No other investment available holds as much potential as
stocks over the long run. Not real estate. Not bonds. Not savings
accounts. Stocks aren’t the only things that belong in your investment portfolio, but they may be the most important, whether they’re purchased individually or through stock mutual funds. Since 1926, the stocks of large companies have produced an average annual return of
more than 10%. (Remember, that includes such lows as the Great Depression, Black
Monday in 1987 and the stock slide that followed September 11.)
You don’t have to beat the market to be successful over time. There is risk involved,
as there is in all investments, but the important thing is to balance the amount of
risk you’re willing to take with the return you’re aiming for.

Different Kinds of Stocks
First it’s important to understand what a stock is. When investors talk about stocks,
they usually mean common” stocks. A share of common stock represents a share of
ownership in the company that issues it. The price of the stock goes up and down,
depending on how the company performs and how investors think the company will
perform in the future. The stock may or may not pay dividends, which usually come
from profits. If profits fall, dividend payments may be cut or eliminated.
Many companies also issue “preferred” stock.

Like common stock, it is a share of ownership. The difference is preferred stockholders get first dibs on dividends in good times and on assets if the company goes broke and has to liquidate.
Theoretically, the price of preferred stock can rise or fall along with the common.
In reality it doesn’t move nearly as much because preferred investors are interested
mainly in the dividends, which are fixed when the stock is issued. For this reason,
preferred stock is more comparable to a bond than to a share of common stock.
It’s hard to think of a compelling reason to buy preferred stocks. They generally pay a slightly lower yield than the same company’s bonds and are no safer. Their potential equity kicker (the chance that the preferred will rise in price along with the common stock) has been largely illusory. Preferred stock is really better suited for corporate portfolios because a corporation doesn’t have to pay federal income tax on
most of the dividends it receives from another corporation.
Stocks are bought and sold on one or more of several “stock markets,” the best
known of which are the New York Stock Exchange (NYSE), the American Stock
Exchange (AMEX), and Nasdaq. There are also several regional exchanges, ranging
from Boston to Honolulu. Stocks sold on an exchange are said to be “listed” there;
stocks sold through Nasdaq may be called “over-the-counter” (OTC) stocks.
There are lots of reasons to own stocks and there are several different categories of
stocks to fit your goals.



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  1. GROWTH STOCKS have good prospects for growing faster than the economy or thestock market in general and in general are average to above average risk. Investorsbuy them because of their good record of earnings growth and the expectation thatthey will continue generating capital gains over the long term.BLUE-CHIP STOCKS won’t be found on an official “Blue Chip Stock” list. Blue-chip stocks are generally industry-leading companies with top-shelf financialcredentials. They tend to pay decent, steadily rising dividends, generate somegrowth, offer safety and reliability. and are low-to-moderate risk. These stocks canform your retirement portfolio’s core holdings—a grouping of stocks you plan tohold “forever,” while adding other investments to your portfolio.INCOME STOCKS pay out a much larger portion of their profits (often 50% to80%) in the form of quarterly dividends than do other stocks. These tend to bemore mature, slower-growth companies, and the dividends paid to investors makethese shares generally less risky to own than shares of growth or small-companystocks. Though share prices of income stocks aren’t expected to grow rapidly, thedividend acts as a kind of cushion beneath the share price. Even if the market ingeneral falls, income stocks are usually less affected because investors will stillreceive the dividend.CYCLICAL STOCKS are called that because their fortunes tend to rise and fallwith those of the economy at large, prospering when the business cycle is on theupswing, suffering in recessions. Automobile manufacturers are a prime example,which illustrates the important fact that these categories often overlap. Other indus-tries whose profits are sensitive to the business cycle include airlines, steel, chemi-cals and businesses dependent on home building.DEFENSIVE STOCKS are theoretically insulated from the business cycle (and there-fore lower in risk) because people go right on buying their products and services in bad times as well as good. Utility companies fit here (another overlap), as do compa-nies that sell food, beverages and drugs.VALUE STOCKS earn the name when they are considered underpriced according toseveral measures of value described later in this booklet. A stock with an unusuallylow price in relation to the company’s earnings may be dubbed a “value stock” if itexhibits other signs of good health. Risk here can vary greatly.SPECULATIVE STOCKS may be unproven young dot-coms or erratic or down-at-the-heels old companies exhibiting some sort of spark, such as the promise of an imminent technological breakthrough or a brilliant new chief executive. Buyers ofspeculative stocks have hopes of making big profits. Most speculative stocks don’tdo well in the long run, so it takes big gains in a few to offset your losses in themany. Risk here, no surprise, is high.

