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Executive Summary:

The hedge funds, pros, etc. bought big in KMI, VOD, FB, and JNJ during the previous quarter, and because none of those stocks have outperformed the index since the previous quarter's end, they represent excellent value and strong buys. My system of buying stocks in which a lot of hedge funds bought has achieved about 4% alpha over the past 15 months, with articles to document the returns.

Great American Novel:

(scroll down to the last two paragraphs of this article for new comments on the system)

Hedge funds and institutional investors must publish their investment activity each quarter for all the world to see. There are many websites which will give you access to various degrees of this knowledge for your potential gain. What I am sharing is my personal belief about how best to use this information. The two main factors I use are as follows:

1. Net Market Value Bought. This is the total market value of an individual stock purchased by the professionals less any market value sold. Obviously larger is better, as it shows that a great deal of money was bought in that stock vs. sold. Each quarter I rank stocks and assign them a score from 0-100%, with 100% representing the largest net market value bought stock (all time, in my data), and 0 the worst. I do the same scoring for the 2nd factor:

2. Price drop as % (relative to global stock index). Since our information is delayed by approximately 45 days, and also the 3 month quarter, I subjectively select the most likely average price that each stock would have been purchased at by the pros, calculate the change from that price as a percentage, then assign a score from 0-100%, where 100% is a stock that has dropped by the most (all time, in my data). The bottom line is that I prefer getting a stock that's gone down 20% vs. one that has gone up 20%, since I'm getting a better value for my purchase price. I throw out many stocks that clearly have already taken off to the upside. I'm not a trend follower. I seek stocks that I can buy cheaper than the pros have.

As I've disclosed in previous articles, the following chart shows my purchases using an imaginary $300,000 portfolio, and 1% per position resulting in amounts centered around $3,000. I simply invest more or less than $3,000 in accordance with how well the stock does in the two factors listed above. I then compare the returns I get (after buy and sell commissions) vs. those I'd have gotten in the Vanguard Total World Index (NYSEARCA:VT) (no commissions).

TickerDate BoughtPos Size ($)Sold DateNet Alpha vs Index
SLB5/23/2011$1,883 ($122.04)
WFC5/23/2011$1,884 $478.09
COP5/23/2011$2,215 $250.98
GOOG5/23/2011$3,102 $1,032.31
AAPL5/23/2011$1,979 $2,068.49
CVX5/23/2011$2,527 $333.43
JPM5/23/2011$3,531 ($304.68)
PFE5/23/2011$2,302 $401.99
DIS5/23/2011$2,097 $479.19
COV8/22/2011$2,055 $39.14
TEL8/22/2011$2,888 $321.10
C8/22/2011$2,269 ($179.83)
CTL8/29/2011$3,776 $448.54
CSX8/29/2011$4,710 $10.88
MDT11/18/2011$3,352 $301.38
ESRX11/18/2011$4,102 $1,238.01
V11/18/2011$2,843 $742.49
LVS11/18/2011$3,332 ($482.25)
VTR11/18/2011$2,330 $318.16
BRK.B11/18/2011$3,687 $146.37
BXP11/18/2011$3,936 $363.05
BIDU11/18/2011$3,598 ($515.34)
MSFT11/18/2011$3,025 $307.07
PCLN2/22/2012$2,354 ($12.78)
SNDK2/22/2012$2,765 ($263.99)
XYL2/22/2012$1,642 ($160.00)
CSCO2/22/2012$1,579 ($80.52)
XLS2/22/2012$1,684 $18.85
GOOG2/22/2012$3,064 $295.60
MON2/22/2012$1,898 $193.79
ABT2/22/2012$2,592 $398.24
CMVT2/22/2012$3,606 ($228.52)
SIRI5/23/2012$2,027 $456.32
COF5/23/2012$1,189 $25.95
BNS5/23/2012$2,245 ($72.99)
EGO5/23/2012$3,273 $328.89
EXC5/23/2012$1,859 ($192.22)
CFX5/23/2012$2,103 $118.13
SPN5/23/2012$3,353 ($64.78)
AMT5/23/2012$1,166 ($31.59)
WPX5/23/2012$1,762 ($309.86)
TEL5/23/2012$1,623 $35.58
FTR5/24/2012$3,022 $760.61
KMI8/20/2012$2,433 ($1.69)
VOD8/20/2012$2,113 ($30.99)
AIG8/20/2012$1,180 ($54.32)
JNJ8/20/2012$4,880 ($22.30)
FB8/20/2012$3,687 $65.51
TSM8/20/2012$964 ($15.72)
GE8/20/2012$1,087 ($22.90)
INTC8/20/2012$1,155 ($39.62)

(Table as of market close 8/22/12)

New buys for this quarter are in bold. You'll note that several stocks have seen significant enough net market value sold that I've decided to sell from my portfolio (and therefore this portfolio). The following table shows the overall results of the entire portfolio:

Net alpha all:$7,377.37
Stock return:$16,225.16
Stock return%:9.06%
Index return%:4.94%
Net alpha %:4.12%

The Zynga pick was the first really solid kick in the groin that the hedge funds pushed our portfolio into. It forced me to do a lot of data slicing and deep thinking. My data shows that of the two factors I use (net market value bought and price drop), price drop is actually non-predictive. In fact, buying stocks that have gone down is actually counter-profitable. So with Zynga, I entered a large position because its stock had dropped so much, thinking I was getting a great value. The reality is that not much smart money really bought in, only about 1BN worth. My buys tend to average closer to 5BN in net market value bought. Take facebook : about 10BN of smart money bought in. And the stock is about 40% cheaper than when that smart money bought in. I revamped my calculator and now this quarter's buys are more dependent on a huge amount of net market value bought, instead of their price drop. That said, facebook is an unprecedented combination of price crash and boatload of smart money. It's an odd little system I have isn't it? I would have loved to have the information 45 days ago on the pros' buys, but in that case I'd have bought facebook for $30/sh and be sitting on a 50% loss. Instead I buy for $19/sh.

The other change I've made is that any stocks that the hedge funds net sold in the quarter are getting sold. 3 months ago I looked at several stocks where a small amount of market value was net sold and I talked myself into holding, under the shade of "well the stock has gone down since the hedge funds sold so perhaps it's a good value now and shouldn't be sold". Those days are over. I only want to hold stocks that pros are accumulating.

Disclosure: I am long SLB, WFC, COP, GOOG, AAPL, CVX, JPM, PFE, DIS, COV, TEL, C, CTL, CSX, MDT, ESRX, V, LVS, VTR, BRK.B, BXP, BIDU, MSFT, PCLN, SNDK, XYL, CSCO, XLS, GOOG, MON, ABT, CMVT, SIRI, COF, BNS, EGO, EXC, CFX, SPN, AMT, WPX, TEL, FTR, KMI, VOD, AIG, JNJ, FB, TSM, GE, INTC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.