Saving and investing: Schwab 100, Wall Street 0

Charles Schwab & Co. isn't the first name that comes to mind when you think about stock advice. Indeed, when Schwab rolled out its computer-driven rating system three years ago, critics derided it as a mechanistic toy.

But in a bake-off of brokerages' model portfolios conducted by Zacks Investment Research, Schwab's 100 highest-rated stocks possessed the best three-year track record by a long shot, leaving Wall Street lions such as Merrill Lynch and Smith Barney in its dust.

From 2002 through 2004, Schwab's recommended list returned an annualized 15 percent, vs. 4 percent for Standard & Poor's 500-stock index. Credit Suisse First Boston came in a distant second, at 9 percent annualized. Smith Barney's and Merrill's picks returned 2 percent per year.

Schwab's stock-picking prowess came with its 2000 acquisition of Chicago Investment Analytics, a research firm that catered to big money managers.

The system Schwab acquired is strictly numbers-driven. Chicago Analytics co-founder Greg Forsythe, who became Schwab's head of equity research, had spent a decade studying the attributes that spell future success for a stock. Schwab wrapped up those traits in a formula that it describes only in general terms.

For starters the system looks at the quality of a company's earnings — whether they come from increased sales or more efficient operations, for example, instead of one-time events. In determining value, a low stock price relative to earnings is important.

To judge sentiment toward a stock, the rating takes its cues from what Forsythe calls "smart-money investors," such as companies that buy back their shares. Then it factors in signs of risk, such as whether earnings growth has been on a steady track.

Every week Schwab puts 3,000 firms through their paces. The stocks are ranked and assigned letter grades of A, B, C, D or F.

To construct its 100-stock model portfolio, Schwab picks from the 1,000 largest companies in proportion to the makeup of sectors in the S&P 500. So if a sector makes up 10 percent of the index, the model generally includes 10 stocks from that group, though there is wiggle room. The top 100 recently included names such as Barnes & Noble, Cigna, Electronic Data Systems, 3M, Valero Energy and Verizon.

Ironically, Schwab doesn't put this 100-stock model portfolio in front of its customers. To learn what's in it, customers have to ask their Schwab rep. And if you're not a Schwab customer, you're out of luck.