  2. A Smart Way to Buy StocksThe secret to choosing good common stocks is that there really is no secret to it.The winning techniques are tried and true, but it’s how you assemble and applythem that makes the difference.Information is the key. Having the right information about a company and knowinghow to interpret it are more important than any of the other factors you might hear credited for the success of the latest market genius. Information is even more important than timing. When you find a company that looks promising, you don’t have to buy the stock today or even this week. Good stocks tend to stay good, so you can take the time to investigate before you invest.You get the information you need to size up a company’s prospects in many places,and a lot of it is free. The listing on pages 6 and 7 offers a guide to the most readilyavailable sources of the data described below.WHAT YOU NEED TO KNOW.Perhaps the smartest way to succeed in the stock market is to invest for both growthand value. That means concentrating the bulk of your portfolio in stocks that passthe tests described on the following pages and holding them for the long term—three, five, even ten years or more. For those in search of income, not growth, it means applying the same tests so that you don’t make any false and risky assumptions about the stocks you buy.This method is not based on buying a stock one day and selling it the next. It does not depend on your ability to predict the direction of the economy or even the direction of the stock market. It does depend on your willingness to apply the following measures before you place your order. If you do that,you’ll find most of your choices falling into the growth, value, income and blue-chip categories.You’ll quickly discover that the number of stocks that meet all these tests at anygiven time will be low. So what you’re really looking for are stocks that exhibitmost of the following signs of value and come close on the others. These shouldform the core of your portfolio.EARNINGS PER SHARE.VALUE SIGN #1: Look for companies with a pattern of earnings growth and a habitof reinvesting a significant portion of earnings in the growth of the business.Compare earnings per share with the dividend payout. The portion that isn’t paidout to shareholders gets reinvested in the business.This is the company’s bottom line—the profits earned after taxes and paymentof dividends to holders of preferred stock. Earnings are also the company’s chiefresource for paying dividends to shareholders and for reinvesting in business growth.Check to be sure that earnings come from routine operations—say, widget sales—and not from one-time occurrences such as the sale of a subsidiary or a big awardfrom a patent-infringement suit. The exhaustive stock listings in Barron’s give the latest quarterly earnings per share for each stock, plus the date when the next earnings will be declared. Historical earnings figures are available in annual reports,Standard & Poor’s (S&P) and Mergent, Inc. publications, and Value Line Investment Survey, plus the databases offered by many Internet services.

  3. PRICE-EARNINGS RATIO.VALUE SIGN #2: Look for companies with P/E ratios lower than other companiesin the same industry.Many investment professionals consider the price-earnings ratio (P/E) to be thesingle most important thing you can know about a stock. It is the price of a sharedivided by the company’s earnings per share. If a stock sells for $40 a share and thecompany earned $4 a share in the previous 12 months, the stock has a P/E ratio of10. Simply put, the P/E ratio, also called multiple, tells you how much money investors are willing to pay for each dollar of a company’s earnings. It is such a significant key to value that it’s listed every day in the newspapers along with the stock’s price.Any company’s P/E needs to be compared with P/Es of similar companies, and withbroader measures as well. Market indexes, such as the Dow Jones industrials and theS&P 500, have P/Es, as do different industry sectors, such as chemicals or autos.Knowing what these are can help you decide on the relative merits of a stock you’reconsidering.It’s hard to say what the “right” level is for a company’s P/E ratio, or for the marketas a whole. You should expect to pay more to own shares of a company you thinkwill increase profits faster than the average company of its type. But high-P/E stockscarry the risk that if the earnings of a company disappoint investors, its share pricecould drop quickly. Just one poor quarter—or a rumor of one—can mean a steeploss for a stock with a sky-high P/E. By contrast, investors don’t expect a low-P/Ecompany to grow so rapidly and are less likely to desert the company on mildlyunfavorable news. If profits rise faster than expected, investors may bid up that lowP/E. The combination of higher earnings and a growing P/E add up to profit forinvestors.One way to employ P/E ratios in the search for good stocks is to find companieswith low P/Es relative to others in their industry. Assuming prospects are good forthe industry as a whole and companies show signs of strength, relative P/Es can bea good clue to their value. For instance, the auto and truck manufacturers industryhas traded at an average annual P/E of 10 or so in recent years. By comparison, thetelecommunications services industry has experienced an average P/E closer to 17.Thus, when the price of an auto manufacturer’s stock gives the company a P/E of 15,the company is relatively expensive for its industry. But if a telecommunicationscompany’s stock is selling at a P/E of 15, it’s relatively cheap for its industry.A low P/E is not automatically a sign of a good value. A stock’s price could be lowrelative to earnings because investors have very good reason to doubt the company’sability to maintain or increase its earnings. Never pick a stock on the basis of itsP/E alone.You don’t make any money from the stellar performance of a company before youbuy its stock. You want it to do well after you buy it. So look not only at the “trail-ing” P/E, which is based on the previous 12 months’ earnings, but also at P/Esbased on analysts’ future-earnings estimates. While not infallible, they are anotherpiece of information on which to base your decision to buy or not to buy. Brokerswill happily provide the forecasts of their firms’ analysts, and you can find otherforecasts in many of the sources listed on pages 6 and 7.There are other factors to weigh before deciding which stocks to buy. But P/E ratiosare the natural starting point because they provide a quick way to separate stocksthat seem overpriced from those that don’t.

