Stocks with Rising Institutional Ownership

	Paul Tracy Street Authority.com
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Big, well-established companies like Microsoft (MSFT), Wal-Mart (WMT) and Home Depot (HD) made investors millions in their heyday. Microsoft returned nearly +10,000% for investors between 1990 and 1999. Meanwhile, Home Depot (HD) returned nearly +4,000% over the same period. That means that a $10,000 investment in each stock back in 1990 would have grown to nearly $1.5 million fewer than 10 years later.

Investing legend Peter Lynch used to call such investments "ten-baggers" -- stocks that can produce gains of +1,000% or more in the space of just a few years. Lynch argued that the individual investor need only find a handful of such stocks every decade in order to beat the market handily. Lynch was quite successful in coming up with stocks like Home Depot and Microsoft, and in his writings he revealed one key criteria he used when searching for these winning companies. In today's issue, my staff and I will look for stocks that meet this important criteria.

Why Do Stocks Increase in Value?

Let's take a step back for a minute to look at the big picture. In the process, let's think about what exactly makes a stock rise. While it's true that solid, rising cash flows are what make companies valuable, we're looking for a far simpler answer here.

The bottom line is that a particular stock will move higher when investors purchase a large number of that firm's shares. When millions -- or in some cases even billions -- of investment dollars flow into a stock, that stock is likely to rise sharply.

The Importance of Institutional Dollars

America is blessed with an investor culture. Literally millions of Americans invest part of their salaries into the stock market every year. And discount brokers like E*Trade (ET), Ameritrade (AMTD) and Schwab (SCH) have made small stock purchases affordable for a growing cadre of the population.

But individual retail investors, while certainly important, don't control the big bucks. Instead, most Americans buy stock indirectly by purchasing mutual funds. In fact, over half of American households have placed a portion of their investments dollars in mutual funds.

And mutual funds certainly are no longer the only institutional buyers out there. Hedge funds have grown into a more than $1 trillion industry. Meanwhile, other large players such as pension funds, individual companies and insurance providers also invest in the stock market.

In fact, institutional players are the elephant in the bathtub. About three-quarters of the daily volume on the major exchanges comes from institutional purchases and sales. That's a tremendous amount of cash -- mutual funds in the U.S. alone boast total assets north of $7.4 trillion dollars. With this in mind, when institutional players decide to pile into a stock, all that extra cash usually causes the stock's price to rise.

This cash is how Microsoft returned so much to investors in the 1990s. Believe it or not, back in 1990 Microsoft wasn't yet recognized as the dominant force on the desktop as it is today. Apple Computer (AAPL), IBM (IBM) and Texas Instruments (TXN), among others, were the big blue-chip tech plays back then. But as Microsoft's Windows platform took off, sales and earnings soared, attracting institutional players. These institutional investment dollars are what really caused the stock to soar.

That brings us back to Peter Lynch's key to finding ten-baggers. One of the key criteria that Lynch looked for in a stock was low but rising institutional ownership. Institutional ownership can be measured by looking at the percentage of a company's outstanding shares that are owned by institutional players.

These stocks, Lynch claimed, had the potential to produce extraordinary returns. More specifically, promising businesses with strong fundamentals that are also under-owned by institutional players have tremendous potential. These stocks can deliver huge gains as Wall Street catches on to the story and puts its vast pool of institutional money to work.

And don't think for a second that Microsoft and Home Depot are the only firms that have handed investors huge gains as their institutional sponsorship has risen. This pattern of exceptional gains and rising institutional ownership was also not just a bull market phenomenon. Take Mine Safety Appliances (MSA) as an example.

MSA makes various safety and protection equipment used by the military and first responder units like firemen and policemen. Three years ago, MSA sported a revenue base of $600 million and solid profitability. Even better, a little over a year after September 11, 2001, the company had already begun to see the effects of rapidly rising spending on military and first responder services nationwide. Nevertheless, although the firm's earnings were growing like a weed, only about 15% of the company's outstanding shares were owned by institutional buyers.

Over the next few years, however, institutional ownership in MSA grew from about 15% to nearly 50%. In short, Wall Street discovered the Mine Safety story and piled into the stock. The result: $5,000 invested in the stock on December 31, 2002 would have grown to just over $27,000 by May of 2005. That's a more than five-fold rise in less than two and a half years.

In this issue, my staff and I will look at two promising companies with low institutional ownership but rising institutional interest. To identify these ideas, we first screened for companies that currently sport an institutional ownership ratio of less than 35% but that have seen rising attention from the analyst community (more analysts following the stock) over the past year. In the table below, we present some companies that fit the bill. And in the analysis that follows, we detail two of the most promising plays from this group.

ALCON (ACL, $101.70)

Business Overview
Alcon is a pharmaceutical and healthcare company that focuses exclusively on eye care. The company is involved in three main business lines: consumer products, branded drugs and medical devices.

On the consumer products front, ACL makes consumer contact lens fluid and eye drops. Meanwhile, pharmaceuticals include a drug for macular degeneration -- an eye disease that normally results in gradual, permanent sight loss -- called Retaane. The company also sells drugs to treat eye infections, allergies and glaucoma.

