Lead, don't follow, institutional investors

They’re the folks who, multiple times daily, take that long pole and those plastic numbers and stretch and lift to the top of the sign to change gas prices.

Some days it’s just the third digit, but some days – wow! – it is all three. These folks, including the grandmas behind the counter at the fast-service places I use, are getting a workout, proving that there’s a positive side to everything.

Last month I reneged on my commitment to write about different screens used in our stock selection process. I felt it was more important to get out the word about the identity theft that can result from phishing. I hope it served you well and that you passed the information on to your family, friends and employees.

Now, back to the screens. One screen has been especially beneficial over the years. It’s a screen that I was not allowed to use in the days when I managed the investments for a trust company, in spite of my very best efforts to explain my rationale.

The screen is for the percentage of institutional holdings for a stock. In those trust company days, the chairman of the board took great comfort in what he perceived to be strength in numbers. In a screen that was just the opposite of what I proposed for our selection method, he wanted a large percentage of any stock we acquired for our clients to be held by institutions.

Here’s why I disagreed and why we use a screen that looks for those that are under-owned by institutions.

Should our other screens, such as the PEG – price, earnings, growth – method that I have written about several times, identify a stock that appears undervalued on a fundamental basis, we prefer to further define it as a candidate for purchase if it has less than 60 percent institutional ownership. Ideally, the lower that percentage the better.

It should not surprise any investor that mutual funds, hedge funds, pension funds and other large investment pools dominate trading in the markets. Nor should it be a surprise that many of them have become very short-term-performance-oriented.

A lower level of institutional ownership gives the individual investor two advantages. The first is the ability to discover opportunities before the huge institutions begin acquiring the issue(s). The second is the ability to avoid the selling pressure when the institutions decide to exit an issue.

Let’s look at the first advantage.

Peter Lynch, author of “One Up on Wall Street” and a legendary investor, wrote that by the time institutions discover what he referred to as “hidden gems,” they were no longer hidden. He preferred to own issues that were not followed by a large number of analysts or owned by a large number of institutions.

For the individual investor who does his homework and finds such hidden gems – and is patient enough to hold them until the big boys discover them – the rewards can be outstanding.

The home builders that we began acquiring nine years ago are good examples: Toll Brothers and Pulte Homes having appreciated over 600 percent and 700 percent, respectively. Patience and the ability to stay with the issue is required, often a problem for investors who frequently sell the winners too early and hold the losers too long.

On the sell side, which is the second advantage, think in terms of the expression, “It’s late at the party, dance close to the door.”

If a very high percentage of stock is held by institutions and they (as is too often the case these days) decide to sell, it can place a heck of a lot of pressure on the price of the stock. As a matter of fact, in the past it has even caused serious declines in entire industries and sectors. (Think auto stocks!)

For us, 90 percent institutional ownership is a caution flag, even if the fundamentals for the company are positive. We simply do not want to be too far from the door when the party ends and the herd starts leaving.

That means that there are times when we have to eliminate positions in companies whose goods or services we like, but it is part of the discipline that has worked well for us over the years.

You, too, can have an advantage over the big boys. Take it.

Clark Davis is a 34-year investment veteran and CEO of Saint Louis Investment Advisors, a specialized money-management company.