  4. DIVIDEND YIELD.VALUE SIGN #3: For long-term investments, look for a dividend to generateincome to reinvest in the company. The target: a pattern of rising dividends sup-ported by rising earnings.Dividend yield is the company’s dividend expressed as a percentage of the shareprice. If a share of stock is selling for $50 and the company pays $2 a year in divi-dends, its yield is 4%. In addition to generating income for shareholders, dividendsare a good indicator of the strength of a company compared with its competitors.A long history of rising dividends is evidence of a strong company that manages tomaintain payouts in good times and bad. Even better is a company with a history ofrising dividends and rising earnings per share to match. A stock’s current dividendpayout and yield are included in the daily stock listings in the newspaper. For his-torical information, the S&P Stock Guide and Value Line are excellent sources, asare the stock data bases of the online services (see page 7)Sometimes lowering the dividend can boost the price of a stock. It’s important toknow why. For example, investors might see a cut in the dividend, coupled with aplan to close down some unprofitable operations and write off debts, as a smart steptoward a stronger company in the future.Although dividends occasionally are paid in the form of additional shares of stock,they are usually paid in cash; you get the checks in the mail and spend the money asyou please. Many companies encourage you to reinvest your dividends automaticallyin additional shares of the company’s stock, and have set up programs that make iteasy to do so. Such arrangements, called direct investing plans, dividend investmentplans, reinvestment plans, or DRIPs, are described beginning on page 9.

  5. BOOK VALUE.VALUE SIGN #4: For stocks with good long-term potential, look for book valueper share that is not out of line with that for similar companies that are in the samebusiness.Also called shareholders’ equity, book value is the difference between the company’sassets and its liabilities (which includes the value of any preferred stock that thecompany has issued). Book value per share is the that number most investors areinterested in.Normally, the price of a company’s stock is higher than its book value, and stocksmay be recommended as cheap because they are selling below book value. A compa-ny’s stock may be selling below book value because the company shows little prom-ise, and you could wait a long time for your profits to materialize, if they ever do.You need to look for other signs of value to confirm that you’ve found a bargain-priced stock.Still the idea of buying shares in a company for less than what they’re really worthdoes have a certain appeal. At any given time, there will be stocks selling belowbook value for one reason or another, and they aren’t all weak companies. Some maybe good small companies that have gone unnoticed or good big companies in anunloved industry. How can you tell? If the company has a low P/E ratio, a healthydividend with plenty of earnings left to reinvest in the business and no heavy debts,it may be a bargain whose down-and-out status is a temporary condition that timeand patience will correct.On the other end of the scale, you want to stay away from companies whose price istoo far above book value per share. It’s difficult to say what’s too high because thestandards vary so much with the industry. In some industries, such as technology—where the greatest assets reside in the brains of the companies’ employees, not inbuildings or machinery—book value per share isn’t considered particularly signifi-cant. In start-up companies, book value is utterly meaningless. Not only do theyhave few or no assets, they may have very high liabilities as a result of borrowing toget started. Still, in general, when the figure is available, you want it to be on thelow side.

