(MONEY Magazine) – If you're like most small investors, you probably worry that you're at an enormous disadvantage to the pros when it comes to stock picking. And since, on average, even experienced mutual fund managers can't quite keep up with the stock market indexes, you may have concluded that your wisest choice is to put the bulk of your equity money in an index fund that will roughly match the overall market.

Fair enough. If you want a safe, low-maintenance way of locking in long-term profits, you should put as much as 50% of your money into index funds (for a full discussion of such funds, see MONEY's August 1995 cover story, "The New Way to Make More Money in Funds"). However, investors who have a little experience and, say, $25,000 or more to invest shouldn't limit themselves to such funds. For one thing, if you plan to buy and hold shares for longer than five years, you can cut your total investing costs by purchasing individual stocks. For another, there are actually some techniques that will give you an excellent shot at outrunning the S&P 500.

There's a widespread belief that no simple strategy can outperform the market averages. And up to a point, that's true. Nonetheless, extensive academic research over the past decade has shown that some specific situations give investors a slight edge over the broad market indexes.

For this story, I've boiled down research discussed in my new MONEY book, Michael Sivy's Rules of Investing (Warner Books, $24.95), to seven smart stock-picking strategies. As an example for each one, I've identified a high-quality stock. There's also a discussion on the opposite page of three top-performing mutual funds that make use of these and similar investing approaches.

Two caveats, however: First, although these strategies all outperform the overall market, there's no guarantee that any single stock will beat the market. Be sure to include these picks in a diversified portfolio of a dozen or so issues. Second, these strategies work best over periods of two or three years. So be sure you're investing for the long term and don't expect overnight profits--especially if, as I believe, the market has a temporary 10% to 15% slide ahead of it over the next six to 12 months.

Now here's a rundown of the strategies and the stock picks, in order of their potential returns over the next 18 months:

BUY DEPRESSED SHARES AFTER A COMPANY STARTS GETTING ITS ACT TOGETHER

When a stock is selling at a price that analysts consider cheap and the company starts reorganizing its businesses, the shares often get a hefty boost. The only twist is that the biggest jump in share price frequently comes immediately before major changes are announced by management. Reason: Savvy shareholders who watch the company closely anticipate when a restructuring is about to begin. One study of more than 1,000 companies that sold off major assets found that nearly all the benefit occurred in the two weeks immediately prior to the announcement of a sale.

As a result, investors should buy a stock after a company has made initial reorganization moves but before the biggest potential changes have occurred. One timely candidate for further restructuring is Viacom (VIAB; recently traded on the American Stock Exchange at $41; no yield), the New York City entertainment conglomerate that includes MTV Networks, the Paramount movie studio and the Blockbuster video-rental chain. Estimated 1996 revenues: $12.6 billion. Last year, in the first of several expected strategic moves, chairman Sumner Redstone, 72, sold Viacom's Madison Square Garden properties to Cablevision Systems and ITT for $1 billion--or about $350 million more than most analysts expected. The company also plans to spin off its cable-television business to cable giant Telecommunications Inc. later this year for $2.3 billion.

In addition, Viacom has made a deal giving KirchGroup, the leading independent television broadcaster in Germany, the German-language rights to Paramount films and other programming. "The agreement could be worth as much as $1.7 billion for Viacom over the next 10 years," says analyst Alan S. Gould at Oppenheimer in New York City. And further major deals are likely as Redstone reshuffles Viacom's holdings. The company's nonvoting B shares are the most actively traded. Gould thinks the stock could rise as much as 46% to $60 over the next 18 months.

FAVOR FIRMS THAT INVEST IN THEMSELVES

When a company's top management decides that the firm should repurchase its own stock, that's often a sign that you should be buying too. Buybacks frequently boost share prices for two important reasons: First, they are a signal that insiders think the stock is too cheap--and they have access to the best available information, including facts that are not publicly known. Second, buybacks can boost a company's earnings per share, because profits are divided among fewer shares outstanding.

Moreover, research supports this reasoning. "In the three years following the announcement of a buyback, stocks outperformed comparable shares by an average of 12.6%," says finance professor David Ikenberry at Rice University in Houston. Along with his colleagues Josef Lakonishok at the University of Illinois and Theo Vermaelen of the French business school INSEAD, Ikenberry studied more than 1,200 companies that announced stock buybacks between 1980 and 1990.

