Imitating Big Money Could Hurt You

You might often come across investment ideas from analysts to mimic institutional investors at the time of picking stocks. Such ideas are targeted at helping you benefit from the power of institutional investors (mutual funds, pension plans, money managers, etc.) who are seasoned players in the stock market and have access to valuable research reports.

But this might not be a profitable strategy for you. You may even incur a huge loss by doing so.

How So?

Primarily, the time between institutional buying and your consequent action will not allow you to buy an institution favorite stock at an attractive price. If institutional investors target a particular stock, they spend millions of dollars to buy it. This pushes the stock to its peak, making it overvalued for you. Now, if you still pick that stock, it could be risky as institutions may book their profits before you realize some gain.

Also, institutional investment managers (managing more than $100 million) are required to disclose their holdings by filing Form 13F with the SEC once per quarter. And this is the primary source of information that you get on which stocks are attracting big money investors.

Now the problem is, institutional investors get up to 45 days to submit these quarterly filings, and they may change their portfolio position during that period. So the information from the 13F could be dated. Your chosen stock may have already been sold off by the institutional investor. And this information will be made public in its next quarterly filing.

Another major drawback of tracking the 13F filing is the absence of disclosure on short equity positions. This could mislead you as the number of shares of a particular stock held by the institutions might be part of their large net short position.

So, Is It Smart to Mimic Big Money Investments?

Some may say that analyzing institutional holdings may give an idea about their past performances which may help you make money, but strong performances in the past do not guarantee future results.

Moreover, as an individual and small investor, it would be difficult for you to adequately diversify holdings and hold positions for an extended period of time.

What Should You Do?

Since buying a big money favorite stock could turn out to be dangerous, it's better you take a look at the valuation of the stock to see if it is still undervalued. If a stock is attracting institutional investments during the current quarter and is undervalued, you can gain by buying this stock as it may continue to witness buying pressure until it reaches fair value or becomes overvalued.

A smart way to pick stocks backed by institutional buying is to analyze whether or not these are trading at a discount to their book value. You should focus on the price-to-book ratio or P/B ratio (stock's current price per share/last quarter's book value per share), which is a measure of how cheap a stock is. If P/B ratio of a stock is less than 1, it is cheaper than its accounting value. This is only one among many metrics used to find undervalued stocks.

Not that this is a foolproof strategy. You need to do an extensive homework to select stocks that will help you make money. But you can use this strategy as a starting point.

Bottom Line

Institutional investors are widely experienced, and their actions may appear attractive or dependable in theory. In practice, it's difficult to reap profits if you don't do your own research on reasons other than the fact that these are endorsed by institutional investors before buying a particular stock.

It's always better to focus more on the valuation of a company before choosing it for your portfolio. This way, even if you are unable to gain in the near term, there would still be a fair chance to benefit in the long run.

-Kalyan Nandy, Zacks Investment Research