  6. RETURN ON EQUITY.VALUE SIGN #5: Look for a return on equity that is consistently high, comparedwith the return for other companies in the same industry, or that shows a strongpattern of growth. A steady return on equity of more than 15% may be a sign ofa company that knows how to manage itself well.The return on equity number is the company’s net profit after taxes, divided by itsbook value, and it can usually be found in the annual report. It shows how much thecompany is earning on the stockholders’ stake in the enterprise. If return on equityis growing year after year, the stock’s price will tend to show long-term strength. Ifthe number is erratic or declining even though profits are steady, you may haveuncovered problems with debt or profit margins and you should probably stay away.DEBT-EQUITY RATIO.VALUE SIGN #6: Consider companies that have debts amounting to no more thanabout 35% of shareholders’ equity.The debt-equity ratio shows how much leverage, or debt, a company is carrying,compared with shareholders’ equity. For instance, if a company has $1 billion inshareholders’ equity and $100 million in debt, its debt-equity ratio is 0.10, or 10%,which is quite low. In general, the lower this figure the better, although the defini-tion of an acceptable debt load varies from industry to industry. You’ll find data ondebt in company annual reports, Value Line, Mergent Inc. and S&P publications,and in stock reports provided by the on-line services.

  7. PRICE VOLATILITY.VALUE SIGN #7: Whenever you assume the risk that goes with an oversize beta,should be in expectation of receiving an oversize return.Probably the most widely used measure of price volatility is called the beta. It is cal-culated from past price patterns and tells you how much a stock price can be expectedto move in relation to a change in the stock market as a whole (usually represented bythe S&P 500, which is assigned a beta of 1.00). A stock with a beta of 1.50 historical-ly rises or falls half again as much as the S&P index. A stock with a beta of 0.50 is halfas volatile as the index; it would be expected to go up only 5% if the index rose 10%,or go down 5% if the index fell 10%. A few stocks have negative betas, which meansthat they tend to move in the opposite direction from the market.Betas are published by several stock-tracking services such as those mentioned onpages 6 and 7 and are usually available from a broker. The key to remember is thatthe higher the beta, the bigger the risk.More Clues to Value in a StockThere you have the number-crunching, balance-sheet approach to finding value inthe stock market. Those numbers are extremely important, but they aren’t the onlyfacts you need. If the stock meets most of the above tests, look for these additionalsigns of value. ++The company’s industry is on the rise. Even though you can make money in a declining industry, you’re more likely to succeed in big and growing markets than in small or shrinking ones.Exciting young industries offer profit potential (and often correspondingly higher risk), but the staying power of any particular company is hard to predict. ++ The company is a leader in its industry. Being number one or two in its primary industry gives a company several advantages. As an industry leader it can influence pricing, rather than merely react to what others do. It has a bigger presence in the market: When the company introduces new products, those products stand a better chance of being accepted. Also, the company can afford the research necessary to create those new products. ++The company invests in research and development. Any company worthy of your investment dollars should be concerned about product development and future competitiveness. Compare the company’s spending on research and development—both in actual dollars and as a percentage of earnings and sales—with that of other firms in its industry.

