Seven Steps for Handling Stock Tips

Such (bad) actors are difficult to identify, but trust me when I tell you they exist. Touts are like the classic definition of pornography; hard to define, but folks on Wall Street know it when they see it.

Skeptic's Guide to Stock Tips

Stock tips have an illicit appeal. Everyone loves finding out something before the crowd does. And many of these tips sound like they have merit. There's often a good story attached, one that has visceral, emotional appeal. But it's often an ambush, specifically designed to ensnare unwary investors who bought the "story."

To avoid that trap, I have developed a specific process to separate the real stocks from the tipped, touted ones. If you use these techniques, you will never get caught in the web of stock promoters:

• First, check out the chart. This eliminates most of the real dogs right away. If the chart indicates a stock in a long-term, secular downtrend, it's game over.
• Second, see how the volume has developed over the past few months. Notice if a recent uptrend was accompanied by a surge in volume. A stock that's done nothing for years that suddenly starts moving on significantly higher trading volume may signify touts, who typically get paid (in part) in shares of the stock.

When you come across a stock that's already had a good run after a sudden surge in volume, that tells you that you are very late to the party. The odds favor that you will be left holding the bag, as those traders who got into the promotion early -- and the insiders -- will be selling their shares to you.

It's the old rule of poker: Look around the table; if you cannot spot the mark, the odds are it's you. That's the advantage of reviewing volume: You can use that same rule to see whether or not you're the sucker.

• If neither the chart nor the volume kills the tip, then the third item for review is the news. Most tips are based upon some unknown catalyst. At their heart is this "hot" info, something that the tipster claims to know (and is willing to share with you) but is not yet widely understood by the marketplace.

If the concept the tip is based upon is already in the news, i.e., already public knowledge, then how can this work as a catalyst? The answer is it can't, and the story is merely part of a tout's handiwork.

• Step four is to look at the relative strength of the sector. Why? Sector strength is very important, and has been shown to be responsible for about a third of a given stock's progress. Think about the oil services sector recently, or the transports. You could practically throw a dart to pick stocks in those sectors and do well. That's the advantage of sector strength. Check out how the tip's competitors have been doing. If they have been mired in mud, that's another reason to avoid the shares.

OK, you've made it this far, the fifth step is examining analytical coverage.

• In addition to providing some insight into the fundamentals, analyst coverage implies the potential for institutional ownership. Over the long term, when mutual funds accumulate shares, they are what drive stock prices higher. Most mutual funds require some sort of analytical coverage as a condition of ownership. It adds legitimacy. If the tipped stock has no coverage, then the odds are against big institutional buyers coming around. That bodes poorly for its long-term prospects.