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Seven Steps for Handling Stock Tips

The Apprenticed Investor guide to what to do the next time you hear about a 'sure thing.'

Pssst! Buddy! Have I got a tip for you! This is the next red-hot stock, and it's a potential 1,000% gainer. Remember the last hot tip? You could have made 6,376%. Do not miss this next moneymaker!

Yes, stock tips are hot again. Activity on the Nasdaq bulletin board (OTC:BB) is on the rise -- volume has exploded nearly 40% recently (see chart below). And that is over the bulletin board volume record set in February.

I refer not to the small-cap stocks on the Russell 2000 but to the tiniest of them all -- the delisted and Pink Sheets stocks. They have become movers once again, and that often means bad news for unwary investors.

I don't mean the so-called spam stocks either, which's

Kevin Kelleher revealed to be huge money losers.

No, what I am referring to are the word-of-mouth stock tips passed from person to person. Emails and instant messaging now help to spread the word faster than ever before.

The vast majority of these "tips" are for horrific little stocks that don't have a snowball's chance in hell of ever amounting to anything, at least not on a sustainable basis. Many so-called tips are nothing more than the work of paid promoters whose sole role in life is to run up the price of some worthless paper so sellers can exit at a higher price while the "tippee" is left holding the bag.

Yes, you read that correctly.

Stock promoters operate in the shadows, just beyond the reach of the


and the

Securities and Exchange Commission

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, avoiding regulatory scrutiny by exploiting the fine line between legitimate investor/public relations and outright touting.

Under a variety of different names and aliases, touts often post breathless tales on the Yahoo! and Raging Bull message boards. Anyone who posts factual information that contradicts the story will be harassed on the boards and shouted down. Typically, stock promoters have a broad network of followers -- traders who can get in and out early of a promoted stock, pocketing a quick buck and leaving the unsuspecting retail investor holding the bag.

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.
  • If we still haven't raised any red flags, then step six is to have a look at the company's Web site. A slow-loading, ugly-looking site is a very bad sign -- especially for a technology, Internet or telecom company. A lousy site suggests a shell company with no true assets or products. These are, not surprisingly, good stocks to avoid.
  • If all these steps haven't dampened your enthusiasm yet, then go to step seven: Order an investor relations package from the company. You want to receive something professionally written on high-quality paper with glossy photos. It should arrive quickly (but not by express mail). It should contain no typos or printing errors, and certainly nothing that looks like it was quickly and cheaply photocopied.

Note that you can do all these steps without even getting into the fundamentals of a company. The goal is to quickly eliminate the dogs before you waste a lot of time or money on them.

This entire process of reviewing a tipped stock should take you anywhere from 30 seconds to several weeks. Start doing this on a regular basis, and you won't get all hot and bothered every time you hear the next great stock tip.

And that can save you a lot of money.

Barry Ritholtz is the chief market strategist for Ritholtz Research, an independent institutional research firm, specializing in the analysis of macroeconomic trends and the capital markets. The firm's variant perspectives are applied to the fixed income, equity and commodity markets, both domestically and internationally. Other areas of research coverage also include consumer, real estate, geopolitics, technology and digital media. Ritholtz is also president of Ritholtz Capital Partners (RCP), a New York based hedge fund. RCP is driven by the analysis performed by Ritholtz Research. Ritholtz appreciates your feedback;

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