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.

More resources

Lunch price inflation: 8 strategies to profit in the age of social media

With the 24/7 nature of financial news, commentary and data,there are no more free lunches for investors.  In fact, given that access and dissemination have improved tremendously, lunches have gotten a lot more expensive. It’s harder and harder to cut through all the noise.

Financial content sites like Seeking Alpha and Stock Twits provide a window into long tail investment content.  Expert investment communities like Covestor and Wealthfront take this up a notch and provide real-time access to the tradestream — the collective flow of real, audited trades of investment advisors.

With these platforms, we no longer have to lose our lunch money.  We can play smarter by following the truly exceptional investors with well-documented, long-term investment returns.  Why recreate the wheel when you can copy others who are so successful?

I discuss these mimicking strategies at length in Tradestream.  In short, there are eight different types of investment mimicry, from cloning top hedge fund managers’ stock picks to identifying and piggybacking the next Warren Buffett.

  1. Blog bigwigs: The financial blogosphere has created a virtual stock research bonanza and enabled top researchers to strut their stuff.  These investment bloggers provide institutional-grade advice at the fraction of the cost.  How is $0 for your own, personalized stock research team?
  2. Present-day gurus: While most investors underperform, there are those few who are exceptional (for those interested, check out Forbes editor Matt Schifrin’s new book, The Warren Buffetts Next Door).  While you and I may not be gurus, Warren Buffett is.  Eddie Lampert is.  Seth Klarman is.  These superinvestors exhibit great long-term performance.  We can win, as well, by strategically  following their moves and tools like AlphaClone help a lot.
  3. Undiscovered experts: Thousands of people manage virtual and real portfolios, competing against one another for top performance.  As time elapses, expert investors emerge from the rabble.  Previously unknown and unsung top performers bubble up to the top.  Following their moves can lead to the promised land of profits.
  4. Rumor mills: Strategies can be developed to harness the information — or disinformation — inherent in most rumors.  Monitor these in real time or view them in the aggregate.  The information here is important even if you don’t trade on it.
  5. Insiders: Corporate insiders are notoriously good investors in their company’s stock, even when they trade legally.  And they should be: Given access to sales forecasts and operational metrics, these investors have a knack for buying low and selling high.  They too can be followed and followed profitably.
  6. Historical gurus: Stock screening allows investors to sort quickly through thousands of stocks for those select few that exhibit specific criteria.  Mimic screens allow us to search for the same parameters historical investors like Peter Lynch and Benjamin Graham used in their hunt for great stocks. Validea has created a whole business around helping investors do just that.
  7. Crowds: There is a lot of predictive power in the wisdom of the crowds.  Crowdsourcing can be used to locate good investments.  Here, changes in sentiment can be an investor’s key in determining the next winning investment.  Piqqem has made a lot of strides here and new firms like RecordedFuture (hear my recent podcast where I interview them)
  8. Co-lateral information: Not all tradable information is purely investment related.  Much of it exists in other forms.  Learn to recognize valuable resources that can be gleaned to aid our search for investing profits.  Google search data is just one example.

Some of these forms of flattery have been studied closely while others are so new that they’re just beginning to inspire research.  Regardless, all have been inspired by the sheer transparency that today’s Internet provides.

What is Tradestreaming: Ride the Long Tail

Now, with online distribution and retail, we are entering a world of abundance. And the differences are profound.

—Chris Andersen, The Long Tail

Blogging investment ideas

As fundamental, structural changes have occurred in the stock research industry over the past few years, investors no longer have to rely on their brokers to get access to information about investments. A scarcity of information with limited distribution has given way to almost unlimited abundance of information widely available. Technology investor and venture capitalist Fred Wilson calls this entire process a dislocation “because of this move from scarcity and exclusivity to abundance and scale.”

The velocity of information is continuing to accelerate, led by technological advances in Internet connectivity, social media, push email, blogs, and an easy-to-use method of publishing Internet content, Really Simple Syndication (RSS).

News + Blog Analysis = Actionable, tradable information for investors

Bloggers are quickly rivaling investment bank analysts and top journalists in their capacity to research a broad swath of stocks as well as drill deep down in their analysis. As financial information has become more democratized, investors should harness the long tail to help make sense of it all. In turn, this new model provides investors with a real-time research platform to bubble up previously undiscovered investment opportunities and then surgically analyze them. Blogger opinion resides in the long tail, a tremendously valuable repository of information just waiting to be tapped.

Sites like Seeking Alpha and Stock Twits enable investors to tap into great investment research being published 24/7 around the world.

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