Picking stocks: Tips from an insider

If you bumped into Ron Muhlenkamp in the supermarket, you probably wouldn't guess that he manages a $2 billion mutual fund. That's because he's as likely to stroll the aisles in jeans dirty from working his farm, or in a leather jacket after cruising on his Harley, as he is to be wearing a business suit.

Certainly not your typical investment insider, Muhlenkamp has his home office in suburban Pittsburgh, far from the bustle of Wall Street. His quarterly newsletters read like a conversation between old friends, sprinkled with folksy expressions and farming analogies that reflect his rural roots.

This seemingly casual approach shouldn't be underestimated, however. Over the years, Muhlenkamp has proven himself a topnotch investor garnering accolades from financial experts, his peers, and the business press. Muhlenkamp Fund-the only fund that his company offers-has returned an average of 18.1 percent annually over the 10 years ending Jan. 31, 2005. That puts it in the top 3 percent among its mid-cap-value peers, according to Chicago-based Morningstar, which analyzes stocks and mutual funds.

What's the first step in finding good companies?

We start with return on shareholder equity, or what's referred to simply as return on equity. The number's available online from lots of sources, including Morningstar and Value Line. Technically, it's a company's earnings divided by its book value. In plain English, it's a measure that indicates how well the company is earning money and growing.

What's your cutoff?

We won't consider investing in a company that doesn't have an ROE of at least 14 percent, which is about the average since the end of World War II.

That's a pretty big universe. How do you whittle it down?

We look for companies that have a price-to-earnings ratio that's less than the ROE. Today, the average ROE is 14 and the average P-E ratio is 18. The typical company in our portfolio has an ROE of 18 percent and is selling at 14 times earnings. Just the opposite of the averages. Our goal is to buy good companies at reasonable prices-Buicks at Chevy prices, if you will. It's literally that simple. Where it gets interesting is when you find reasonably priced companies with strong ROEs that Wall Street doesn't think are sustainable.

Which companies in your portfolio match that description?

Homebuilders, which have a return on equity of 18 to 24 percent and are selling at eight times earnings. Low interest rates have helped these companies immensely, but Wall Street assumes higher interest rates will slow demand and thus reduce the prices of homebuilders' stocks. Low interest rates aren't the real reason we own these stocks, though. We own them because the large public homebuilders are getting market share from the smaller, private companies. The 10 largest homebuilders could go from the 20 percent of the market that they now control to as much as 40 or 50 percent. That's what we're betting on, not on interest rates or that demand for houses goes up.

What else looks attractive?

We like Johnson & Johnson. In the past, the company's ROE has been 25 to 30 percent. While we don't expect it to remain that high, we do think it can sustain 20 percent, maybe a little more. With a reasonable P-E, J&J qualifies as a smart buy for us.

Where I really spend my time on stocks, however, is trying to determine whether the numbers are sustainable. A lot of companies look great on an initial screening, but then you've got to sort them out.

If the numbers look interesting, what's next?