Note: this was published at RealMoney on 3/23/2004. This was part two of a four part series. Part One is lost but was given the lousy title: Managing Liability Affects Stocks, Pt. 1. If you have a copy, send it to me.
Fortunately, these were the best three of the four articles. The copy I received has no links, so sorry for the lack of links. I hope you enjoy the article.
On April 9th 2021, Bruce Greenwald, the founding director of the Heilbrunn Center for Graham and Dodd Investing at Columbia Business School, sat down for a Fireside Chat with Li Lu, the founder and chairman of Himalaya Capital as part of the 13th Columbia China Business Conference. Q1 2021 hedge fund letters, conferences and more Read More
Watch how the stock reacts to news.
Examine the short side.
Pay attention to what insiders are doing.
A little more than a month ago, I wrote a column to help explain some of the differences between the market’s strong and weak hands, and I received quite a response.
It’s been a while since the story appeared, so here’s a chart to clarify some of the ideas I put forth in it.
Table of Actions for Investors With Long Positions
Consider four classes of investors and how they behave with respect to market action
|Investor Action||Stock price goes down||Stock price goes up|
|More likely to hold||Valuation-sensitive and strong holders||Momentum investors and strong holders|
|More likely to sell||Momentum investors and weak holders||Valuation-sensitive and weak holders|
To put it another way:
- Weak holders play for small gains and losses.
- Strong holders play for big gains, will ride out big losses and sometimes get killed with the firm.
- Momentum investors require liquidity from the market and exacerbate price moves.
- Valuation-sensitive (or mean-reverting) investors provide liquidity to the market. They hold or buy more when prices decline, and they sell when prices rise enough to hit their valuation targets. This category describes my normal posture in the market.
These four descriptions here are ideal investor types. Some investors and institutions fit only one of them, but many use a mix in their investing activity.
After Part 1 of this piece appeared, the most common reader question was, “How do you identify whether a stock’s holders are weak or strong?” There’s no simple answer, but I can offer a bevy of techniques and tools that I use for this purpose. Some require a good deal of experience and judgment; beginners can use others easily. Here are some tips to get you started:
Assess how the stock reacts to news
Good news should make a stock go up, and bad news should make it go down. But we learn the most when the price reaction is different from what we expect. For example, if a stock refuses to go down much — or even rises — on significant bad news, then it has many strong holders. If it doesn’t go up much — or even falls — on significant good news, then it has many weak holders.
Examine the short side.
Short-sellers are typically weak antiholders of a stock. The percentage of the float that is shorted will tell you how much of the stock is subject to buyback if the price rises significantly.
Now, short-selling is a double-edged sword. Although short-sellers have an impulse to buy back into strength, high short interest usually indicates problems at the company. If you encounter a heavily shorted stock, take a close look to see whether it’s strictly a valuation issue or if something is fundamentally broken at the company on an accounting or operational basis. Short interest is available on Yahoo! Finance; here’s an example of a heavily shorted stock, Phoenix (PNX:NYSE) .
Find out who the large holders are.
The higher the proportion of stock held by insiders and long-term investors, the more strongly a stock’s holder base is. I track this by reviewing proxy statements as well as 13D and 13G filings, which are freely available at the SEC Web site.
These data require some judgment to interpret. First, I find out who holds more than 5% of the stock, because some of those large holders tell a story about the stock.
Most institutional investors will not take stakes of more than 5% in a corporation’s shares, as getting into and out of such large positions requires careful trading. Once they are above the 5% limit, changes in position size must be disclosed via 13D filings, which give away information to other traders who may trade against the large holder. Large holders by their very nature tend to be strong holders; the costs of exiting a position are significant.
Look at insider activity.
Insiders, if they hold large positions, tend to be strong holders of a company’s shares. Additionally, they often have a clearer perspective on the company’s prospects. Insider buying can be a great indicator of potential value, particularly if the insider pays for the shares from his or her own pocket. Small insider holdings and holdings acquired for compensation are more likely to be cashed in when insiders need the proceeds. Insider data are freely available at Yahoo!; here is an example.
One exception needs to be understood regarding large insider holdings. If the holdings are so large that a single investor has discretionary control over the company, then it pays to review how that “control investor” has treated outside passive minority investors (folks like you and me) in the past. If he or she acts on self-interest to the detriment of smaller investors, then it’s time to look elsewhere.
Review proxy statements.
After spending enough time looking at such data, you begin to see what kinds of investors are among the large holders. Most tend to be value investors or long-term growth investors. After this, a list of the remaining institutional investors can be instructive. A limited view of this is freely available on Yahoo!; here’s an example.
This particular example tells me that the major holders are value investors and index managers. These are relatively strong holders of the stock; they don’t run away after minor disappointments. In general, growth investors tend to be weaker holders than value investors.
Take note of turnover.
To the extent that you can obtain turnover rate data, for example, in mutual fund prospectuses, that’s a good proxy for how weakly a manager holds stocks. Quantitative managers tend to be weak holders of securities; many of them try to profit from short-term mispricings of securities, often trading at very high turnover rates. Qualitative managers who are tightly benchmarked to indices, including many institutional managers who are scrutinized by the consultant community, can find themselves in the same boat.
Glance at the message boards.
Although there are exceptions — and this is squishy — the amount and shrillness of postings on message boards seems proportional to the weakness of the holder base. The more reasoned and slow the message board, the less speculative the stock’s retail holder base.
Gauge the volatility of the price action.
If market prices are more volatile compared with the factors that drive the stock’s underlying value, there are relatively more weak holders. If market prices are less volatile compared with the factors that drive the underlying value, there are relatively more strong holders.
Valuation also affects the holder base: The higher the valuations, the lower the proportion of valuation-sensitive investors in the holder base, and that tends to increase price volatility. The lower the valuations are, the lower the proportion of momentum investors in the holder base, and that tends to decrease price volatility.
Review chart action.
I’m not a technician, so bear with me. One simple question to ask is whether buyers or sellers are more motivated. A simple way to answer that for the immediate past is to look at a money flow graph. Here is an example of a noncumulative money flow graph from Yahoo! The top part of the graph is the price; the bottom part is money flow. When the money flow figure is over 50, more trades have been occurring on upticks than on downticks. The opposite is true when money flow is below 50. Momentum investors dominate the buy side of trading when the money flow indicator is persistently high. Valuation-sensitive investors dominate the buy side of trading when the money flow indicator is persistently low.
As I’m not a technician, I won’t explore levels of support and resistance. I use those techniques, but I’ll leave it to the expert technical analysts to describe them in detail. Levels of support and resistance often indicate where valuation-sensitive investors are accumulating and selling shares.
What I promised at the end of Part 1 will have to wait for Part 3 of this series. In response to the questions I received, I’ll also cover the effect of dividends and weak holders in the Treasury bond market. If you have any questions, please feel free to email me.
By David Merkel, CFA of alephblog