Chapter 2: Strategy enhanchement
Why take institutions into account
Why should we care about these companies? Why not just stick to your strategy and wait for the money to flood in when you're right? The reason is that institutions account for a significant portion of the market—in the U.S. market, for example, they represent almost 70% of the market. This is why we can't disregard them.
Even if you're correct in your investment thesis, if institutions don't agree with you, your potential gains could be reduced by up to 70%. Their influence on the market is too substantial to ignore.
Ownership
How to exploit them
How do we "exploit" these institutions? We can start by understanding what they prioritize when investing and take that into consideration. Institutions often have different criteria for what makes a stock appealing compared to retail investors. By recognizing these differences, we can position ourselves strategically.
Additionally, we can exploit the limitations that institutions face. For example, institutions are often bound by regulations, mandates, or internal policies that restrict certain investment strategies or asset classes. As individual investors, we can take advantage of these opportunities by employing strategies that institutions might not be able to pursue, allowing us to capture value in areas they might overlook.
What makes institutions like a stock
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Momentum in stocks is something institutions like to see because it indicates that a stock is already moving in a strong direction, either upward or downward, and may continue in that trend. Institutions prefer this because it shows that the stock has gained traction and investor interest, which can reduce the risk of entering a bad trade. Stocks with momentum also tend to have higher trading volumes, providing the liquidity institutions need to buy or sell large amounts of shares without significantly impacting the stock price.
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Low valuations are attractive to institutions because they provide a margin of safety—if the stock doesn't perform as expected, the downside risk is limited compared to higher-valued stocks. Additionally, institutions often use fundamental analysis to assess whether a company's earnings, cash flow, or assets support a higher valuation.
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Institutions also look for stocks with clear visible advantages, such as strong growth relative to their price-to-earnings (P/E) ratio. This signals that the company is not only undervalued but also has significant growth potential. When a stock shows good growth prospects relative to its P/E ratio (sometimes referred to as the PEG ratio, which adjusts P/E for growth), institutions see it as an opportunity to achieve higher returns in a shorter time frame.
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Institutions generally prefer investing in larger companies because they offer several advantages, such as stability, liquidity, and predictable growth. Bigger companies, often referred to as large-cap stocks, tend to have established business models, steady revenue streams, and a proven track record of success, making them less risky compared to smaller companies.
Oppertunities
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A significant opportunity for institutional investors lies in going beyond the numbers, which many tend to shy away from because it involves greater risk and longer time horizons. This approach often requires looking at qualitative factors such as a company's innovation, market disruption potential, leadership strength, or emerging industry trends. While these factors are harder to quantify, they can present opportunities for exponential growth that may not yet be reflected in traditional financial metrics.
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Long-term investments are generally more daunting for institutions because they are under pressure to show presentable gains on a regular basis, often quarterly or annually. Many institutional investors, such as mutual funds and pension funds, are held accountable by their clients, boards, or shareholders, which means they need to demonstrate consistent performance. If a stock takes years to show substantial returns, this can be a challenge for institutions, as underperformance in the short term may lead to pressure to sell or shift strategies.
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Volatility is something that institutions are particularly wary of because it can lead to sharp swings in the value of their portfolios, which may alarm their investors and the people whose money they manage. This is a significant concern for institutions like mutual funds, pension funds, and endowments, as they are accountable to a large group of stakeholders. When a portfolio experiences too much volatility, it can cause clients to lose confidence, prompting them to withdraw their funds or pressure the institution to adjust its strategy.
In contrast, individual investors or those with more flexibility don’t face the same pressure from external parties. They can afford to ride out periods of volatility as long as they believe in the long-term potential of the investment. For individuals, short-term price swings may be seen as part of the natural market cycle, especially when investing in high-growth stocks or emerging markets. As long as the end goal is achieved, the day-to-day fluctuations are less concerning.
Calculator
Institution Friendliness Calculator
Institution Friendliness Score: 0
Score Scale
- 80 - 100: Excellent - Highly attractive to institutional investors.
- 60 - 79: Good - Likely attractive to many institutional investors.
- 40 - 59: Moderate - Could attract some institutional interest.
- 20 - 39: Weak - Unlikely to attract institutional investors.
- 0 - 19: Poor - Very unattractive to institutional investors.