Big Money Is Scared of Rackspace Hosting

One of the great maxims of traders and Wall Street pros is to follow the "smart money."

I'm not much for the thesis that institutional shoppers tend to make smarter investing decisions, but many of you who've read my ruminations on insider buying say you'd also like to know how the Big Money is betting. Your wish is my command.

Next up: Rackspace Hosting (NYSE: RAX). Are institutions bullish or bearish when it comes to this cloud computing infrastructure supplier?

Foolish facts

Data current as of Nov. 16.

Those who follow our Rule Breakers service know I've twice recommended Rackspace and I still love the stock. The business is improving exactly as any high-growth investor should expect. Earnings growth is accelerating, and returns on capital are rising.

Skeptics will tell you this is the result of a mad rush to cloud computing and that the good times can't possibly last. They're wrong. This isn't a rising-tide-lifts-all-boats type of story. Rackspace has taken deliberate steps to squeeze more customers onto, and more revenue and profit out of, every server it deploys (63,996 at last count).

Consider the numbers from the latest earnings report. Revenue and per-share earnings surged 23% and 50%, respectively, over last year's third quarter. Return on capital for the 12-month period ended in September was 12.5%, up nicely from 10.9% for the year ended in June. Free cash flow more than doubled. Add it all up, and you've got a company that's executing as well as any in the business.

"Quality management is of paramount importance to Foolish investing, and Rackspace is certainly doing its part to stay on top of the game," wrote my Foolish colleague Anders Bylund in rating the stock to outperform.

Institutional ownership history

Source: Capital IQ, a division of Standard & Poor's. *Indicates the number of shares owned.

Big Money investors would appear to agree. The top 25 have more than doubled down on Rackspace since its summer 2008 initial public offering. Of that group, the top five institutional owners account for nearly one-third of the 80.3 million shares they hold.

They've become skittish in the last quarter, however. Since June, the top 25 institutional holders have parted with roughly 3 million shares. Wells Capital Management, a subsidiary of banker Wells Fargo (NYSE: WFC), is largely responsible for the selling.

Competitor and peer checkup

Source: Capital IQ. Data current as of Nov. 16.

Interestingly, the two stocks most would consider overvalued look like the best opportunities in this table. Amazon.com and Rackspace not only share high insider engagement, there's headroom for interested institutions to buy more if they so choose.

Bearish investors have also sold close to 30 million Rackspace shares short, or 23% of the shares outstanding. This creates an interesting dynamic. If the underlying business continues to outperform, skeptics may be forced to forfeit their short positions in a wave of buying, pushing the share price even higher than it is today.

On the flip side, if business slows, more bears could pile on and force the share price down to levels investors haven't seen in months. I wouldn't bet on that, but it is a possibility.

Want to learn more about Rackspace? Join us in a live chat with CEO Lanham Napier at noon EST on Nov. 19. Mr. Napier will be taking questions directly from you, our Fool.com readers, so click below to set an email reminder so you don't miss out on this opportunity!

Interested in more info on Rackspace Hosting? Add it to your watchlist by clicking here.