On the medical products front, Alcon's main products are focused on cataract surgery. More specifically, ACL makes artificial lenses and related equipment used during this surgery.

Competitive Advantages

Alcon's competitive advantage stems from its focus on a single, profitable niche of the healthcare industry. The company doesn't attempt to compete in very crowded areas like cholesterol or cancer drugs.

Partly due to this singular focus, ACL boasts either the #1 or #2 best-selling products in each of its major business lines. For example, the company's cataract surgery equipment and devices each hold better than 50% market share. And this offers an advantage for new products as well -- the company is able to leverage its well-known brand name among doctors to push new products as they come available.

Because most of the company's products are protected by patents, it would be extremely challenging for a competitor to enter the market with a competing product. These patents have helped Alcon retain its leading positions in key business lines.

Growth Drivers

Alcon's future growth will likely be driven by a variety of new products. One of the most promising is recently-launched ReStor, an artificial lens used to replace the natural lens in patients suffering from cataracts.

Oftentimes, cataract surgery patients need reading glasses. After all, traditional artificial lenses aren't designed to help patients focus on nearby objects. However, ReStor is different, as it gives cataract patients the ability to see objects near and far after surgery -- a significant, measurable improvement in post-surgery sight.

Additionally, Alcon should benefit from strong growth in emerging markets. Eyecare in less developed markets isn't as advanced as it is in the U.S. However, as these countries become wealthier, cataract surgery and other common procedures should become much more popular.

Alcon's revenue growth from emerging markets is running at nearly +30%, or about 10 percentage points higher than overall sales. Right now, emerging markets account for less than 20% of the firm's total. However, that's rapidly changing, and in the future we expect these markets to become important growth drivers.

Valuation and Outlook

Alcon trades at 27 times 2006 earnings. At first blush, that might seem expensive. However, when you consider that the company has delivered +30% annual growth over the past five years, that valuation starts to look much more reasonable.

And while analysts expect the company's long-term growth to slow to +17%, growth estimates have been ticking higher over the past 6 months, so this may prove rather conservative. What's more, it's not unusual for a market-leading company like Alcon to trade at a premium to its growth rate.

My staff and I are looking for Alcon's new ReStor lens to further enhance the company's lead in the cataract business. ReStor sells at a substantial premium to existing lenses, so this should help boost the company's margins.

Right now, institutional investors hold just 21% of Alcon's shares. This is unusually low for a high-growth company with a market-leading position. In recent months, several analysts have picked up coverage of the stock, and we believe it's only a matter of time before institutional interest in ACL starts to pick up. And as it does, the firm's share price should follow.

SHANDA INTERACTIVE (SNDA, $33.89)

Business Overview
Shanda Interactive develops, markets and hosts online video games in China. Some of these are role-playing games that go on continuously for many days and require players to assume certain characters. Others involve smaller groups of players in competition. The company also offers instant messaging capability between gamers.

Competitive Advantages

SNDA has two main advantages. For starters, it's the first mover in the Chinese market and has already grabbed a sizable market share in online games. On average there are nearly 1 million Chinese players online playing SNDA games at any given time. Peak loads are closer to 1.5 million users.

In addition, the company has developed its own line of popular in-house gaming titles. Just as in the West, Chinese gamers become loyal to certain series of game titles -- these games are proprietary to Shanda. What's more, because the games are played online (rather than remotely on a console or PC), it's much harder to pirate these games.

Growth Drivers

Shanda's future growth will continue to be fueled by the rapid increase in Chinese Internet users. As China develops, more consumers will be able to afford Internet access. And every year, more and more families will purchase a personal computer (PC). By the end of 2004, there were already around 90 million Chinese Internet users. This figure represents roughly 12% of the 750 million or so Internet users worldwide.

But while those sounds like big numbers, they're nothing compared to what we're likely to see in the future. For example, that 90 million figure only represents just 7% of the Chinese population. By comparison, over 70% of the U.S. population has access to the Internet.

Although it will take years for Chinese Internet usage to equal U.S. levels, it's not hard to fathom 10% to 20% of the Chinese population online by the end of the decade. That spells huge growth for companies like SNDA that are leveraged to the growth of the Internet.

Valuation and Outlook

SNDA trades at roughly 20 times estimated 2006 earnings and is growing at a +35% annual clip. That gives this high-growth stock a PEG ratio of only 0.6 -- cheap by any measure.

Other Chinese Internet plays like Sina.com and Netease sport institutional ownership ratios in the region of 40% to 50%. Meanwhile, SNDA is only about 22% owned by institutional players. With a 40+% return on equity, growth in the 30% region and no net debt, it's only a matter of time before more institutions pile into this stock.

The company should surpass $4.50 per share in earnings over the next five years. Assuming a constant multiple of 20 times, the stock could eventually trade close to $100.

Paul Tracy will be available to take your questions until Monday, May 30. Please use the form below to submit your questions.