In his 1989 letter to shareholders, Warren Buffett mentions the term “institutional imperative”. As an example of what he means by this goes as follows:
“Any business craving of the leader, however foolish, will be quickly supported by detailed rate-of-return and strategic studies prepared by his troops.”
To further illustrate the point:
“When executives mindlessly imitate the behavior of their peer companies — whether they are expanding, acquiring, setting executive compensation or whatever — no matter how foolish it may be to do so.”
Institutional Shareholders
The majority ownership of most public companies today is in the hands of institutions. In developed nations, retirement funds are significant holders. Due to the sheer size of their holdings, you can’t exactly call their stock very liquid. When institutions buy or sell stock, it is usually done in controlled volumes, in order to not cause volatile price movements.
Usually when a larger company’s stock makes big moves (either up or down), chances are various institutions are engaging in the same behavior simultaneously. These big moves can sometimes cause stocks to become over or undervalued. But why would these institutions and the “professionals” that man them dump their stock at undervalued prices? The answer lies in institutional investment policy.
Institutional Investment Policy
Many institutions that are large shareholders of public companies operate under some type of investment policy. Here are some examples of what typically guides institutional ownership:
- No holdings of companies under X market capitalization.
- Only hold companies that pay a dividend.
- Only own stocks with a rising price for the past 6 months.
- Dispose / reduce stocks in case of disappointing quarter.
- Maintain a predetermined asset allocation strategy, e.g. 60% stocks 40% bonds.
As humans are social animals and imitate the behavior of others, this obviously extends to companies and institutions. Institutions with similar characteristics and operating in the same sector tend to have similar policies. This sometimes creates herd behavior of which you, the intelligent investor, can use to your advantage.
The Winners and the Losers
In the earlier paragraph, five examples were listed. Let’s go through each one and further explain how it can create opportunities for the enterprising investor.
“No Holdings of Companies Under X Market Capitalization”
The reason institutions want a certain threshold on market cap is that it relates to the firms size. The larger the market cap, the larger the company. There is a (justifiable) argument that a larger company is a safer company.
But we must remember that all market cap is is the total price of all the shares outstanding (share price x shares outstanding = Market cap). As an intelligent investor, you understand that price and value are not always in equilibrium.
If a company loses market cap below institutional threshold (whatever that may be), the institution must start selling shares. Often this is done with a disregard to price. Now with more supply than demand, prices can drop into undervalued territory.
“Only Hold companies That Pay a Dividend”
In order to pay a (healthy) dividend, companies must first generate enough cash to cover all expenses and investments. Institutions want passive income, especially if they hold a nations retirement money. Additionally a large portion of total stock market returns come from dividends, which further justifies this particular policy.
Having a philosophy of owning only dividend stocks may work. This post is not going to argue for or against it. Having a dividend does not define if a company is good or bad. This, as all things, depends on so many factors.
For the individual investor, this can work both ways. If you hold a company that announces its first dividend, chances are your investment capital will appreciate. If you hold a dividend payer that announces a cut to the payment, its highly likely your investment capital will diminish. An example of the latter is General Electric. The graph below shows what happens to stocks hitting financial dire straits.
The above mentioned two scenario outcomes are due to institutional policy. Before you buy a dividend payer, make sure the dividend is well covered for the foreseeable future.
“Only Own Stocks With a Rising Price for the Past 6 Months”
When a company does well, the stock will do well. A rising stock price will attract new investors as if being under a spell. Likewise, a falling stock price will cause capital to flee to pastures perceived as greener.
If an institution’s policy involves following price movement, without adherence to value, the institution will be leaving money on the table in the long run. A declining stock price may indicate undervaluation, just as a rising price may indicate overvaluation. Institutions ought to follow the famous disclaimer “past performance is not indicative of future results.”
“Dispose / Reduce Stocks in Case of Disappointing Quarter”
This is perhaps the most foolish one to follow, especially if you have a long-term mindset. Companies are not robots where earnings are always as predictable as clockwork. In life as in business, there are good times and bad.
A streak of winning quarters are not guaranteed to continue, just as a streak of losing ones. Over-expectations in many cases set the stage for an inevitable “disappointment” which in reality is just a correction and return to more normal levels.
The key for the enterprising investor is to stay within their circle of competence and recognize when Mr. Market has overreacted.
“Maintain a Predetermined Asset Allocation Strategy, e.g. 60% Stocks 40% Bonds”
This stems from the philosophy of diversification. But why should “professionals” have a forced asset allocation strategy? If there are no good opportunities in either stocks or bonds, why enter or exit the market at unfavorable prices?
If the demand for either asset class is low, chances are there are opportunities to buy. The higher the demand, the less opportunities. By opportunity I mean getting something for less than its worth. A forced asset allocation strategy will inevitably lead to buying and selling at inconvenient prices.
Conclusion
Markets have, and always will fluctuate. The purpose of this post was to shed some light on some of the reasons for market movements. One of the greatest advantages the individual has over the institutions is an unchained existence with no institutional imperative.
Institutional investors are like slow moving elephants compared to you, the intelligent investor; a smooth nimble panther in comparison.
-IGTSKasimir
Further Reading
Warren Buffett – The Partnership Days (1956 – 1969)
Philip A. Fisher – Lessons From The 15% Man
The Best of Ben Graham – Security Analysis
Phil Town – The Compounding River Guide
Margin of Safety – The Most Important Thing
Intelligent Investing = Thinking In Probabilities
The Emotional Stages of a Value Investor
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