How Brokers Pick Stocks (Really)

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Imagine this scenario. Your broker calls you with a hot new stock. After you successfully dodge a relentless volley of bullet points, he pauses and asks what you think.

"Sounds interesting," you reply with a notch less enthusiasm than the caffeine warrior on the other end of the line. "Where did you get the idea?" you ask innocently, bracing yourself for the second wave. What usually follows is a cryptic laundry list of details like earnings growth figures, new product pipelines, relative values and maybe even a beta or technical chart reading thrown in for good measure.

But what's the real skinny? How do guys like me pick the stocks that we show to clients? And why are the recommendations often radically different than those of the financial pundits that you watch on

CNBC

over your morning cup of Kona? The truth is that your average nickel-and-dime broker trying to move stock is shackled with certain complications that a portfolio manager with full discretion doesn't have to face.

Before I get too detailed here, I've got one caveat. I'm just one guy, and I'm not going to claim to speak for all 50,000 or so full-service retail brokers across the nation. But in reality, for most of us the actual selection of specific stocks plays only a minor role in the entire decision process. That said, let's dig in.

When I recommend a stock, I have to be confident that three main criteria are met. First, I need some major assurances that my own butt is squarely covered by a steel plate provided by the firm thick enough to repel a rocket attack and guarded by a platoon of battle-scarred, machine gun-toting corporate legal wonks with flack vests and deep pockets. In other words, the first question I ask myself when looking for new stock ideas is, "can I get sued for this?" (or maybe more accurately, "who's backing me if I get sued for this?").

Just about anything listed on the Big Board is usually considered a safe bet from a legal standpoint (the lawyers must figure that if a company has met certain listing requirements then the scam potential is limited). Stray away from the NYSE, however, and things can get dicey.

Start flirting with the small-caps, penny stocks (officially, anything under $5) or (God help you) the

Vancouver Exchange

and you could wind up hanging out to dry in front of an arbitration panel faster than you can say "

Bre-X

." All it takes is one disgruntled client and a deal gone sour to ruin a career.

So the first stop on my stock shopping trip is usually the firm's BUY list. Rarely are these issues the kind of slinky vixens that you find at Jason's in Windsor just dying to stimulate your portfolio. These stocks are more like Mrs. Cunningham on

Happy Days

-- loyal and consistent. Always ready with a hot meal after a long day but with not quite enough going on to inspire jungle lust.

They may not be sexy, but, come the day of reckoning, I'd rather saunter into that arbitration hearing flanked by the team of analysts that recommended the stock in the first place than to slither in by my lonesome, tail tucked between my legs.

The second step of the screening process encompasses what most people think of when it comes to "picking stocks" -- performance screening. To pass this step, I need to be convinced that the stock price has a reasonable chance of going up significantly in the long run -- about 12 to 18 months or so.

"Booooor -- ing!" cries a boisterous gang of day traders and 1/4-point bandits. "My adrenal glands are going to atrophy from disuse," they cry painfully. Maybe so, but the retail scullions out here have little choice. Once again, this isn't money management in the strictest sense, this is sales. The chains lashing us to this particular masthead of torpid turnover come in the form of time and money.

The vast majority of brokers need to get specific approval from the vast majority of their clients for any transaction within their account (there are a few discretionary exceptions that firms generally frown upon from a liability standpoint). I don't have the luxury of instantly snapping up 30,000 XYZ with the touch of a button and allocating these shares proportionally among 300 or so accounts. I have to contact every single client individually and persuade him or her to buy in. Figure on 10 minutes a call with no interruptions and I'm already looking at 50 hours of phone work in an ideal world with secretaries feeding me peeled grapes and mopping my sweaty brow.

In reality, it could take me all month to work an idea using a combination of fax, phone, email and the USPS, so I don't really want to build a position with a fast mover that spikes before all of my people are in. Getting out once the move has been made is even harder (folks love to buy, but getting them to sell is like wrenching away their firstborn).

To come up with these bread-and-butter picks, most brokers use some sort of screening process or quantitative model that can range from the simplistic to the outright bizarre. Personally, I employ more of a holistic approach, drawing on a variety of fundamental, technical and news-related indicators to develop a feeling for a particular issue. I'll look at

Value Line

,

S&P

,

Dick Davis

and

O'Neil's

figures in

Investor's Business Daily

for starters before digging deeper.

When I've finally got a short list, I launch them over my third and final hurdle. The ones that land face up are the ones with the most sizzle. These will be stocks that I can really get behind, develop a compelling pitch and sell with conviction. When I'm on a roll, I can't afford to stop and explain the concept of asynchronous transfer mode to a 55-year-old surgeon on his way to the golf course. If I can't figure out a way to simply and easily state the prospects for a given company at an eighth-grade level, it goes in the circular file.

So, in the end, the stocks that survive are ones that appear to carry limited legal liability, a decent chance of appreciating over the next year and have something about them that's easy to sell. Are there a lot of great ideas out there that we miss because they didn't meet one of the three basic requirements? You bet there are. But we end up nailing a few of them too.