Profit From Wall Street's Misfortune

Institutional investors dominate day-to-day trading in the market. With the tremendous amount of cash they manage, even trading small portions of their portfolios moves huge numbers of shares.

A significant chunk of their trading, however, is due to factors outside their direct control. As institutional, rather than individual, investors, they manage other people's money. Ultimately, they answer to the folks who really own that cash. When those people lose faith in the institutional money managers, they can -- and do -- pull their cash out.

A chain reaction
At Legg Mason (NYSE:LM), for instance, there was $18.4 billion in net redemptions in the quarter ending in June. Amazingly, that was an improvement from the $19.2 billion in the previous one. The fund run by Bill Miller, whose legendary 15-year streak of beating the market was unparalleled in recent times, represented around $2.4 billion worth of Legg Mason's first-half redemptions.

As investors' money leaves an institution's control, fund managers can be forced to sell stock to meet those redemptions. When billions of dollars flow out of a fund, its manager is left with no choice but to sell some of the stocks it holds to come up with the cash. Since many of these funds share the same holdings, all of that forced selling drives their prices down.

The consequence of selling
In a perfect world, a fund manager would be able to pick which shares to sell based on valuation. The more expensive a stock relative to its true worth, the more of it the fund manager would sell, thereby minimizing the long-term damage to the fund. In the real world, however, a fund manager facing huge redemptions will sell whatever stocks happen to be liquid enough to support it.

There aren't all that many stocks with enough trading volume to support a sell-off of that magnitude. Over the past month, for instance, there have only been 69 individual company stocks across the U.S. and Canada with at least half a billion dollars' worth of average daily trade volume. They're virtually all names you know, including:

If a single fund manager needs to sell tens of millions of dollars in a single day just to meet redemptions, these highly liquid stocks are about the only ones that manager can easily sell. Multiply that impact by all the fund managers who face redemptions in a generally declining market, and you can see how stock prices can quickly plummet.

Your opportunity to profit
That huge selling pressure is largely based on answering the question "How can I raise cash now?" rather than "What's this stock really worth?" It's times like these when a company's stock can fall well below its true value.

As an individual investor managing your own money, you're not beholden to the redemption pressure that massive mutual funds feel. On the contrary, you can do what those fund managers only dream of doing: buy into an irrational, forced sell-off. At Motley Fool Inside Value, we're always on the lookout for those cases where forced selling puts great companies on sale.

If you'd like to see what we think is ripe for the picking now, consider a 30-day free trial of Inside Value. You'll find our list of best buys now, as well as all of our past recommendations. Click here to get started -- there's no obligation to subscribe.

At the time of publication, Fool contributor Chuck Saletta owned shares of General Electric. Legg Mason and Home Depot are Inside Value recommendations. Amazon.com and Apple are Motley Fool Stock Advisor picks. The Fool owns shares of Legg Mason. The Fool has a disclosure policy.