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Winning trade of the week: front running the hedgies

From the great-idea-but-really-hard-to-implement:

comes a strategy to find profits by uncovering lesser known stocks before the big institutional investors come and plunk their money down on ’em — essentially front-running hedge funds.

By looking at stocks varying investor recognition, Sloan and Lehavy found 4 ways that recognition and stock prices are related

  1. security value is increasing in investor recognition
  2. expected return is decreasing in investor recognition
  3. the above two relations are increasing in a security’s idiosyncratic risk
  4. financing and investing activities are increasing in investor recognition

Performance

The researchers find that those stocks in the decile of  stocks with the highest change in institutional ownership generate size-adjusted returns of 14.4% whereas the lowest decile generates returns of –11.0%.

Takeaways

Well, this is all nice and dandy but actually applying this strategy is quite difficult. In fact, according to Empirical Finance (h/t for bubbling this paper up)

As amazing as these results are, they are of little use to the investor because the returns and the change in institutional ownership are occur during the same quarter.  That is, the investor won’t know which stocks have the highest change until after the 14.4% return has already been generated.

Nevertheless, it appears as if the gains in the owned stocks point to an underpricing in the market.  In addition to the issue of returns and ownership occurring in the same quarter, we still don’t know a whole lot about what constitutes investor recognition — how investors encounter stocks and continue to drink from a particular issue’s tradestream.

How investors discover new opportunities

  1. David Jackson, founder of Seeking Alpha, always believed that investors would encounter smaller companies by way of researching their bigger competitors. In fact, we launched an advert product that enabled smaller companies and their IR firms to target investors researching larger ones.
  2. Companies like StockTwits provide an opportunity for investors to discover lesser-known stocks residing in the long tail.
  3. Peter Lynch, the scion of buy-what-you-know investing, encouraged investors to buy the stocks of companies they’re familiar with.  As tragically hip companies like Skullcandy and Pandora ready to IPO, investors are given opportunities to invest in firms that make products they use daily.
  4. creating backtested strategies that piggyback guru investors a la AlphaClone is something I’ve spoken about a lot on this site (and in my book) — though this helps less if you’re trying to find firms not widely owned on the Street

Regardless, with social media, the dissemination of good ideas in lesser know companies will be something studied, analyzed, and made profitable.  Good times.

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