In the last half century, institutional investors have been playing an increasingly significant role in the equity markets. Total U.S. institutional equity holdings rose from $8.7 billion in 1950 (6.1%) to a stunning $1,432.9 billion (40.6%) by 1990. In the U.K., the share held by individual investors has shrunk from 54% in 1963 to just 10.7% in 2012, reflecting the ever-growing dominance of institutional money.
Due to their sheer size, institutional investors often move markets. Famous momentum investor William J. O'Neill describes these institutional investors as being "as obvious as the elephant that jumps into the bathtub and splatters water all over the place". When they get in or out of a stock, they can send huge ripples through the markets.
Hunting for Elephants
So how do individual investors best screen for their presence? Institutional ownership (IO) is the percentage of a stock's float owned by institutions such as unit trusts / mutual funds, pension funds, endowments, hedge funds or other large investors. Most well-known stocks - e.g. household names like BP or Shell (NYSE:RDS.A) - would have at least 25% institutional ownership. Stockopedia's forthcoming Ownership Module (subscription required) allows you to filter the market for high, low, increasing or decreasing IO.
The reason why individual investors often like to track this metric is because they view institutions as the "smart money". The basic thinking is that, because these managers get paid to pick stocks, screening for stocks with high levels of institutional 'sponsorship' might give us the inside track on the stocks that the experts like as well as helping us assess the weight of money behind a given stock.
While it is true that these investors can afford research teams and experienced managers, as we've discussed, naive faith in "experts" is generally a bad idea - the professional fund management industry also shows a lot of evidence of institutionally bad decision making, herd behaviour and skewed incentives. So is it a good idea or not to pay attention to their choices?
Following the Money...
William J. O'Neill, who we model here, therefore recognised the important of institutional ownership in his book "How to Make Money in Stocks" (which incidentally is a must read). It's the "I" in his renowned CAN-SLIM formula. Without institutional backing, a stock's price is not likely to rally. As he notes, it takes big demand to push up stock prices, and the biggest sources of demand comes from institutional investors, not from individual investors who typically cannot produce enough volume to significantly move stock prices. In his view, a good investor will check to see how many institutional investors a company has - a stock is generally worth investing in if it has at least three to 10 institutional owners.
O'Neill also argues that, if a stock has no sponsorship, the odds are good that some looked at the stock's fundamentals and rejected it. Which raises the question as to why that is.
Or Looking for Hidden Gems?
Set against this, though, the (just as legendary) growth investor, Peter Lynch (who we model here), argues that institutional investors make poor role models for individual investors. In his best-selling book "One Up on Wall Street," he lists thirteen characteristics of the perfect stock. One of them is: "Institutions Don't Own It and the Analysts Don't Follow It."
His contention is that stocks with a relatively small level of institutional sponsorship offer the most upside. Lynch dismisses the notion that companies without institutional support risk never being discovered: he argues that the market eventually finds undervalued companies with solid fundamentals. The market catches up with value eventually. And, by the time institutional investors discover these hidden gems, the companies will no longer be hidden but fairly valued, if not overvalued. So he argues:
Look for companies with little or no institutional ownership.
Err... So High or Low?
The sharp difference in views between these two Gurus (high vs. low institutional ownership) partly reflects the nature of momentum investing (O'Neill) versus growth (Lynch) investing. In fairness, even O'Neill suggests that you should be wary if a very large portion of the company's stock is owned by institutions. CAN SLIM acknowledges that a company can be institutionally over-owned and, when this happens, it is too late to buy into the company. The reason for this is that, if a stock has too much institutional ownership, any kind of bad news could spark a nasty sell-off. A stock with a lot of institutional support may be close to the peak of its valuation (think Cisco (NASDAQ:CSCO) during the DotCom bubble!). When every mutual and pension fund in the land owns a chunk of a particular stock, it may have nowhere to go. Instead, O'Neill suggests checking to see if institutional sponsorship is going up. If it is, this should be a sign that the stock still has momentum.