Harry Domash's Winning Investing


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


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