The Influence of Institutional Investors
People who trade stocks are broadly defined into one of two groups: institutional investors and individual investors. Institutional investors are the professionals who manage the trillions of dollars invested in mutual funds, investment banks, hedge funds, etc. Individual investors, also referred to as "retail investors," are people who independently invest for their own private accounts.
Studies have shown that institutional investors can and do move the market due to the large amounts of money they invest with. Because of this, the market has a tendency to move in the same direction as these institutional investors.
Here at Zacks, we have always known about the power of the institutional investor. Through the Zacks Rank you can benefit by getting into the stocks that are highly sought after by these large professionals, due to their focus on earnings estimate revisions.
How Institutional Investors Use Earnings Estimate Revisions
Most institutional investors attended prestigious business schools where they were taught a number of classical financial models, many of which were designed to calculate the fair value of a company and of its shares. Almost without exception, these valuation models focus on earnings and earnings estimates. Very simply, if you raise the earnings estimates used in the model, then it will create a higher fair value for the company and its stock price.
If an analyst believes a stock is worth 20 times next year's earnings (P/E of 20), with an earnings estimate of $1.00 per share ($1.00 Estimated EPS), then it would be under its fair value at any price below $20. (20 P/E x $1.00 Est. EPS = $20).
If the analyst changes his forecast and believes the company will instead earn $1.10 per share, the fair value would then be $22. (20 P/E x $1.10 Est. EPS = $22.)
Institutional investors then act on these changes in earnings estimates, typically buying those with rising earnings estimates and selling those with falling earnings estimates. As you can see, an increase in the earnings estimates can translate into a higher price for the stock and bigger gains for the investor.
And since it can often take weeks, if not months, for an institutional investor to build a position (given their size), the individual investor who can get in at the first sign of upward earnings estimate revisions (e.g., new Zacks Rank #1s), has a distinct advantage over these larger investors, and can benefit by the expected institutional buying that will follow.