  8. Dollar-Cost AveragingNow that you know the characteristics of good stocks, you have to address the ques-tion of how to go about buying them. One of the biggest worries is timing. Suppose you’re unlucky enough to buy at the very top of the market? Or suppose something unexpected happens to dash the price of your shares overnight? How can you protect yourself against bad things happening to good stocks while you’re holding a basketful of them?Dollar-cost averaging is a time-tested method of smoothing out the roller-coasterride that awaits those who try to time the market. You don’t have to be brilliant tomake dollar-cost averaging work, and you don’t even have to pay especially closeattention to what’s happening in the stock market or in economy. With dollar-costaveraging, you simply invest a fixed amount regularly, depending on your savingschedule. The key is to keep to your schedule, regardless of whether stock prices goup or down.Because you’re investing a fixed amount at fixed intervals, your dollars buy moreshares when prices are low. As a result, the average purchase price of your stock willusually be lower than the average of the market prices over the same time.Here’s an example of how dollar cost averaging usually works. Say you invest $300 amonth over a six-month period in Acme Enterprises, a stock that ranges in pricefrom a low of $20 to a high of $30. Here’s a look at what dollar-cost averagingwould do. (This example ignores brokerage commissions.)FIRST MONTH: The stock is trading at $30 a share. Your $300 investment buys tenshares of Acme.SECOND MONTH: The market has taken a tumble and the price of your stock hasfallen to $25. You buy 12 shares.THIRD MONTH: Things have stabilized. The price of your stocks is still $25, andyou buy another 12 shares.FOURTH MONTH: On news of a takeover bid by another company, the price soars to$33. Your $300 buys you only nine shares, with a little change left over.FIFTH MONTH: The takeover bid falls through and the price dips back down to$25. You pick up another 12 shares.SIXTH MONTH: An earnings report that falls short of analysts’ expectations causes acouple of mutual funds to sell your stock, pushing the price down to $20 a share.You acquire 15 shares

  9. LET’S ADD IT UP: So far you’ve spent, in round numbers, $1,800 (not countingcommissions) and you own 70 shares of Acme, which means you paid an average of$25.71 a share. Compare that with other ways you could have acquired the stock: Ifyou had bought ten shares during each of those six months, you’d own 60 shares atan average price per share of $26.33. If you had invested the entire $1,800 at thestart of the period, you’d own 60 shares at $30 per share. You can begin to see theadvantages of dollar-cost averaging.Now, you might have noticed that at the end of the sixth month you were holdingstock for which you had paid an average price of nearly $26 in a market that waswilling to pay you only $20 a share. What now? Should you sell and cut your loss-es? Not necessarily. Now is a good time to reassess your faith in Acme; reexaminethe fundamentals described earlier. If the fundamentals still justify your faith, thisdip in the price represents a good opportunity to buy more shares.Dollar-cost averaging won’t automatically improve the performance of your portfo-lio. But don’t underestimate the value of the added discipline, organization andpeace of mind it gives you. It’s natural to be frightened away from owning stockswhen prices head down, even though experience has shown that such times can bethe best time to buy.Because they charge no sales commissions, no-load mutual funds can be better suit-ed for dollar-cost averaging than stocks. You’d incur relatively large commissions tobuy a small number of shares of stock, and your fixed monthly investment mightnot buy whole shares. You can buy fractional shares in a mutual fund. Many fundswill let you arrange to have money transferred regularly from a bank account, andsome can arrange payroll deductions.Although dollar-cost averaging lets you put your investments on autopilot, youshouldn’t leave them there indefinitely. Inflation and increases in your salary makeyour fixed-dollar contribution less meaningful over time, and you shouldn’t contin-ue to buy any stock merely out of habit. Reexamine the company’s investmentprospects on a regular schedule—at least once a year—and adjust your investmentaccordingly.

  10. Reinvesting Your DividendsAnother investment strategy that, like dollar-cost averaging, pays little attention tothe direction of prices uses corporate dividends to boost profits over the long term.It’s called the direct investment plan, dividend reinvestment plan, or DRIP. Morethan 1,300 companies offer these special programs. Instead of sending you a checkfor the dividends your initial shares earn, the company automatically reinvests yourmoney in additional shares. Because most companies pay dividends quarterly, yourportfolio grows every 90 days without your having to lift a finger.In a DRIP, shares are held in a common account. You receive regular statements butno stock certificates unless you request them. Companies seldom promote theirDRIPs, so unless you ask about them you may not know that they exist.DRIPs have other advantages:

  11. +++Small dividends buy fractional shares, a help to small investors. +++Many DRIPs let you make additional investments on your own.In addition, a handful of companies allow you to buy more shares with your dividends,sometimes even offering DRIP shares at discounts of 3% to 5% from the market price. +++You reduce risk by investing via a DRIP because it’s a form of dol-lar-cost averaging. +++Some plans charge small fees, such as a maximum $2.50 adminis-trative fee per transaction, or $1 to $15 if you want possession of stock certificates. Brokers who hold stocks that are in a DRIPcharge little or nothing to add these shares to your account eachdividend period. +++

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