When can low institutional ownership destroy your share's returns?

Buying shares is a really simple process, but buying smart is much harder. As we’ve seen in recent articles, one way to ensure you avoid stocks that have a high probability of underperforming is to look at how many of their shares are currently being shorted. But to really avoid the worst of them, it’s vital to look at how the level of institutional ownership impacts on the supply of those shares to short sellers. By owning a heavily shorted stock with low institutional ownership, investors can be exposed to a particularly risky situation that will very possibly end in tears. Understanding this balance of interests is crucial, regardless of whether you’re long or short.

In earlier short selling articles we’ve looked at how the short interest ratio - or the percentage of a company’s shares sold short in relation to the total number of shares outstanding - is a gauge of short selling sentiment. However, the short interest ratio really only tells you one side of the story, and that’s how much demand there is to short the stock. It takes no account of the actual supply of shares available to short, which is generally measured by the level of institutional ownership. This is because short sellers typically ‘borrow’ stock from institutional holders (via a broker) - and the fewer there are the tighter the supply of available shares will often be.

What are the signs that a stock could be in trouble?

A wide range of research into the relationship between these supply and demand factors has shown that share prices become particularly vulnerable to a fall when very high short interest combines with low institutional ownership. These so-called ‘short constrained’ shares often require strong conviction on the part of short sellers, who face potentially higher trading costs (in the form of borow rates) than they would otherwise encounter in stocks with higher institutional ownership. Analysis by Asquith et al. of US shares over the period 1988-2002 found that the very highest constrained shares underperformed by a significant 215 basis points per month on an equally weighted basis. They found that this underperformance was focused on a relatively small number of heavily shorted small-cap stocks and that the period of underperformance was fairly brief.

Who can profit from ‘short constrained’ shares?

For short sellers looking for opportunities, the research suggests that trading the right constrained stocks can be profitable but is likely to require frequent portfolio rebalancing and the associated costs that go with it. Moreover, short sellers not only face the usual challenges of being able to locate stock to borrow and the constant risk of being squeezed out of the trade if it goes wrong, but also that constrained stocks are more expensive to short sell in the first place. Interestingly, Asquith notes in his research that because the sweet spot of underperformance exists in a comparatively small section of the market, the average hedge fund is unlikely to be creating significant value from short selling stocks.

For long-only investors, however, this research has some pretty stark conclusions: namely that they should avoid shares that are short constrained - or being shorted when institutional ownership is low. While the number of these stocks is likely to be low - Asquith’s US research identified between 20 and 60 per month - constantly changing short interest positions means that investors should check before buying and be wary of changing sentiment towards shares already held in a portfolio.

How can you avoid purchasing these kinds of shares?

Tracking this delicate balance of sentiment and stock ownership doesn’t come easy, of course. Ahead of launching the Stockopedia Ownership add-on in the coming weeks we’ve been waist deep in academic research that until now has only really been relevant to professional fund firms. Not any more. Detailed ownership insight, including short positions, offers a much more effective means of identifying opportunities and avoiding problems.

Not only this, but we’ll be merging our Short Interest Rank, Insider Rank and Institutional Best Ideas Rank into an overarching ‘Smart Money Ranking’ for every stock in the UK, and later the world. If you want to be one of the first to on the list to test out our new Ownership features and piggy back the smart money - please sign up here.

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