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A company's key investors are not necessarily its largest shareholders. Some large shareholders—especially in big companies—are passive investors that hold their stock for years. Others' positions are determined by the company's inclusion in a market or sector index. These latter investors buy, sell, or hold based on the overall appeal of the stock market or the sector, and they will play a major role in determining company-specific movements in the share price only following unique, easily recognizable events. For example, when a company is dropped from a market index, a flurry of selling activity may take place from passive investors rebalancing their portfolios.
Those occasions aside, a subset of active traders in a company's stock constitutes the group of investors with the most influence on stock price, and these investors typically come in four guises. Some are large shareholders that, for their own reasons or as a result of changes in a company's strategy, suddenly burst into life. Others are past shareholders that, for similar reasons, buy back into a company. Still others are those small, current investors that are willing and able to substantially increase their holdings or trade in and out of them very actively and frequently. Finally, some future influential movers currently trade in comparable companies but have never owned shares in the company in question. The first step, therefore, in identifying your company's active traders is to make a list of all the actual and potential investors that match those descriptions.
Your list will certainly and fairly easily capture the majority of a company's current and past key investors. As part of the research mentioned above, we analyzed the large institutional trades in eight companies over a year. We found that, on average, fewer than 100 traders accounted for more than 90 percent of the trades. Looking more closely at those 100, we saw that about 30 percent of those trades were made by investors that held large amounts of the stock on January 1. About 25 percent were carried out by investors with small holdings on January 1 but with the resources to become big players. Another 20 percent came from investors that held no stock as of January 1 but that were predicted from their history to become big players. Only about 25 percent of the trades were made by investors that we wouldn't have guessed would be interested in the company.
After compiling your list, the next step is to establish the patterns that characterize each key trader's buying and selling behavior in your company. Most investors have formal and informal rules governing the ways they invest and trade. To begin with, professional fund managers usually have an upper limit—usually around 5 percent—on the size of their holdings in a particular company. In some cases, the limit is driven by the fund manager's desire to maintain a diversified portfolio. In other cases, the limit may exist to keep the fund manager below a regulatory threshold (in some countries, holdings above 5 percent require a public announcement). Many investors also have concerns about trading liquidity and will not own more shares than are typically traded in a company in three to five days, which often results in an even lower practical upper limit on their holdings. Finally, investors differ markedly in their trading styles. Some, such as Fidelity, are "blasters": When they decide to sell a stock, they rapidly reduce or eliminate all holdings. Others, such as Janus, are "bleeders": Once they decide to sell, they take as long as nine months to fully liquidate their position. Some investors are limited to making only a single investment in a company; once they invest, they can only hold the stock or sell.
| Characterize each key trader's buying and selling behavior in your company. |
| — Kevin P. Coyne and Jonathan W. Witter |
Much of the necessary information about investment policies and trading norms is made public by investors themselves. You should carefully review SEC 13(f) filings (reports by institutional investment managers with discretion over $100 million or more in securities, required under the Securities Exchange Act of 1934) and stock surveillance reports to determine investors' actual trades of your stock and those of comparable companies. You may find contradictions between formal and informal practices. For example, in its November 2000 registration statement with the SEC, the Putnam Voyager Fund stated that it would not own more than 10 percent of any issuer or invest more than 5 percent of the fund's value in any one stock. Analysis of actual trading and holding behavior suggested more conservative holding limits: At the time of the filing, Putnam Voyager did not invest more than 3.8 percent of its fund in any one company, and, in fact, more than half of its holdings were in companies in which it invested less than 1 percent.
By matching observed behavioral characteristics to one of the four investor categories mentioned above, you can further narrow the list of likely large active traders. At one company, for instance, we found that all the key investors had either bought shares slowly over time or built up their position within a few weeks; they did not combine the two approaches. We were therefore able to eliminate from the list of likely large active traders all those investors (many of them deep-pocketed) that had traded busily but had not ended up with large holdings in the company's stock.
You can also use the trading data to compare an investor's movements in or out of a stock with its movements in and out of the company's sector as a whole. This comparison can help you determine whether the investor is buying or selling because it is bullish or bearish on the company, the sector, or both. Other revealing analyses include examining an investor's holdings in a company relative to its average holding size of comparable companies, the duration of those investments relative to the average holding time, and so on.
Although large active traders are the most important group of investors, they are not the only ones that matter in determining how a company's share price will react to changes in strategy or management. Small and midsize investors that spontaneously react the same as one another to a particular event can have a major impact as well. For example, we identified a group of regular traders in a biotech company's stock that always sold when acquisitions were announced.
To identify whether such like-minded small investors are essentially trading a company's stock as a group, you need to identify times when a meaningful change in stock price occurred in the opposite direction from that caused by the actions of the large active traders alone. Then, by cross-checking the buying and selling of the smaller investors relative to external media events such as press releases, you can determine whether certain shareholders consistently buy or sell following the release of a certain type of news. Often, investor groups will follow the lead of a single prominent independent analyst such as David Tice, whose damning analysis of Tyco's financial reporting caused that company's stock to fall sharply.
Do Retail Investors Matter?
Should companies care about the views of noninstitutional investors? For the most part we have found that retail investors act randomly enough that they rarely create the trading imbalances necessary to move stock prices significantly. That's especially true for large companies like Microsoft, GE, and Exxon Mobil, which are so well known that their retail investor base is large and widely diversified. But small investors can sometimes act in unison to tremendous effect, particularly in response to a major event like an acquisition or the dismissal of a CEO. They can also form an important constituency during a proxy fight.
Companies are most likely to be vulnerable to collective behavior by retail investors if those shareholders are geographically concentrated. Companies can suffer if the local media adopt strong points of view about a particular decision. Geographic concentration also makes it easier for rumors about a company to spread among investors. Similarly, retail investors often work in professions related to the company's business, which may lead them to act monolithically.
Like institutional investors, retail investors can be differentiated in terms of time horizon and content. But here it is useful to add a third dimension: trading velocity. Low-velocity shareholders hold shares for many years—often because they have inherited them or are using them for retirement investments. They are unlikely to buy, sell, or make any decisions unless forced. At the other end of the spectrum, day traders and some financial addicts are high-velocity traders who turn over entire portfolios every few days or weeks. High-velocity traders, however, seldom have much impact because they move in and out of stocks much too quickly to have a significant net effect. The most important group, therefore, is the event bettors who trade at a medium velocity, generally holding stocks for a few months or even a few years.