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money, you can make mistakes without incurring any actual losses, develop the discipline to avoid frequent trading, compare your approach against those of leading money managers, and learn what works for you. Best of all, tracking the outcome of all your stock picks will prevent you from forgetting that some of your hunches turn out to be stinkers. That will force you to learn from your winners and your losers. After a year, measure your results against how you would have done if you had put all your money in an S & P 500 index fund. If you didn’t enjoy the experiment or your picks were poor, no harm done—selecting individual stocks is not for you. Get yourself an index fund and stop wasting your time on stock picking.

If you enjoyed the experiment and earned sufficiently good returns, gradually assemble a basket of stocks—but limit it to a maximum of 10% of your overall portfolio (keep the rest in an index fund). And remember, you can always stop if it no longer interests you or your returns turn bad.

Looking Under the Right Rocks

So how should you go about looking for a potentially rewarding stock? You can use websites like http://finance.yahoo.com and www.morningstar.com to screen stocks with the statistical filters suggested in Chapter 14. Or you can take a more patient, craftsmanlike approach. Unlike most people, many of the best professional investors first get interested in a company when its share price goes down, not up. Christopher Browne of Tweedy Browne Global Value Fund, William Nygren of the Oakmark Fund, Robert Rodriguez of FPA Capital Fund, and Robert Torray of the Torray Fund all suggest looking at the daily list of new 52-week lows in the Wall Street Journal or the similar table in the “Market Week” section of Barron’s. That will point you toward stocks and industries that are unfashionable or unloved and that thus offer the potential for high returns once perceptions change.

Christopher Davis of the Davis Funds and William Miller of Legg Mason Value Trust like to see rising returns on invested capital, or ROIC—a way of measuring how efficiently a company generates what Warren Buffett has called “owner earnings.”2 (See the sidebar on p. 398 for more detail.)

FROM EPS TO ROIC

Net income or earnings per share (EPS) has been distorted in recent years by factors like stock-option grants and accounting gains and charges. To see how much a company is truly earning on the capital it deploys in its businesses, look beyond EPS to ROIC, or return on invested capital. Christopher Davis of the Davis Funds defines it with this formula:

ROIC = Owner Earnings Invested Capital,

where Owner Earnings is equal to:

Operating profit

plus depreciation

plus amortization of goodwill

minus Federal income tax (paid at the company’s average rate)

minus cost of stock options

minus “maintenance” (or essential) capital expenditures

minus any income generated by unsustainable rates of return on pension funds (as of 2003, anything greater than 6.5%)

and where Invested Capital is equal to:

Total assets

minus cash (as well as short-term investments and non-interest-bearing current liabilities)

plus past accounting charges that reduced invested capital.

ROIC has the virtue of showing, after all legitimate expenses, what the company earns from its operating businesses—and how efficiently it has used the shareholders’ money to generate that return. An ROIC of at least 10% is attractive; even 6% or 7% can be tempting if the company has good brand names, focused management, or is under a temporary cloud.

By checking “comparables,” or the prices at which similar businesses have been acquired over the years, managers like Oakmark’s Nygren and Longleaf Partners’ O. Mason Hawkins get a better handle on what a company’s parts are worth. For an individual investor, it’s painstaking and difficult work: Start by looking at the “Business Segments” footnote in the company’s annual report, which typically lists the industrial sector, revenues, and earnings of each subsidiary. (The “Management Discussion and