Taking the plunge into buying stocks?

Fifty years ago, the average person intent on equity investing would purchase stocks and bonds directly using a full service broker. Then, mutual funds and other manufactured financial products overwhelmed the marketplace. Now, the advent of discount brokers and the Internet have put direct stock and bond investing back in the spotlight. Today, do-it-yourself investors with the motivation and time to master the subject can forgo funds and invest directly in stocks and bonds, an approach best suited to portfolios of $50,000 or more.

Setting up a portfolio of stocks in a direct investing account follows a four-step process:

1. Determine your investor profile.
2. Choose the asset allocation that fits your profile.
3. Select specific stocks and bonds.
4. Buy the stocks and bonds.

Whether you invest using mutual funds, exchange-traded funds (ETFs) or directly in stocks and bonds, the first two steps of this process are the same. You complete an online questionnaire on such topics as investing experience, personal financial goals and risk tolerance, and the tool generates a suggested investor profile. It also recommends a specific asset allocation of cash, bonds, stocks and perhaps real estate for your portfolio.

The third step, selecting specific stocks and bonds for your portfolio, involves more effort than choosing mutual funds and ETFs. In two previous articles, I outlined the steps involved in selecting quality and . Here, I'll focus on selecting stocks.

Model stock-based portfolios designed for Canadian investors are seldom found at discount brokerage sites. What you will find are reams of equity research from the broker's own analysts or third party firms. Invariably, there will be ever-evolving lists of recommended stocks such as TD Newcrest's Best Ideas Action List or the Morningstar Canada Income and Core Picks Lists available at Qtrade. While this research will give you stock ideas, there is no substitute for doing your own research.

Successful stock purchase decisions are based on understanding the business behind the stock. In addition, when building an equity portfolio, you should buy businesses in different industries to reduce the risk of a major loss if a stock or an industry sector runs into trouble.

I like to choose stocks from the following five major industry sectors, with a tilt toward Canadian dividend stocks due to favourable dividend taxation:

1. Consumer products and services
2. Industrial products and services
3. Natural resources
4. Utilities
5. Financials

Stock screeners are an efficient way to start your equity research. Discount brokers and financial websites such as Globe Investor have these tools. Most work the same way: You select specific criteria and the tool generates a list of qualifying stocks. You may need to tinker with the criteria to produce a reasonably-sized list of stock ideas. Here is a set of common screening criteria to get you started:

• Industry sector
• Total debt to equity ratio - less than 1.5 for utility stocks, less than 0.5 for others
• Earnings - the company is profitable and has been for at least three years
• Return on equity (ROE) - at least 10%
• Price over Earnings ratio (P/E) - maximum 15
• Dividend yield - has a dividend
• Analyst's recommendations - strong buy or buy.

Once you have a list of candidate stocks, your goal is to select the 15 to 20 best stocks representing all five of the aforementioned industry sectors. Begin by reading the information your broker has published about the company. This information will usually include details about the company's business and prospects, financial analysis, stock performance, peer group comparisons and buy/hold/sell recommendations. Also, check out the company's website and read what the financial media have to say about the company. Your objective is to choose stocks of well-run, profitable and sustainable businesses. You'll want to answer these questions:

1. Does the company produce a product or service that makes sense to you?
2. Are there recognizable opportunities to grow the business?
3. Is the company's management competent?
4. Does the company have growing profits?
5. What are the company's revenue sources and are they growing year over year?
6. Is there a dividend and is it growing?
7. How much debt is the company carrying and is it reasonable for its size and type of business?

The result of your research efforts will be a set of stocks to populate the equity portion of your portfolio. For a balanced investor profile, a portfolio might look something like this:

The final step in setting up your portfolio is to buy your chosen stocks and bonds. Discount brokers provide detailed how-to instructions for online purchasing. With the recent discount broker price war, stock trades are cheap - usually a flat rate of $9.95 or less if you have $50,000 or more in your account. Placing telephone orders is another, though more expensive, option.

Investing directly in stocks and bonds requires personal interest, motivation, time and perseverance. For DIY investors with these characteristics, it can be a financially and intellectually rewarding pursuit.

Gail Bebee is the author of No Hype - The Straight Goods on Investing Your Money. She can be reached at gbebee@gailbebee.com. Her website is www.gailbebee.com