(MONEY Magazine) – Investors clearly don't need convincing about stock mutual funds. So far this year, more than $65 billion has poured into them, on top of 1995's near-record $128 billion. Where else can you get professional management, broad diversification, liquidity and a risk/reward ratio that suits today's nervous market? Trouble is, not all equity funds have been rising as fast as the market. Over the past five years, fewer than 40% of them have beaten the S&P 500 index's 15% annual return. If your funds are among the lagging 60%, you may be wondering, could you do better investing in stocks on your own? The surprising answer: You probably could.

Just ask Martha Rhode, 49, of St. Paul, a supervisor in the State Office of Minnesota. Over the past eight years she has built a $67,000 portfolio of shares in big national corporations like $34 billion K Mart, which she bought in November, and smaller local Minnesota companies. "I had some funds," she says, "but I was looking for a better payoff, so I started buying my own stocks." She got it too: an annual return of 21% compounded since 1988, six percentage points better than the market. Similarly, Dennis Horvath, 49, president of his own communications consulting firm in Indianapolis, has reaped a 17% compound annual return. In seven years he has accumulated a $32,000 portfolio of companies he's become familiar with through his work, like $14 billion Compaq Computer. "Buying and selling my own stocks lets me invest in companies I understand," he says. "I like that type of control."

This is not to say you should stop investing in funds altogether. Common sense dictates that, as a beginning stock investor, you should keep around 70% of your equity portfolio in them. That said, here are two major advantages you gain by investing the other 30% in individual stocks:

--First, no one is rating your performance. As a result, you can sit patiently with your picks until they pan out. By contrast, fund managers must endure scrutiny by Chicago fund rater Morningstar, which publishes the funds' top holdings every 20 weeks. Not surprisingly, just before the list comes out, fund managers regularly sell losers and buy issues that have performed well, creating impressive-looking collections for the record book. "Being evaluated every five months can lead managers to make the wrong decisions about stocks," says John Markese, the president of the American Association of Individual Investors. But no one is looking over your shoulder demanding to know why you let a dog keep on howling in your portfolio.

--Second, fees and taxes are less of a drag on stock returns than on fundholdings. True, stock investors must pay commissions. For example, a discounter will charge you $54, or 1.35% of your investment, to buy 100 shares of a $40 stock, the average price of an issue listed on the New York Stock Exchange. In comparison, the average stock fund's annual expenses amount to 1.42% of your investment; on $4,000, that would be $57. The difference is minimal, but you're charged that 1.42% year in, year out. Once you've paid a broker his commission, that's it until you sell your shares.

In addition, funds make capital-gains distributions on which you owe taxes even though you haven't sold any fund shares. The average fund turns over 82% of its portfolio every year, and tax law requires that gains be distributed annually. Although managers try to offset gains with losses, the distributions can substantially reduce your after-tax return. (For more on this, see the next story.) Says Charles Carlson, market strategist of the Dow Theory Forecasts newsletter: "The timing of taxation has huge implications for a portfolio's appreciation over time." Of course, if you own stocks outright, you are also liable for taxes on capital gains, but you decide when to take your profits. Possibly you may never do so, leaving your portfolio intact to your heirs, who will owe taxes just on the stocks' gains after your death--and then only if they sell the shares.

Now that you know the two big advantages of investing directly in stocks, you're ready to figure out what companies you should buy:

--How to get the information you need. Start at the source: Call the investor relations office at a company that interests you, and ask for the most recent annual and quarterly reports and any timely press releases. For historical perspective on the firm's operations, check the Value Line Investment Survey or Standard & Poor's Stock Reports at your local library. "This is an essential first step," says Alvin Hall, author of Getting Started in Stocks (John Wiley & Sons, $16.95). "These reports allow you to become familiar with the company and its earnings potential." If you use a full-service broker, ask him for analyst reports on the company. You also can get them from online databases, such as Dow Jones News/Retrieval (800-522-3567).