Currently, buybacks are running at the highest levels in history. So far this year more than 450 companies have announced plans to repurchase $65 billion worth of stock. One buyback candidate that has Wall Street purring right now is Ralston Purina (RAL; New York Stock Exchange, $58.25; 2.1% yield), the $6 billion producer of pet food and Eveready batteries.

Ralston has been a steady buyer of its own shares since 1982, repurchasing more than half its outstanding stock. As a result, the share price has risen tenfold--from less than $6 to today's $58.25--over that time period. "Ralston virtually stopped its buyback program last year, however, because it was selling off assets," explains analyst John C. Bierbusse at A.G. Edwards & Sons in St. Louis. "But with that restructuring out of the way, we suspect they'll start repurchasing stock again." Bierbusse figures the shares could reach $80 over the next 18 months. Including the $1.20-a-share dividend, that's a 40% total return.

PUT MONEY IN COMPANIES WHERE TOP EXECUTIVES OWN BIG STAKES

It stands to reason that when a company's management holds a big chunk of the firm's stock, executives will work extra-hard to push the share price up. And research shows that this commonsense view is correct. "If the CEO owns a lot of stock, a company tends to perform better," says Ira Kay, a director of the Washington, D.C. consulting firm Watson Wyatt Worldwide. A study by the firm of 105 large U.S. companies over a five-year period found that businesses with high CEO stock ownership outperformed their peers by an average of as much as four percentage points annually.

For corroboration of the theory, you need only look at America's two richest men: Warren Buffett, the CEO of Berkshire Hathaway, and Bill Gates, the CEO of Microsoft. Both own more than $10 billion of stock in their companies, and both stocks have been magnificent performers over the past five years, with compound annual returns of at least 33%.

Who's next on the list of shareholder CEOs? No. 3 is Lawrence J. Ellison, who owns about $5 billion of stock in Oracle (ORCL; NASDAQ, $33.75; no yield). With annual revenues of $4.1 billion, Oracle is the world's largest maker of database-management software. And over the past five years, the stock has returned an average of 73% annually. "Oracle has been the clear leader in the industry and will continue to be," says analyst James Pickrel at Hambrecht & Quist in San Francisco. He thinks the shares could gain 24% to around $42 over the next 18 months.

TAKE A LOOK AT STOCKS AFTER THEY SPLIT

Although a stock split would seem to have little practical effect--you just own twice as many shares worth half the price, for instance--most investors regard a stock split as a positive sign. And they're absolutely right. "On average, stocks that split outperform their peers by 8% in the first year after the split and a total of 12% over three years," says Rice University's Ikenberry, who along with his colleagues Graeme Rankine at the American Graduate School of International Management and Earl K. Stice of the Hong Kong University of Science and Technology recently examined all 1,275 two-for-one splits that occurred between 1975 and 1990 on the New York and American stock exchanges. In addition, two other studies over periods of 15 years or longer have found superior performance ranging from four to nine percentage points for up to three years after the split.

One attractive stock that's about to split is American Home Products (AHP; NYSE, $52.75 adjusted for the split; 2.9%), a $14.2 billion maker of drugs and other health-care items. For several years, AHP has been out of favor with investors because it has had relatively few major new products in the pipeline, compared with what drug stock superstars such as Merck and Pfizer have had. But recently AHP's new product lineup has improved significantly, says Mariola B. Haggar at Deutsche Morgan Grenfell in New York City.

"The company's prospects are now underestimated," says Haggar. "They have at least six new drugs in development that could have potential sales of half a billion dollars apiece and sustain a double-digit earnings growth rate through the end of the decade." She thinks the stock could rise to $62.50 within 18 months. With the $1.54-a-share dividend, that's a 23% return.

BUY CLOSED-END FUNDS SELLING AT DISCOUNTS OF MORE THAN 10%

Unlike open-end mutual funds, which can be bought directly from fund companies at prices virtually equal to the value of the securities in the funds' portfolios, closed-ends trade on stock exchanges and can sell for more or less than the value of their holdings (known as net asset value, or NAV, for short). Numerous studies have found that when closed-ends are selling at exceptionally large discounts, they outperform the overall stock market.

From 1981 through '94, for example, closed-ends with discounts of more than 10% returned 18.5% a year, on average, compared with 13% for the typical closed-end and about 12.5% for open-end mutual funds, according to Norman Fosback, editor of the monthly newsletter Mutual Fund Forecaster ($49 a year; 800-442-9000). "The size of the discount is the most significant factor for the future performance of closed-end funds," says Fosback.

