Columnists

How potential investors can screen stocks before buying

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Nairobi Securities Exchange trading floor. FILE PHOTO | NMG

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Summary

  • Institutional investor ownership is an even more significant factor in the largest company at the bourse.
  • Safaricom has the largest institutional ownership at nearly 85 per cent.
  • This group is called the smart money.

We all know from research that retail money is dumb money on average. Studies show that on average, the stocks they buy go on to underperform after purchase and the stocks they sell go on to outperform.

On the flip side, research show that with the highest levels of institutional investment, companies significantly outperformed those with the lowest levels.

To be clear, institutional investors have been found not to be necessarily better than individual investors at picking big winners, but are much better at avoiding the worst-performing investments.

That said, if this stance is correct, should institutional investors make good role models for individual investors? Is it true that if a stock has no institutional sponsorship, the odds are good that some looked at the stock's fundamentals and rejected it.This raises the question as to why that is.

For starters, let's begin by defining institutional ownership. This is the percentage of a stock's float owned by institutions such as unit trusts/mutual funds, pension funds or other large investors.

Most well-known stocks - East African Breweries (75 per cent), Equity Bank (53 per cent), Kenya Commercial Bank (62 per cent) - have at least 50 per cent institutional ownership.

Institutional investor ownership is an even more significant factor in the largest company at the bourse. Safaricom has the largest institutional ownership at nearly 85 per cent. This group is called the smart money.

Again, is it a good idea to pay attention to “smart money’ choices? Should retail investors be cautious of stocks that are over-owned by institutions as they would typically want to get in before the big money is fully invested?.

Here’s the other view. Some believe that when every mutual and pension fund in the land owns a chunk of a particular stock, it may have nowhere to go.

A stock with a lot of institutional support may be close to the peak of its valuation. The reason for this is that, if a stock has too much institutional ownership, any kind of bad news could spark a nasty sell-off. This may explain the nearly 20 per cent shareholding still held by retail shareholders.

The bottom line is, that as a whole, institutional investors own a larger share of a larger market. Due to their sheer size, institutional investors will often move markets. When they get in or out of a stock, they can affect the markets. Hence for this reason, individual investors can track this metric - tracking the CMA quarterly Statistical Bulletin.

Essentially, screening for stocks with high levels of institutional 'sponsorship' might give them the inside track on the stocks that the experts like as well as help them assess the weight of money behind a given stock.

But while it is true that these investors can afford research teams and experienced managers, blind or naive faith in "experts" is generally a bad idea - the professional fund management industry shows a lot of evidence of institutionally bad decision-making, herd behaviour and skewed incentives.

Consistent studies have proved that most “smart money” often lags the market over long periods of time. Too bad, the “smartest guys in the room” can’t help you.

Mwanyasi is the managing director at Canaan Capital