by Archie M. Richards, Jr., CFP^®
October 27, 2003

I favor index funds over individual stocks. But if individual stocks are your bag, subscribe to the inexpensive Journal of the American Association of Individual Investors. (www.aaii.com or call 800-428-2244.)

The September 2003 issue lists stocks whose prospects seem favorable. AAII's computer reviewed thousands of candidates and selected 39 that passed AAII's standards. Here are the standards:

The price-to-sales ratio is lower than the company's average price-to-sales ratio for the last 5 years. I like this approach. Ordinarily, companies are valued in relation to earnings per share. But earnings are always a matter of interpretation. Sales are less subject to finagling. The lower the price in relation to the sales per share, the cheaper the stock.

The price-to-sales ratio is lower than the median ratio for the respective industry. You want your stock's price-to-sales ratio to be lower than that of most other companies in the industry. A median is the middle number in a sequence. Take 1, 3, 4, 8, and 9, for example. The median is 4; the average is 5.

The annual compound growth rate in sales for the last 5 years is greater than that of the median for the industry. The faster the sales growth, the better.

The liabilities-to-assets ratio for the last fiscal quarter is less than that of the median for the industry. If a company owes $50 million and has $100 million in assets, its liabilities-to-assets ratio is 50 percent. Low liabilities are safer.

The relative strength is greater than that of the industry median. Relative strength measures the movement of a stock price over the past year compared with that of a market index, such as the S&P 500 Index. Relatively strong price movement has a value above 1.0. Weak movement is valued below 1.0. AAII considers high relative strength to be positive.

The market capitalization for the latest fiscal quarter is at least $50 million. Market capitalization is the company's total market value. Let's say a company has 20 million shares of stock outstanding. The price is $30. The capitalization is therefore $60 million. AAII's minimum of $50 million excludes companies that are too small. As to "fiscal quarter," the accounting year of some companies ends on a date other than December 31. A retail company for which the Christmas season is important, for example, might choose March 31 as the last quarter of its fiscal year, giving time to process holiday sales and returns.

The stock is traded on an exchange or on Nasdaq. The stocks of tens of thousands of companies are not traded on either an exchange or on Nasdaq. They're too small, and their trades are too infrequent.

The company is not in the financial or real estate industries. AAII's standards don't work well with financial or real estate companies. The exclusion is unfortunate. I prefer maximum diversification.

The company is not foreign. I don't like this exclusion either. Over the next few decades, I expect the stocks of foreign companies to outperform those of U.S. companies.

Diversify to sectors the AAII list omits by buying the following exchange-traded funds:

• iShares Dow Jones U.S. Financial Sector Index Fund

• streetTRACKS Wilshire REIT Index Fund

• iShares MSCI EAFE (stocks of Europe, Australasia, & the Far East)

If you can't afford all 42 items (39 plus 3), spread your money in equal amounts (say, $2,000 each) to as many industries as possible.

In making choices of industries or stocks, exercise judgment as little as possible. Make your choices randomly, by flipping a coin, for example. That'll beat Wall Street analysts almost every time.

Since EAFE covers such a large portion of the globe, invest more in that fund than in the other items. Hold the EAFE for at least a couple of decades. Hold the individual stocks for at least five years.

To cut costs, I recommend Ameritrade (www.ameritrade.com) as a broker. Commissions on orders placed with that firm via the Internet are only $11.

To invest in individual U.S. stocks, the American Association of Individual Investors's Journal is a fine place to start.