Schwab's rating system makes the grade

(Fortune Magazine) -- Charles Schwab, which made its name as a no-frills discount broker, is building quite a reputation for stock picking. Since the company began using its Schwab Equity Ratings system in 2002, its model stock portfolio has returned a total of 97 percent (through 2006), vs. 35 percent for the S&P 500, according to Zacks Investment Research, and its actively managed stock funds have beaten their benchmarks. Chief investment officer Jeff Mortimer talked to Fortune's Katie Benner about the company's stock-picking system and some of the companies it is highlighting now.

How does the Schwab Equity Ratings System work?

Mortimer says market dips create great entry points.

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To develop the system, we identified stocks that have been winners over time and looked for the traits they shared. After analyzing hundreds of factors, we found 18 that predicted future performance. The 18 factors are divided into four broad categories: fundamentals, valuation, momentum and risk. The stocks are given grades, A through F, based on how they perform in the four categories.

And you use the system in some of your mutual funds too.

We developed the Equity Ratings mutual funds because retail investors said they'd rather buy funds than use the research to buy individual stocks. We use ratings to choose stocks that fit the style of the portfolio, and the system also weeds out the riskiest companies.

Based on this ratings system, which companies do you like now?

Two stocks we like are Cigna (Charts, Fortune 500) and Boeing (Charts, Fortune 500). Cigna is a free-cash-flow machine, and it has beaten expectations 16 out of 16 quarters. We also recognize that it has been volatile, particularly in the first half of 2006. It has recovered from those losses, it's pushing higher, and management is buying back the stock. We see wonderful opportunity for future appreciation.

Boeing also has good cash flow, strong fundamentals, and good momentum. Plus, it has had some positive surprises while its competition is running into trouble. It's beating the competition and putting itself into a strong market position.

We have had a buy rating on MetLife (Charts, Fortune 500) since May 2004. The stock, which has topped analyst expectations 12 out of the past 12 quarters, has $18 billion in cash on hand and a stable earnings stream that makes the firm good from a risk standpoint. Analysts are also upbeat, expecting 11 percent long-term growth.

The Dow is setting record highs, but there's also plenty to worry about, including the slumping housing market and the impact it could have on consumer spending. What's your advice for investors in this environment?

The smartest thing an investor can do is to get started, because there's no way to know whether now is the perfect time to start investing. To get around market swings and mitigate risk, people should use dollar cost averaging and have a diversified portfolio, but the most important thing is to start as early as possible.

People say they're waiting for the market to bottom, but you could miss out on gains while you wait for that magic moment. People have been predicting a slump since 2003, and if you waited for it to come, you missed out on three years of gains.

Volatility is back, and that's not necessarily a bad thing for longer-term investors. For them, six to 12 months doesn't matter. Dips in prices offer investors wonderful entry points and opportunities to reposition the portfolio. It sounds counterintuitive, but volatility allows our managers to enter and exit at better prices.