Recapping again:  Our hypothetical investor decides to place 85% of his equity money in an S&P 500 index fund and another 10% in sector funds following the business cycle.  The strategy, which has to be continuously monitored and tested for its accuracy, is that, after almost two years of discounting bad economic news, stock markets are much more likely to shift their attention to the possibility of a better economy next year than to continue to discount the current situation.

What’s left to invest?  –the 5% that’s going to go into individual stocks.  This will be the highest risk portion of the portfolio, and will most likely consist of two or three names.

How do you figure out what to hold?  You want to end up holding a stock where:

–you’re confident you know something about it that the market generally isn’t yet aware of;

–that “something” is important enough to move the stock price up a lot;

–you have a way of monitoring whether your insight is proving to be right or not;

–you have an exit strategy.

These four points will lead to different stocks for different people.  But in the US, it’s much more important to have a fundamentally sound stock that you know a lot about than to be invested in the strongest sector (in non-US markets, in contrast, it’s probably better to have  weak stock in a strong sector).

Knowledge

Ideas can come from anywhere.  In his first book, Peter Lynch (of Fidelity Magellan fame) talks about noticing Dunkin’ Donuts because he bought coffee there on the way to work.  One of my relatives pointed out Chicos to me (while it was still a good stock) years ago.  Watching my kids play Guitar Hero made me add to Activision.

One advantage we may have over professional investors is that they tend to be finance experts who live affluent, urban lifestyles.  As a result, they probably don’t experience as much of everyday American life as the average citizen.  They may also not have the deep knowledge that one may get from a lifetime of work in a specific industry.  They may be able to assess the stock market relevance of information faster, but others have the information earlier.

The important thing is to find an area where you have reason to believe that you have an edge.

Relevance

I’ll admit that I’ve never liked GE, which has always seemed to me to more a product of  former chairman Welch’s PR skills than stellar operating performance.  In any event, it’s an interesting case because one might have known its industrial prospects in China inside-out, but the most important determinant of GE’s stock price has been the collapse of its always-opaque finance arm.

You could also have spotted the growth potential of Coach while it was buried in Sara Lee, but that didn’t do you any good until the business was spun off.

Apple is perhaps the best recent example where individual investors understood the potential for a new product, the i-Pod, to double the profits of the company long before Wall Street did.

A Blueprint

Ideally, you’ll have a spreadsheet that projects the company’s revenues and costs, line-of-business by line-of-business, over the next several years.  You’ll also reconcile cash flows. You’ll monitor your projections against company announcements.  And you’ll try to have some early warning indicators that can give you a heads-up if things are going especially well or poorly.

You may not be able to develop the spreadsheet data that I’ve just described.  But you should at least be aware that this is the minimum the professional competition has.

What other monitoring can you do?  You can pretty easily get on a company’s email list by signing up on its website.  Anyone can listen either to the quarterly results conference calls or their internet replays.  You should also download and read the annual and quarterly reports and their SEC equivalents, the 10-k and 10-q.

Many times trade associations or government agencies have valuable information about overall industry trends.  If you’re lucky, you may be able to identify an indicator that is closely related to a company’s revenues or costs.  You can visit  trade association or government websites.  Often you can call to ask questions.  There may also be product user group websites, or, in the case of big companies, websites dedicated to the company itself.

Sometimes you can find a key customer or supplier, whose results shed light on those of the company you’re interested in.  In Intel’s early days, for example, the newest chips ran so hot they had to be put in ceramic packages, which were supplied by two publicly-traded Japanese companies.  These firms’ announcement of new orders were very closely linked with Intel’s.  More recently, monitoring makers of components for small form factor hard disk drives has given good insight into demand for Apple’s i-Pods, which are the dominant product using such drives.

Exit Plan

I think that before you buy a stock, you should be able to state your general investment idea in a few short sentences, sort of like an elevator speech.  For example:

CAT makes construction equipment.  It’s a cyclical company at the bottom of the cycle.  It typically trades from 5x cash flow in bad times to 10x cf in good times.  It’s now at 5x.  I think cash flow can double in the next five years and CAT can easily trade at 8x again.  Therefore the stock can more than triple.   (I’m a growth investor, so don’t take this as conviction on my part.  I just made this up after looking at CAT historical data.)        or

AAPL is just about to open an online iTunes store.  This will stimulate sales of the iPod tremendously, to the point where the product can add at least 50% to company profits–and maybe more–each year for the next two, boosting the growth rate from 25%.  If we’re lucky, the combination of Apple Stores and i-Pod will get more computer users to make their next laptop a Mac, boosting profits further.  Wall Street thinks the company is growing at 25%/year and trading at 40x.  It’s actually growing at 80%+ and trading at 28x.  The multiple can expand to the true growth rate,  meaning the stock can triple.

Two short statements of an investment thesis.  Also two exit plans.  As long as the stock is doing what the thesis says it should, hold the stock.  As soon as the company starts not living up to the thesis, either recalibrate or just sell.