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Stocks & Bonds

Four Stock Picking Tips from the Pros

Learn how to pick stocks like the pros with these four pointers.

No doubt about it, the managers of Jensen Portfolio fund (JENSX) have a knack for stock-picking. The large-company growth fund's five-year annualized return is 6% -- more than 6 points ahead of its benchmark, the Standard & Poor's 500-stock index.

When you understand Jensen's approach to buying stocks, its success isn't all that surprising. In fact, the principles its managers apply to buying winning stocks are ones you can use to pick stocks at home.

Companies that can

Compared with other funds, Jensen doesn't own many stocks -- just 25. So the managers can be extra picky when they're considering candidates to buy. Above all, when Jensen's managers go shopping, says co-manager Robert Zagunis (who shares the helm with Robert Millen and Val Jensen), they buy shares of a company -- not just a stock. Companies they consider for the fund must show financial strength and consistency, not just an impressive chart.

One key to strength the fund focuses on: return on equity. Return on equity is a company's net income divided by the market value of its common and preferred stock. Jensen looks for ROE of at least 15% over the past ten years. The average ROE of the fund's stocks is a notch north of 20% says Zagunis. To find a company's ROE, enter the symbol in ths stock quote box on any Kiplinger.com page. Then scroll down to "Financial Highlights."

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The fund also looks for steadily rising free cash flow, or cash on the books after normal operating expenses. It's what gives a company maneuverability to pay shareholder dividends, buy back stock, make acquisitions or pay down debt. And it's an important element of growth. Getting cash-flow data is as simple as paging through a company's annual report. In most cases, you can find annual reports on the company's Web site. Or you can find annual and quarterly cash flow reports within a Kiplinger.com stock quote. From a stock's overview page, click "Financials" and then "Cash Flow."

"The companies that meet these criteria and perform at consistently high levels tend to do so in good times and bad," Zagunis says.

Two examples from Jensen's portfolio: Abbott Laboratories (ABT), the pharmaceutical and health care company, has produced positive free cash flow every year for the past ten years and has an exceptional ROE of 24%.

The fund buys stocks with the expectation that it will hold them for a long time -- another principle individual investors should practice. Jensen's 5% turnover rate (a turnover rate of 100% means all the stocks in a portfolio are, on average, replaced once in a one-year period) attests to its buy-for-the-long-term philosophy.

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Stock picking pointers

What advice would the Jensen team give to do-it-yourselfers?

Keep cash on hand. First, says Zagunis, make sure you have enough money invested for income or for short-term needs before you start socking away all your cash in the stock market. Then you don't have to sell stocks when the market is in a slump.

Be sure stocks are right for your goals. Is your investment approach in line with how long it will be until you need the money? The longer your horizon, the greater the chance that you will be able to ride out the ups and downs in the stock market and come out ahead of fixed-income investments. For any goal more than five years away, you should be primarily invested in stocks.

Don't get hung up on price. "Try to assess what you're paying for a stock by comparing it with what it's worth -- not what the price was in the past," Zagunis says. In other words, what will the company be able to earn down the road? "It's really difficult to assess that with a brand-new company that has yet to prove itself," he says.

Be patient. Like the Jensen team, buy with a long-term bent. "Don't get discouraged in a down market," Zagunis says, "and remember that quality will protect you in the long run."