The Best Stocks for New Money

If I told you I'd hand you some money to buy a few shares of a stock, but only if you could tell me which company was at the top of your buy list, could you do it? Most folks probably could do no more than toss out a random name, because few keep an up-to-date short list of their best investing ideas.

Yet such a list is crucial -- and not just because it's obviously important to know which stocks you want to buy when opportunities arise. The very act of diligently keeping up with such a list will sharpen your investing skills, because you'll be forced to develop a thesis for every company, and you'll constantly be reassessing the business to make sure your thesis still holds. You'll also be in better tune with valuation, especially relative to other companies in the industry.

For example ...
I can give you an example from my own portfolio. I have full positions in some relatively stable blue-chip stalwarts such as Microsoft (NASDAQ:MSFT) and Procter & Gamble. I also have positions in some mid-caps, including Constellation Brands (NYSE:STZ), and small caps such as Audible.

So, when it was time to add new money a last year, I felt I had good balance in the portfolio and was free to consider almost any stock. For many reasons, including solid management, reliable cash flows, and compelling valuation, Johnson & Johnson had been on my short list. After a 10% drop in less than a month, it had moved up to No. 1. I pulled the trigger in early February and got in at $56.95.

Of course, only time will tell whether that was a good buy. But because I keep an up-to-date list of my best stock ideas, I was able to buy with confidence when the opportunity presented itself.

Look inward, grasshopper
When making your list, don't forget stocks you already own. All of us will have a limited number of great ideas in our investing lifetime, so your best stocks are often already sitting in your portfolio, just waiting for new money.

Most of history's greatest investors followed this route. You may already be familiar with Charlie Munger's disdain for overdiversification; he'd rather have his money in a small handful of stocks, allocating not a single penny to any second-tier idea. David and Tom Gardner are thinking along the same lines for their Motley Fool Stock Advisor members, and each month they publish their top five stocks to buy now for those ready to allocate new money.

That said, don't think that you need to limit yourself to just four or five stocks. In fact, the less experienced you are as an investor, the more diversity you need in your portfolio. This is simply to keep one or two bad mistakes from torpedoing your net worth. Masters such as Munger and Warren Buffett are tops in their field; they're not perfect, but it's highly unlikely that any one investment of theirs will completely tank and significantly harm Berkshire Hathaway shareholders. The rest of us, however, need a bit more diversification.

But no matter your investing experience, you'll want to focus on your best ideas as you add new money. And as the years roll by, if you were right about most of your ideas, the extra concentration in them will supercharge your returns.

The short story
Do you need help compiling your own short list? The most important consideration, especially for the average individual investor, is balance: between large and small caps, between less risk and more risk, and among different industries. One way to find ideas is through screening. Here a few stocks, for example, that passed my screen for companies in out-of-favor industries with good returns on equity and assets compared with their peers:

If you research any of these, make sure the problems that sent the stocks down in the first place are fixable.

And don't be afraid to seek out qualified help. As I mentioned, David and Tom now publish their own short lists in Stock Advisor; each list contains their five best stock picks for new money now. They happen to be pretty good at what they do, with 65% average total returns for their recommendations since the service began over four years ago, versus 27% for equal amounts invested in the S&P 500.

It won't cost you a dime to see their lists and all their recommendations. If you're interested, click here for more information on a 30-day free trial.

This article was originally published on June 10, 2006. It has been updated.

Rex Moore has a hot-water heater but wonders why hot water needs heating. He owns shares of Microsoft, Constellation Brands, Procter & Gamble, Audible, and Johnson & Johnson. Johnson & Johnson is an Income Investor recommendation. Microsoft is an Inside Value recommendation. This information is brought to you by the Fool's disclosure policy.