"You need to satisfy yourself that a company has the potential to continue growing," says Thomas O'Hara, chairman of the National Association of Investors.To do that, get answers to such questions as: What's the market for the company's products? How much debt does it have relative to its equity? How can a company keep growing if its earnings are going to debt service rather than being reinvested in the business? Are profit margins expanding? In addition, like Dennis Horvath, you may favor companies whose managers own at least 5% of the stock. "That lets you know they believe in the company," he explains.

--How to tell if the price reflects the company's earnings potential. This is where the art of investing really begins. For example, in the table below, we list 10 companies selected by three different methods. First, we asked Value Line to identify companies with strong historical earnings growth of 15% compounded annually, balance sheets that Value Line rates B+ or better for financial soundness, and prospects of continued growth of 15% or more. (All this information is available in the Value Line Investment Survey.) From this list, we selected the three largest companies in three of the economy's strongest sectors: Coca-Cola in consumer goods, Microsoft in technology and Fannie Mae in financial services. Any of them could serve as the big, blue-chip core of a stock portfolio.

Then we asked two successful fund managers to name their top picks, based on the criteria they use to buy stocks for their portfolios. Sam Stewart, co-manager of the $95 million Wasatch Growth Fund (up an annual 22.9% compounded for the past three years), recommended four growth stocks that met his two principal tests: projected 15% annual earnings increases for the next five years and price/earnings ratios that are no more than 25% higher than a company's forecast growth rate. Most pros base P/E ratios on estimated future earnings. But Stewart relies on earnings for the most recent 12-month period because, he says, "that's what the company has proved it can produce."

Our second fund co-manager, Nick Whitridge of $434 million Babson Value (up 20.3% compounded annually over the past three years), looks for stocks trading below the value of the issuing companies' assets or earnings or for stocks whose dividend payout ratio is below its historical norm. For example, Whitridge compares a company's current P/E to that of the overall market and to its own historical levels. Companies that have fallen below the pack by these measures but still have good prospects become candidates for his fund. "Value investing is hard for some investors to swallow," he admits, "as it involves finding companies that aren't in the spotlight."

--How to minimize market risk. Just as you invest in several mutual funds with different investment objectives, you need to diversify your stock portfolio. That way, you don't get killed if, say, a market sector crashes. Fortunately, you don't have to own dozens of issues to do this. Says Alvin Hall: "Academic studies have shown that eight to 10 stocks in a diverse group of industries is sufficient to eliminate about as much risk as mutual fund portfolios made up of large-cap stocks do." Moreover, don't put more than 5% of your total equity portfolio in any one stock. Balance one or two big, blue chips with a couple of small, fast-rising companies, and include both growth and value stocks.

--How to bid farewell to a stock. So what happens when you make a wrong choice? "You should sell a stock only if the fundamental reasons that caused you to buy it have changed," advises Michael Murphy, editor of the California Technology Stock Letter. Suppose earnings have slowed at your growth company and it has started paying a substantial dividend. Bail out; you didn't buy the stock for income. Conversely, your value pick may be a candidate for the discard pile when its P/E ratio returns to its historical level or to the market's average ratio. You bought the stock because it was undervalued; now it isn't.

Unfortunately, most selling decisions aren't that easy. You're more likely to own a stock that starts to slide--and you don't know if the problems are temporary or the beginning of the end. "Most investors are unwilling to admit that they've lost," says Merrill Sands of the Independent Investor Protective League, a Fort Lauderdale organization that seeks to protect individual investors from unfair brokerage practices. "You have to have the discipline to know when to sell." He suggests bailing out if a stock declines 20% from the price you paid for your shares.

A rising stock presents you with a similar--but happier--problem. You could protect your gain by liquidating some of your holding. But Thomas O'Hara suggests continually re-evaluating the company's prospects instead. "If it's still growing strongly, the best move may be to hang on," he says. "Otherwise you'll have to pay capital-gains taxes on your profit and find another equally attractive place to put your money."

Reporter associate: Jennifer Zajac