Stocks: Reduce Risk Yet Maximize Profits - By: John Lux

Most investment theorists tell you that in order to increase stock market profits, you must suffer more risk. We all want to increase profits and limit risk.

Naturally, this conventional idea is not true in all cases.

When I was a professional stock trader, I made most of my profits from appreciation in my portfolio, not in short term trading. In other words, I was a position trader. Any losses in my stock positions were taken out of my paycheck at the end of the month - in fact, I had to pay back any loss. If this is you, you want to know how to make large gains with little risk, and you want to know badly. I became an expert out of necessity. With almost no loses or losing months, I had gains of up to 300% per year.

In my stock picking, I first looked for stocks that were so cheap they could not go down. If they did go down, I was happy to buy more because at those prices, you could buy the whole company and sell off the assets for a profit.

From this group of "safe" stocks, you select the ones most likely to have large appreciation.

A stock is cheap in my book if it sells below the liquidation value of its assets, and most cheap if it sells anywhere near the net amount of cash it has on hand. So the first two measures of value I looked for were book value per share and cash per share.

The value of the shareholders equity on the books is the book value. Generally, since you are buying a share of stock, you will want to know the book value per share.

When you look at book value, be aware that companies usually have intangible assets, things like goodwill. You have to take these intangible assets with a grain of salt. The thing to do to reduce risk is to check "tangible book value." Book value per share is often calculated for you in the various Internet financial stock search programs available.

The next indicator to look for is cash per share or working capital per share. Working capital is current assets minus current liabilities. These assets are near to cash or will generally be turned over in one year: receivables, inventory and the like. To measure the health of working capital, divide current assets by current liabilities to get the "current ratio." A current ratio of two to one or better usually indicates a solid company. As long as the company does not have any long term debt, or at least none coming due in the near future, the company is solvent and should be around for a while - little or no bankruptcy risk.

Next, we look for low price-earnings (P/E) ratios. In my opinion, buying high P/E stocks to chase growth companies is inviting real risk. If the company disappoints in earnings, not only will the stock drop from lower earnings, the P/E ratio will deflate as well, giving you a double hit.

OK, so you have found a company that is selling at or below book value with a current ratio better than 2:1, and a low, low P/E. It may be that the stock will not go down, but will that stock go up?

Picking growing industries and growth companies is more than I can tell you here, but there are two simple things you can look for first: See if the company is doing a stock buy-back about this price. See if the insiders are making large insider purchases? Next, you can look at the ratio of revenues or sales to market values or the dollar amount of sales per share. Generally speaking, the company with a relatively high amount of sales per market value or sales will have more action on the upside. That company has more revenues to make profits from. After you have narrowed the field using the above techniques, there will be no substitute for intense homework about company prospects to find which of those cheap stocks that truly give you superior returns, what I call my "Home Run Stocks."

As I write this, the market is down sharply over the last few months. This is a good time to go bargain hunting using my techniques.

About the Author

A former OTC Trader, investment banker, John Lux wrote the book, "How to Find a Home Run Stock." that tells his stock picking rules. Get your own Home Run Stocks, click http://www.asklux.com/home-run-stock.htm You can email John at lux.investor @ gmail.com

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