I know what you’re thinking!
How can one retail investor sitting at home with a laptop and an online brokerage account possibly get better returns than a institutional investor? To answer this question, we first need to understand what an institutional investor is.
An institutional investor is an organisation whose primary purpose is to invest its own assets or those it holds in trust for others. There are generally six types of institutional investors: pension funds, endowment funds, insurance companies, commercial banks, mutual funds and hedge funds.
Institutional investors have significant resources that do extensive research on a wide range of investment options. They have portfolio managers who meet with the company executives of listed companies. They have specialists in every industry, and ‘experts’ evaluated individual companies for investment.
The majority of stock market activity is done by these institutions and because of the size of their portfolios, institutional buying and selling greatly influences the price of an individual share.
So basically, they’re a whole bunch of really smart people with a bunch of money under their management looking for investment opportunities.
So how can we, as individual investors, possibly expect to get better returns that these institutional investors in the share market?
Short Term Focus
Institutional investors are typically measured on their short term performance. They have their management and their investors regularly comparing their short term performance to that of their peers. Therefore, they do not have the luxury of time to pick undervalued shares that may take years to show results. It is simply too risky for professional investors to stake their career on a value pick over the long term.
As individual investors we do have time to buy the value shares, when they’re cheap, and wait for them to ‘mean revert’ back to their intrinsic value and provide outstanding returns.
Investors in Institutional Funds
Here’s a quote from Warren Buffett:
“I will tell you the secret to getting rich on Wall Street. You try to be greedy when others are fearful. And you try to be fearful when others are greedy”?
Let’s say you’re a fund manager in a very large company and Apple Inc. is on the rise. Every other fund manager around is buying Apple Inc. even though you know that it’s clearly over-priced. On this same day you can see a bunch of value opportunities in the Oil & Gas sector because the sector is being hammered! Are you:
a) Going to buy the overpriced Apple Inc?
b) Going to go against the trend and buy the really cheap Oil & Gas company that you expect to outperform over the next 18 months?
What do you think your investors will do when you tell them that you’re ‘bucking the trend’ and buying beaten down Oil & Gas and not the rising star, Apple Inc?
Well, there’s every chance they’ll withdraw their funds and walk across the street to the fund manager who is buying the over-priced Apple Inc.
The lesson here is, even when fund managers know which picks have the best opportunity to outperform in the long term, they often have you make choices that are palatable to the majority of their investors in the short term, even if it means mediocre returns. Where as we, as individual investors, are free to make these choices freely without the need to be answerable to anyone except ourselves.
Large funds find it difficult to invest in small cap shares
There’s a couple of reasons why large funds find it difficult to invest in small cap shares.
Large funds have restrictions on the level of ownership they can have in any one company. This results in large-cap funds being forced to buy large companies – the same ones that make up the major market indexes.
Then there’s the issue of liquidity. Even if a large fund does want to invest in small caps, these small investments can’t offer meaningful enough profit opportunities.
Finally, many large funds can’t take substantial positions in small-cap stocks without filing with the Securities and Exchange Commission (SEC), requiring greater transparency of the fund’s holdings.
Once again we, the individual investors, do not have any of these restrictions and are free to invest in large, mid, and small cap opportunities when they are presented. Hence the reason why there are three screens to choose from here at The Acquirer’s Multiple, Large Cap 1000 (Free), All Investable Stock Screener, and Small and Micro Stock Screener.
I just want to make my own picks
Lastly, and this is for purely personal reasons, I want to be able to make my own picks and be the master of my own destiny, rather than leaving it up to someone else. But that’s just me!
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