil (XOM, Fortune 500): This highly diversified energy giant dominates both oil and natural gas.

  • Sector: Energy
  • P/E: 8.8
  • Yield: 2.5%
  • ROE: 26%
  • Standard deviation: 17.4

General Mills (GIS, Fortune 500): Leading brands and cost controls helped it navigate the tough economy.

  • Sector: Consumer staples
  • P/E: 13.8
  • Yield: 3.2%
  • ROE: 24%
  • Standard deviation: 12.3

IBM (IBM, Fortune 500): This tech leader finds steady growth abroad and in cloud computing.

  • Sector: Technology
  • P/E: 11.4
  • Yield: 1.6%
  • ROE: 74%
  • Standard deviation: 15.2

United Technologies: (UTX, Fortune 500) Strong cash flows allow it to diversify through acquisitions.

  • Sector: Industrials
  • P/E: 10.8
  • Yield: 2.7%
  • ROE: 19%
  • Standard deviation: 20.2

Wal-Mart Stores (WMT, Fortune 500): Low debt and solid cash flow lets the retailer keep expanding abroad.

  • Sector: Retail
  • P/E: 12.3
  • Yield: 2.3%
  • ROE: 24%
  • Standard deviation: 15.5

Notes: Price/earnings ratios are based on projected profits. Return-on-equity figures are based on trailing 12 months. Standard deviation is based on 36 months of returns. Source: Morningstar. Data as of June 4, 2012.

More ways to Make your money safer:

7 low-risk funds for the long haul

Fixed income: 4 safer bets for today's market

'Safe' investments that are actually risky  To top of page

Index Last Change % Change
Dow 16,408.54 -16.31 -0.10%
Nasdaq 4,095.52 9.29 0.23%
S&P 500 1,864.85 2.54 0.14%
Treasuries 2.72 0.08 3.19%
Data as of 9:01pm ET
Company Price Change % Change
Bank of America Corp... 16.15 0.00 0.00%
Facebook Inc 58.94 0.00 0.00%
General Electric Co 26.56 0.00 0.00%
Cisco Systems Inc 23.19 -0.02 -0.09%
Micron Technology In... 23.91 0.00 0.00%
Data as of Apr 17
Overnight Avg Rate Latest Change Last Week
30 yr fixed4.36%4.24%
15 yr fixed3.39%3.26%
5/1 ARM3.36%3.27%
30 yr refi4.34%4.22%
15 yr refi3.38%3.24%
Rate data provided
by Bankrate.com
View rates in your area
 
Find personalized rates:
Market indexes are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer LIBOR Warning: Neither BBA Enterprises Limited, nor the BBA LIBOR Contributor Banks, nor Reuters, can be held liable for any irregularity or inaccuracy of BBA LIBOR. Disclaimer. Morningstar: © 2014 Morningstar, Inc. All Rights Reserved. Disclaimer The Dow Jones IndexesSM are proprietary to and distributed by Dow Jones & Company, Inc. and have been licensed for use. All content of the Dow Jones IndexesSM © 2014 is proprietary to Dow Jones & Company, Inc. Chicago Mercantile Association. The market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved. FactSet Research Systems Inc. 2014. All rights reserved. Most stock quote data provided by BATS.