William J. O’Neil: What to Make of Institutional Involvement

Every trading day, millions and millions of buy and sell transactions take place. A majority of that volume comes from one source: institutional investors, including pension funds, mutual funds, insurance companies and hedge funds. Altogether there were more than 10,000 of them when this book was published in 2009.

Because of the vast amounts of capital they manage, O’Neil gave them a full chapter in “How to Make Money in Stocks: A Winning System in Good Times and Bad.”

Specifically, in chapter eight, he dealt with what is called “institutional sponsorship,” the shares of stock owned by institutions. Such sponsorship can be an important indicator—both positive and negative—of a stock’s potential.

In searching for stocks, the author wrote he likes to see at least a solid number of institutional owners, adding that 20 might be a reasonable minimum in the case of smaller or newer companies. He further argued that a stock with no professional sponsorship is likely to deliver mediocre performance.

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Prudent investors will want to know not only how many institutional investors own the stock, but also whether the number of buyers among them is increasing. And, preferably, that the number has steadily increased in recent quarters.

Investors may also improve their odds of success by knowing whether the institutional sponsors have good track records themselves; this is referred to as the quality of sponsorship. Check the fund’s track record for the previous three years; checking back too far can be misleading because portfolio managers frequently change.

O’Neil emphasized again it is critical to know which of the better-performing institutions have ownership positions in a stock,and that it also matters whether the total number of sponsors is going up or going down. Watch the quarterly trends in ownership and combine it with quarterly and annual earnings growth.

About halfway through each quarter, reports on institutional buying in the previous quarter become publicly available, and discerning investors will want to know when strong sponsors are establishing new positions or building on existing positions. Some feel that such information comes too late to be of any value, but O’Neil disagreed—he wants to know what has happened over the past three years and not just the most recent quarter.

He also estimated that institutional trading accounts for as much as 70% of all trading that occurs in the markets and “This is the sustained force behind most major price moves.” The challenge for investors is to distinguish between “intelligent, highly informed institutional buying from poor, faulty buying.” As O’Neil noted, this gets easier as we learn and apply the rules and principles in his book.

So far, we have concentrated on stocks bringing in enough institutional sponsorship to validate ownership by individuals, or “retail investors,” as we’re called. But a stock may suffer if it has too much institutional sponsorship—what’s known as being “overowned.” This is because too much sponsorship might lead to big volume selling if the company has a problem or a bear market begins. For example, many institutions raced into tech stocks in the late 1990s and raced out again as the dot-com bust hit in 2000.

Similarly, O'Neil said owning stocks associated with a group such as the “Favorite 50” can be risky: “By the time a company’s strong performance is so obvious that almost all institutions own the stock, it’s probably too late to climb aboard. The heart is already out of the watermelon.”

Regarding institutional ownership, there is also one very practical benefit: liquidity. Stocks that are broadly traded by institutional investors can be bought and sold more easily and, perhaps, more cheaply. The more liquid a stock, the more buyers and sellers available and the smaller the bid-ask spread.

Some notes

Sometimes it seems retail investors, like us, and institutional investors operate in two parallel but separate universes. Yet, O’Neil’s emphasis on the importance of pension and mutual funds to retail investors is well placed. Their presence in the market is useful both as indicators and as providers of liquidity.

There is a great deal of information about institutional investors on the GuruFocus website. For example, by clicking on the Ownership button for any individual stock, a reader can see information on institutional ownership, such as in this display for Baozun (NASDAQ:BZUN), a holding of the IDB 50 exchange-traded fund:

A chart on the same page shows the history of institutional ownership, an immediate guide to whether it is increasing or decreasing.

In addition, GuruFocus also lists the individual gurus (most of them associated with institutional funds) who have bought or sold shares in previous years. For example, this excerpt from a guru ownership table shows its interest in Baozun over the last several years:

With these tools, assessing institutional interest in any stock can be quickly and easily added to the analysis of any company.

(This article is one in a series of chapter-by-chapter digests. To read more, and digests of other important investing books, go to this page.)

Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.

Read more here:

• William J. O'Neil: Leaders and Laggards
• William J. O'Neil: More Important Than All the Opinions of All the Analysts
• William J. O'Neil: Buying the New

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