The Smart Money Really is Smart

Market analysts often speak of “smart money” and “dumb money.” The exact definitions can vary but individual investors are usually considered to be the dumb money in a market. Smart money is the larger institutional investor or the hedge funds.

These labels are intended to segment the market participants based on the information they have available to them. Although there is a great deal of information available to individual investors, institutional investors still hold an information advantage.

Large investors tend to pay a high price for their information. They may have Bloomberg terminals that can cost more than $20,000 a year to access along with other subscriptions that are expensive. They get value for that money and that value is information that is not widely available.

Large investors also have access to more sources than individual investors. If you, as an individual investor, call a company and ask to speak to the Chief Financial Officer, the answer is most likely no. But a manager with several billion dollars could get that call through. If not, they can call their broker who can assist them with access.

Information access is just one edge the smart money has. They also have more processing power, analysts who can prepare customized research and the ability to execute trades in the best forum possible.

Defining the Smart Money and Dumb Money

Broadly defined, institutions own more than 75% of the shares of publicly traded companies according S&P Market Intelligence.

An institutional investor is broadly defined as an organization that invests on behalf of others. This includes pension funds, endowments of large nonprofit organizations, mutual funds, exchange traded funds (ETFs) and investment managers.

Individual investors have a reputation for being less skilled than these investors. That reputation has been in place for decades. This is based on studies that recorded odd lot transactions many years ago.

For most of the twentieth century, trading on the stock exchanges was dominated by institutions and commissions were regulated. The regulations applied special requirements on odd lot transactions which were defined as trades involving less than 100 shares.

Because these were smaller trades, they were assumed to be trades made by individual investors. The assumption was that individual has less money and couldn’t afford to trade in round lots which consisted of 100 shares.

After the 1987 crash, The New York Times noted, “According to some, history shows that these investors are almost always wrong on the timing of their investment decisions, and anyone, therefore, who takes the opposite position, should benefit.”

The article noted that in the week of the crash, “odd-lotters bought more aggressively than at any time in the last 20 years, purchasing three times as many shares as they sold.” That was viewed as a bearish sign. Individuals were early, but the crash did provide a buying opportunity for long term investors.

Anecdotally, the odd lotters had a bad reputation and some studies showed they underperformed. There are other indicators showing similar results. But, there are few studies showing that the smart money is really smart.

Testing the Smart Money

Standard & Poor’s completed what they called “An IQ Test for the “Smart Money”” to put the idea to the test. The test was whether or not the smart money was smart in the sense that they beat the market.

The report studied four factors associated with institutional ownership. They looked at how much of the company institutions owned, how many institutions owned the stock, changes in ownership levels and how strongly an institution believed in the company, a quality they labelled conviction.

Each of these factors could be used to find market beating investment trading strategies.

When a large number of institutions owned shares of the stock or if a large percentage of the stock is held by these large investors, they found a tendency for the stock to outperform. They also found that that when there are more large buyers than sellers, the stock has a tendency to outperform.

None of these results are surprising. Two other results are also surprising, but they may not be readily apparent.

The researchers found that the managers’ highest conviction picks or “best ideas” portfolio demonstrated the strongest results. For the study, the researchers assumed the manager’s best idea was their largest holding. This makes sense since that is the position that will have the largest impact on the performance of the portfolio.

Another idea that seems obvious in hindsight is that the longer a large investor holds an investment, the more likely it is to be among the manager’s best ideas. They also found a tendency for long term holdings to outperform.

When the smart money has been holding an investment for the long term, they are likely to have a significant gain in it. But, many institutional investors are not concerned with taxes. Some are, but pension funds, endowments and many others are not. That means they are holding because they like the company rather than to avoid a hefty tax bill.

The study found that these effects were present in markets around the world. That is significant because it demonstrates that the smart money effect has an underlying logic behind it. Reliable market indicators, like momentum. all have applicability around the world.

The study also found that combining institutional ownership with fundamentals can improve performance. Buying undervalued stocks that show increased buying pressure from large investors, for example, could be an important component of a complete invetsment strategy.

Putting This Information to Use

There are a number of ways to use the results of this study. Investors could simply find some large investors they admire and would like to follow. The holdings of many large investors is available for free from the Securities and Exchange Commission through the EDGAR search tool.

The largest holders of companies is also available for free from sites like Yahoo Finance. For example, Yahoo shows that Elliott Management is the largest shareholder of Arconic Inc. (NYSE: ARNC).

Source: Yahoo

Elliott is the hedge fund run by Paul Singer. He is among the most aggressive hedge fund managers. His funds seized an Argentinian Navy ship in an effort to force the country to pay on some defaulted bonds Singer owned. Reports indicate he made more than 360% on those bonds.

One way to more fully utilize this information is with the fee stock screening tool available at FinViz.com. At this site,  you could screen for a variety of fundamental factors, high levels of institutional ownership and bullish institutional transactions. An example is shown below.

Source: FinViz.com

This screen used the price to sales (P/S) ratio as a fundamental filter and limited the search to low priced companies trading at less than $5 a share. These are the companies capable of delivering the largest percentage gains in a short amount of time.

Five companies passed this screen and could be a starting point for research. The companies were:

  • Eco-Stim Energy Solutions Inc (Nasdaq: ESES)
  • Inotek Pharmaceuticals Corp (Nasdaq: ITEK)
  • aTyr Pharma Inc (Nasdaq: LIFE)
  • Apollo Endosurgery Inc (Nasdaq: APEN)
  • Kinross Gold Corporation (NYSE: KGC)

The smart money, simply by the definition of smart money, is big money. This means they leave clues as to their buying and selling because their orders are large and potentially market moving.

The Stock Trading Tips service, PPK System, is designed to exploit patterns associated with those market clues by looking for value and momentum in stocks. That’s the combination many researchers found beats the market. You can learn more about this trading service by clicking here.