Get to Know the Holders' Hands, Part 1

Recently, the firm I work for held a large amount of the common stock of Phoenix (PNX - commentary - Cramer's Take). As the stock rallied, I kept moving out my sell target, because the technicals on the stock were so compelling. There were no analysts saying buy, there were a few saying sell and the short interest was high. The company was doing all the right things and the stock had great price momentum, but the valuation was just too high. I wanted to sell, but I couldn't figure out when.

Finally, on Feb. 21, the stock price began to rally on no news. Going to the message boards, I discovered that there was a momentum investor with a radio show who was making one of his occasional television appearances, and was touting Phoenix. I went to our trader and said that we had our chance. There was a group of valuation-insensitive buyers buying the stock with abandon. I said, "Ride the ask [offer stock at the asking price] , and if you get any thick bids near the ask, hit them." (Read: If there are aggressive large bidders, sell to them at their level.) We sold our position in two weeks, without disturbing the market; we were able to get an average price of about $14.25. (Our trader is top-notch.) Today the price of Phoenix is about 15% lower. The momentum investors choked on the stock that we (and others) fed them.

Why did this work for us? We understood two aspects of how Phoenix traded very well: the fundamentals and technicals. The fundamentals taught us what fair value should be, but the technicals taught us how investors would react to movements in the stock price.

Every investor has a mode of funding and a mode of disbursement. The funding and disbursement modes affect how long and under what conditions an investor wants to, or is able to, hold his position. Some examples will illustrate general principles of these modes. I will describe the ways that various classes of investors fund their investments, how their investments are held, how they are liquidated and how all of this affects what kinds of investments they can use from both an asset class and liquidity standpoint. I also will attempt to explain how the behavior of some classes of investors can become temporarily self-reinforcing, leading to booms and busts. Finally, I will try to give some practical advice along the way as to how you can benefit from the behaviors of different classes of investors.

1. Banks and Other Depositary Institutions

Banks make promises to depositors. Some of these promises are absolute; some are contingent on external events. Bank regulations exist to make the keeping of the promises more certain (or, in modern times, keep the guarantee funds solvent). Banks have to keep adequate capital on hand to provide a margin of safety against insolvency. The amount of capital varies on the immediacy with which deposits may be withdrawn, the degree of equity/credit risk of the assets and how well the asset cash flows are matched to the liability cash flows.

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At time of publication, Merkel and/or his fund was long St. Paul Travelers, though positions may change at any time.

David J. Merkel, CFA, FSA, is a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. Previously, he managed corporate bonds for Dwight Asset Management. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. While Merkel cannot provide investment advice or recommendations, he welcomes your feedback and invites you to send your comments to [e-mail].

Analyst Certification: All of the views expressed in the report accurately reflect the personal views of the research analyst about any and all of the subject securities or issuers. No part of the compensation of the research analyst named herein was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed by the research analyst in this report.