Kai Petainen, who teaches investments at the University of Michigan’s Ross Graduate School of Business and contributes to Forbes, has built a quantitative model that predicts which stocks institutional investors are going to find attractive. By anticipating what institutional investors, the elephants of the investing world, are going to buy, Kai’s Marketocracy portfolio has a 10 year track record showing an annualized return of 18% a year. By comparison, the S&P 500 returned less than 9% a year during the same period. Like Justin Uyehara, Kai is also up about 22% so far this year, and he is also profiled in the book “The Warren Buffetts Next Door” by Forbes Investment Editor Matt Schifrin. Could Kai Petainen be the next Warren Buffett?
Investment Style
When I interviewed Kai, my first question was, “are institutional investors really that predictable?” Here’s what he said.
“Institutional investors are much more constrained than individual investors. Individuals have a free hand to invest in anything they want. Institutions have a charter and an investment committee that greatly constrains their choices generally to a single sector or style, and that is what makes it possible to anticipate them in a way that cannot be done with individuals.
In addition, studying the biases of institutional investors should lead to longer lasting trading strategies because individual investors who consistently make bad decisions eventually run out of money and have to stop. But institutional investors can keep making mistakes for much longer because their portfolios are refilled with other people's money.”
Click here to read more from this interview.
What Kai says makes sense to me. Institutions often restrict themselves to investing just in large cap stocks for example. With publicly available data, it is possible to add up the institutional assets that can only be invested in companies that are large-cap, mid-cap, and small-cap.
To see where Kai’s returns are coming from, consider what happens when a stock moves from small-cap to mid-cap. The institutions that invest in small-cap stocks have to sell because the stock no longer meets their mandate. Their selling, however, is offset by buying from the institutions that invest in mid-cap stocks.
If the total assets in the mid-cap institutions who are buying is greater than the total assets in the small-cap institutions who are selling, then the odds are good that the buying will exceed the selling and the price will be driven up.
If Kai also knows that the newly minted mid-cap stock is “above-average” compared to other mid-cap stocks on metrics like price/earnings, price/growth, revenue growth, earnings growth, etc., then the odds are good that the stock is going to get a better than average allocation from mid-cap managers and Kai can be even more confident that the stock price will be moving up.
A Great Stock Picker
Each month Kai uses his model to rank all publicly traded stocks in order of attractiveness. Over the past 10 years, he has invested in a total of 719 stocks at one time or another, and made money on 448 (62%) of those stocks — a pretty good batting average in my view.
An Excellent Trader
Kai’s average gain to loss ratio is 1.28. This ratio tells me that on average he makes 28% more when he is right about a stock than he loses when he is wrong. In other words, when Kai is right about a stock, the price moves up a lot, but when he is wrong he doesn’t lose that much.
Profitable In Many Sectors
This table shows which sectors and market caps accounted for Kai’s gains and losses over the past 10 years. Kai has made money in all market caps, and nearly all sectors showing that his algorithm is pretty robust.
My Assessment
One of the best features of a quantitative approach is that it is unemotional. In volatile markets when fear drives stock prices more than fundamentals, having the discipline to stick with a time-tested quantitative approach can prevent a lot of mistakes. For me, the problem with purely quantitative approaches has been that the market inefficiencies that they are designed to exploit are often small, don’t last long, and only work for a narrow set of stocks. Kai seems to have found a market inefficiency, a pocket of opportunity if you will, that is large, persistent, and robust.
The evidence that this pocket of opportunity is large is that Kai’s gains are spread across all market caps so a great deal of capital can be put to work in this strategy without affecting stock prices. It is persistent because it has already lasted 10 years, and because institutions cannot easily change their mandates. Even after the institutions realize that rigid mandates create opportunities for quant strategies like Kai’s, its going to take a long time for them to change their practices enough to close off this pocket of opportunity. It is robust because it seems to work in almost all sectors.
For the portion of your portfolio that you would be willing to keep fully invested through thick and thin for the next market cycle, Kai’s strategy looks attractive.
Current Top Five Stocks
Marathon Petroleum Corp (NYSE:MPC)
Valero Energy (NYSE:VLO)
Sonic Automotive A (NYSE:SAH)
Philips 66 (NYSE:PSX)
Western Refining Inc. (NYSE:WNR)
Four of Kai’s top 5 holdings right now are energy companies with significant refinery operations in the U.S. For more about what’s driving these stocks read Buy The Dip In The Refiners which I wrote when I saw Kai adding these names to his portfolio.
You Make The Call
Does Kai’s 10 year track record give you enough confidence to stick with him for an entire market cycle? If you think Kai Petainen might be this generation’s Warren Buffett, sign up to follow his track record and receive more information with our monthly Performance Insights, emailed to you at the end of each month.
If you don’t think so, there are still 396 Marketocracy managers and 61 mutual fund mangers to review, all of whom passed our first cut by outperforming the S&P500 by at least 600 basis points, or 6%, per year for the last 5 years.
The next article will discuss a manager with a very different investment style. To be notified when it is posted, click on the link next to my picture labeled "Follow" or connect with Ken Kam on LinkedIn.
The first article in this series is "Finding The Next Warren Buffett."
Disclosure: I am the portfolio manager for mutual and hedge funds advised by Marketocracy Capital Management, an SEC registered investment advisor. Before relying on the opinions expressed in this article, you should assume that Marketocracy, its affiliates, clients, and I have material financial interests in these stocks and may hold or trade them contrary to these opinions when, in our view, market conditions change
