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How
the Big Players Think
Mutual funds,
pensions plans, and other institutional investors can move your
stock’s share price big time when they buy or sell. But, by knowing
how they think, nimble small investors may be able to keep a step ahead
of the big boys.
Why? These
institutional players hold huge positions, so they can’t turn on a
dime. It takes them days, and sometimes weeks, to establish or unload a
position in a stock.
Merrill
Lynch Survey
Here’s why you may be able to predict their next move. Every year,
Merrill Lynch, the nation’s largest stockbroker, surveys institutional
money managers to find out what factors they use to decide which stocks
to buy and sell.
Last week,
Merrill reported the results of its latest survey, which included
responses from over 200 money managers. The results surprised me.
I’ve always
thought of institutional money managers as conservative types who select
stocks by analyzing financial statements and other fundamental factors.
I assumed that they sought out rock solid companies with enduring
long-term growth prospects, so they could hold them for years.
Big Boys
Play Momentum Game
Not so! While they do use traditional fundamental parameters to qualify
candidates, it looks to me as though they rely on momentum factors to
time their buy/sell decisions.
In fact, of
the 26 analysis factors tabulated, “earnings surprise,” which comes
right out of the momentum investors’ toolbox, was number one. What’s
momentum investing?
Momentum
investors believe that earnings growth expectations determine the
direction of stock prices. Analysts’ earnings forecasts define the
market’s growth expectations for a stock. In fact, a firm’s stock
price usually does move up when analysts increase their forecasts, and
down when they cut them.
Momentum
investors focus their analysis on factors that, in their view, predict
the future directions of earnings forecasts. They buy stocks likely to
enjoy higher earnings forecasts over the next few weeks. Then, they dump
these stocks at the first hint that the trend might reverse.
Thus,
momentum money managers are not buy and hold investors. They measure
holding times in terms of weeks and months, not years.
Surprise,
Surprise
Earnings surprises, which, as I mentioned, topped the favorites list,
compares a firm’s reported earnings to analysts’ forecasts. A
positive surprise means that reported earnings were higher than
forecasts, and a negative surprise says they fell short.
Usually,
positive surprises higher than two cents per share move stock prices up.
Conversely, any negative surprise, even a penny, can sink the share
price. Further, positive surprises encourage analysts to increase future
earnings forecasts, which amplifies the effect. Same thing in reverse
for negative surprises.
Momentum
investors believe that earnings surprises are like cockroaches. You
usually don’t see just one. A positive surprise will probably lead to
future positive surprises and vice versa.
Besides for
earnings surprises, two other momentum players’ favorites: earnings
forecast trends and earnings growth momentum, were included in the top
eight factors, which is all I have room to describe here.
Forecast
Trends
As soon as one analyst increases his or her earnings forecast, other
analysts covering the stock fire up their spreadsheets to see if
they’ve missed something. Often, they decide they have, and they up
their forecasts. Thus, the first upward revision usually isn’t the
last. Momentum investors believe that recent earnings forecasts
revisions signal more to come, and the stock price will follow the
revision trend.
Growth
Momentum
The third momentum factor, earnings growth momentum, compares the most
recent quarter’s year-over-year earnings growth to longer trends. For
example, say a company has historically grown earnings at a 15 percent
annual clip. It has positive earnings momentum if its most recent
quarter’s growth rate accelerated to 20 percent. Momentum investors
view that as a signal that earnings growth will continue to accelerate
in future quarters.
Here’s how
to find these three momentum indicators on the Web.
Your
Stock's Momentum
You can see a stock’s earnings surprise history and earnings forecast
trends on most major financial sites. For instance, on Yahoo (finance.yahoo.com),
get a price quote and
then select Analyst
Estimates in the Analyst Coverage menu.
Reuters’
Ratios report is the best place to gauge earnings momentum. From
Reuters’ homepage (www.investor.reuters.com),
get a price quote and then select Ratios
in the Finances menu. Scroll down to the Growth Rates section to see
both the sales and earnings growth rates for the last quarter, last four
quarters (TTM) and for the past five years.
Fundamental
Indicators
Four of the remaining top eight indicators do measure fundamentals, and
as I mentioned earlier, are probably used to qualify candidates.
-
Price/book
ratio
-
Price/cash
flow ratio
-
Return
on Equity
-
Debt/Equity
Ratio
Price/book
and price/cash flow are valuation ratios, which Merrill’s money
managers presumably applied to avoid overpriced stocks. For instance,
they probably ruled out stocks with price/book ratios around 10, and
price/cash flow ratios greater than 40 or so.
Return on
equity is a profitability gauge and most money managers I’ve talked to
avoid stocks with ROEs below 15, and higher is better.
Debt/equity
ratios measure a firm’s debt level. What’s acceptable varies with
industry; so money managers often compare a company’s D/E to its
industry. They avoid stocks with D/E above their industry average.
You can see
all of the information you need to evaluate these four factors on Reuters’
Ratio report.
Finally, PEG,
a valuation gauge, which compares P/E ratio to forecast growth, was also
included among the top eight factors. Yahoo lists the PEG at the bottom
of its Analyst Estimate
report that I referred to earlier. Usually stocks with PEGs below 1 are
considered undervalued and those with PEGs above 2 are overvalued.
Whether you
agree or disagree with institutional money manager’s methods, knowing
how they think should help you predict which way your stocks are likely
to move next.
published 2/5/05 |
