Following the "Smart Money"

by Greg Forsythe, CFA, Senior Vice President, Schwab Equity Ratings®, Schwab Center for Financial Research
September 28, 2007

Wouldn't you just love to know a group of investors who historically have outperformed the market? Better yet, wouldn't you like to know how you can follow the decisions of these "smart money" investors without having to spend a dime in fees? If so, then read on!

What's really "smart"?
According to accepted valuation theory, stock prices reflect collective investor expectations of future fundamentals and risk. But in reality, it seems most investors spend too much time trying to understand a stock's current fundamentals and too little time gauging the expectations embedded in its price.

Since short-term (less than a year) stock price movements are often driven more by changes in expectations than fundamentals, Schwab's equity research team spends a great deal of effort trying to find useful investor sentiment indicators for individual stocks. Historically, our research has found that sentiment change often moves in trends. So it can be extremely useful to identify sentiment changes before or shortly after they begin.

Who's really "smart"?
To outperform the overall market, an investor must consistently do two things: 1) make contrarian decisions, i.e., bet against the consensus, and 2) be right more often than wrong. If you could find someone who fits that description, you would be wise to follow his or her advice. But many investors pay attention to the recommendations of Wall Street analysts whose collective opinion is a very close proxy for the consensus. Very few Wall Street analysts seem to be consistent and accurate contrarians.

Now let me relieve your suspense! There is a group of investors whose contrarian opinions are right more often than wrong, and whose collective opinions are publicly available at no cost. The "smart money" I'm referring to are investors who actively sell stocks short. While their exact identity is unclear, we assume the most active short sellers are professional investors such as hedge funds and brokerage firm market makers. Each month, the stock exchanges report the total number of shares of each company that have currently been sold short. This information is printed in The Wall Street Journal, among other places.

Just how "smart"?
Using hypothetical back-tests on the largest 3,200 market cap companies from 1986 to 2007, Schwab researchers formed stock portfolios monthly based upon each stock's ratio of shares sold short to total shares outstanding. We found that the 5% of stocks with the highest short interest historically underperformed the average stock by 4% annually, while the 5% of stocks with the lowest short interest outperformed by 2% annually.

Furthermore, the 5% of stocks with the largest six-month increase in short interest underperformed by 5.6% annually, while the 5% of stocks with the largest decrease in short interest outperformed by 2.2%. Considering that the stock market has historically returned an average 12% annually, the excess returns generated by these indicators are highly significant.

You can get "smart" too
Of course, these results are hypothetical, and past performance doesn't guarantee future performance. But I believe short interest is an excellent indicator of contrarian sentiment, and mimicking these smart money investors can help you become a better stock picker. That's why short interest is an important component of Schwab Equity Ratings.

Important Disclosures

Schwab Equity Ratings are assigned to approximately 3,000 of the largest (by market capitalization) U.S.-headquartered stocks using a scale of A, B, C, D and F. Schwab's outlook is that A-rated stocks, on average, will strongly outperform and F-rated stocks, on average, will strongly underperform the equities market over the next 12 months. Each of the approximately 3,000 stocks rated in the Schwab Equity Ratings universe is given a score derived from several research factors. Schwab Equity Ratings are not personal recommendations for any particular investor.

This report is for informational purposes only and is not an offer, solicitation or recommendation that any particular investor should purchase or sell any particular security or pursue a particular investment strategy.

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