Now is a great time to profit from the closed-end bonus, because discounts are unusually large. On some foreign stock funds, for example, discounts are as much as 20%. The best strategy for investors who have never owned a closed-end before is to look first at funds that hold the shares of an entire region rather than just a single country. A prime example is the Europe Fund (EF; NYSE, $13.50; 5.2%), with assets of $142 million, which is now trading at an 18% discount to NAV. "This looks like the best of all the funds that hold European stocks," says George Cole Scott, an analyst for Anderson & Strudwick in Richmond, who specializes in closed-ends.

The fund has its money in major developed countries--with about a third in the U.K. and most of the rest in France, Germany, Sweden and the Netherlands. Europe Fund pays a minimum annual distribution of nearly 7% and has returned an average of 17.3% annually over the past three years. Assuming that the fund's discount narrows a bit, the Europe Fund could post price gains of at least 10% over the next 18 months, according to Scott. Combined with its distributions, that would mean a total return for shareholders of about 20% for the period.

BUY SPIN-OFFS A MONTH AFTER THEY GO INDEPENDENT

Giant corporations sometimes decide they can raise the return on their shares by spinning off divisions that distract from the corporation's main businesses. In such cases, the spin-offs can be great investments--several academic studies have shown that they are top performers.

There's a catch, though. A newly independent firm's shares often falter just after it is spun off. Reason: Many investors who receive the shares in a spin-off don't particularly want them and sell them right away. That depresses the price--and creates a great buying opportunity for investors who are willing to wait a month or two. One 1994 study by Lehman Bros. vice president Patrick Cusatis and Pennsylvania State University finance professors James Miles and J. Randall Woolridge found that after an initial price drop, the typical spin-off goes on to outperform comparable stocks by 33 percentage points over the following three years.

The biggest spin-off play of 1996 will almost certainly be Lucent Technologies (LU; NYSE, $35; no yield), AT&T's $22 billion equipment-manufacturing division. In April, AT&T sold 18% of the company, or 112 million shares, for $3 billion in the largest initial public offering in history. The remaining 82% of the company will be spun off before the end of the year. As more than 500 million shares are distributed to AT&T shareholders, it's entirely possible that the temporary glut will push Lucent's price below $30. "Any dip would be temporary because Lucent has great prospects," says Kurt Brunner at PNC Equity Advisers in Philadelphia. (Though the stock hasn't yet begun paying a dividend, some analysts think it will yield 0.9% or so in 1997.) Analyst Simon Flannery of J.P. Morgan Securities figures the stock could reach $41 over the next 18 months, which would be a 17% increase from the current price.

SNAP UP COMPANIES AFTER THEY REPORT UNEXPECTEDLY STRONG EARNINGS

It may seem simplistic, but there's ample evidence showing that after companies report better earnings than analysts expect, their shares go on to market-beating price gains. In fact, according to research by Prudential Securities, stocks that reported significantly better than expected earnings between 1986 and 1993 went up 9% more than their peers over the following year.

In addition, one positive earnings surprise is often a sign of more to come, says Melissa Brown, director of quantitative research at Prudential. "Roughly 40% of the companies that report an earnings surprise have stronger than expected profits the following quarter, and 17% go on to a third quarterly surprise." Similarly, a 1996 study by Josef Lakonishok and his colleagues Louis K.C. Chan and Narasimhan Jegadeesh at the University of Illinois found that over a 20-year period stocks reporting strong earnings gains in the previous six months went on to outpace the overall market by about five percentage points the following year.

One company that Brown thinks is likely to continue reporting hefty earnings increases is Louisiana Land & Exploration (LLX; NYSE, $54; 0.4%), a $530 million domestic oil and gas exploration and production company. "Louisiana Land's recent earnings surprises are the result of an extremely successful restructuring," says analyst Gary Hovis at Argus Research in New York City. He notes that the company has sold its main oil refinery, cut costs and has been quite successful finding oil in Louisiana and the Gulf of Mexico. Hovis thinks the stock could move up to $62--for a 15% total return--within 18 months.

Given our forecast that U.S. blue chips are likely to post single-digit returns at best over the next 12 months, these seven strategies look like potential derby winners--with far better odds than you'll find at any racetrack.

Reporter associate: Jeanhee Kim

For a more detailed discussion of these ideas, see Michael Sivy's Rules of Investing (Warner Books, $24.95) ©1996 by MONEY magazine.