The Best Stocks for New Money

This article is part of our Rising Star Portfolios series.

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 is at the top of your watchlist, could you do it? Most folks could probably 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 businesses to make sure your thesis still holds. You'll also be in better tune with valuation, especially relative to other companies in the industry. These are valuable skills to hone.

For example 
I can give you examples from my own real-money Rising Stars portfolio, where all my buy candidates come from one of the several screens I run. Sometimes I buy quickly, as was the case with yoga superstar lululemon athletica. Its competitive advantages and business strengths give it such potential upside that I didn't dawdle in purchasing it.

But sometimes I'm not ready to pull the trigger. I might want to further assess the business, for example, or wait for an earnings report or two. Such was the case with Zagg. I watched it for a while but finally decided the risk-reward ratio wasn't to my liking. (It's still on my watchlist, however, because I want to see its fascinating story play out.)

Sometimes everything seems right with a company except the price, and I need to wait in order to get a fair deal. Ebix is a great example; its valuation seems too good to be true, and I need to understand why. It's on my watchlist and I check its news and price every day.

The lesson is simple: Because I keep an up-to-date list of my best stock ideas, I'm able to buy with confidence when the opportunity presents itself.

Look inward, grasshopper 
When making your own watchlist, don't forget stocks you already own. All of us will have a limited number of great ideas in our investing lifetime, so many times your best stocks are 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.

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, 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 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 what your investing experience is, 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, which is the backbone of my Rising Stars portfolio. Here are a few stocks, for example, that passed my screen for companies in out-of-favor sectors with good returns on equity and assets compared with their peers:

These are risky companies; if you research any of these, make sure the problems that sent the stocks down in the first place are fixable. I'll be watching them closely for possible inclusion into my portfolio.

Start your watchlist now
We have a great, free watchlist feature you can start using instantly. Use it for any stocks you're interested in buying, currently own, or even those you just want to keep up with. You'll be able to follow all your companies' news, stock price movements, and more. Just click the "Add" button to add any of the companies in the table, or start here.

This article is part of our Rising Star Portfolios series, where we give some of our most promising stock analysts cold, hard cash to manage on the Fool's behalf. We'd like you to track our performance and benefit from these real-money, real-time free stock picks. Click here to see all of our Rising Stars analysts (and their portfolios).

This article is based on an article that was originally published on June 10, 2006. It has been updated.