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Wednesday, December 12, 2012

Having the Inside track

Those that know me well know that I am something of a geek. I spend significant parts of my day reading, testing and reviewing information on everything from markets to baseball. I have also been known to sit down and read academic research on anomalies in the stock market that might help me make money for myself, clients and readers. One of my areas of interest has been insider buying as an indicator or catalyst in deep value situations. I have done a lot of work this year on top executive buying with very positive results. In a recent discussion with some friends I was reminded of the concept of cluster buying.

Cluster buying is several different insiders buying within a very short period of time. The earliest study on this was done by two of the legends of our business and academic research. Victor Niederhoffer and Jim Lorie (if you are not familiar with these gentleman break out your search engine and get busy reading) did a study back in 1968 titled Predictive and Statistical Properties of Insider trading that found that stocks with 3 or more insider buys in a short period of time outperformed the overall stock market by a wide margin. Further research by Jeffrey Jaffe of Wharton, Nejat Seyhun of the University of Michigan and others has confirmed the effectiveness of insider cluster buying.

Looking at the list I find that it confirms my view of the world right now. Real estate is probably the single cheapest asset on the planet right now and insiders seem to feel the same way. Inland real estate owns shopping centers in the Midwest and has seen strong buying by officers and directors in the past month. Seven different insiders, including the CEO and CFO, have made open market purchases of the stock in the past month. Their centers are usually anchored by national retail chains such as drug stores and supermarkets. The company has been aggressively renewing leases in the past year and their strong presence in their key markets of Minnesota and Illinois to do so at very attractive rates. Management has also been working to restructure and reduce the cost of debt used to finance their properties. At the current quote the REIT yield a very attractive 7.2%.

Mortgage REITs have much maligned in the financial press of late for what appear to be good reasons. The continual buying of mortgage backed securities by the Fed is pressuring spreads for these REITs and forcing many to lower dividends. Refinancing is also a risk as older high yield bonds are paid off and the proceeds have to be reinvested at lower yields. In spite of this insiders in the sector seem quite bullish over the past few months.

 ARMOUR  Residential (ARR) is at the higher end of the risk and leverage spectrum with a debt to equity ratio of more than 8. Because of the high leverage the current yield on shares of the REIT is an eye popping 15.410%. In the past month 5 insiders including the CEO and CFO have been buyers of the stocks. Hatteras Financial yields “only” 12% after the recent dividend cut has seen 3 insiders step and buy shares in the open market. The insider buying in this sector flies in the face of many Wall Street downgrades and negative press attention in this sector so it bears watching for contrarian opportunities.

The logical step from real estate is to those who finance all the properties.  It is no secret that I love bank stocks for the next several years and it appears insiders at many of these institutions are in agreement.   Many of the banks are too small to mention here but a few are larger community banks worth considering. MidSouth Bank (MSL) is a bank that I have mentioned in the past and the stock is still a buy. The Louisiana based bank has 40 branches in their home stat as well as neighboring Texas. Right now the shares trade at about 90% of book value and insiders like the price. Three different insiders including the Vice Chairman have purchased shares in the open market in the past month. Chemical Financial (CHFC) of Michigan has seen buying by 4 insider’s right around book value in the past four weeks.

The ground breaking work of Lorie and Niederhoffer has been followed up many academics and investment practitioners and it still works today. Cluster buying can help us identify undervalued stocks with the potential for outsized gains. Sometimes rather than reinvent the wheel it is good to stand on the shoulders of the giants who came before us.

Before we move on from the subject of insider buying I decided to run one last screen for insider activity. One of my favorite screens to run is the search for what I call perfect stocks. A perfect stock in my world trades below tangible book value, profitable and pays a dividend. This has been a fantastic screen over the years producing some wildly profitable stocks. The final criterion is usually a high level of insider ownership but I decided to replace that with insider buying in the past couple of months and see what we found.

The first observation is that there is a serious struggle between Wall Street and insiders over the fate of Mortgage REITS right now. The conventional wisdom on mortgage REITS is that the run is over and the sector is too risky. The bear argument is that low mortgage rates are compressing spreads and making it very difficult for the MREITS to maintain their dividend. The housing market is stabilizing somewhat and we are seeing refinance activity that pays off higher yielding binds earlier than expected. At the same time home sales are still sluggish so not much new paper is being purchased. As a final bear blow they Fed is now a major competitor for what paper is issued as they are buying $40 billion a month of mortgage paper.

The argument seems to make sense and we have seen several mortgage REITs cut their dividend. Why then are the folks running these firms such enthusiastic buyers of their own stock? 3 of the ten largest insider buys by dollar volume on my list are Mortgage REITs. Officers and directors at ARMOUR Residential (ARR), Hatteras Financial (HTS) and Two Harbors (TWO) have all been sizable buyers in the open market. The CEO of one of my favorite long term MREIT holdings Invesco Capital Mortgage (IVR) has been an enthusiastic buyer of his own stock in the past month. Someone is very wrong in this sector and although they may be early I do not think it is the insiders.

The second thing that is apparent form the list is that the executives and board members of small regional and community banks share my belief in the Trade of the Decade. The vast majority of the bank stocks on the list are too small to talk about here but a few names standout. Westfield Financial (WFD) is one my favorite post thrift conversion bank stocks and one of their executive purchased 30,000 shares in the open market recently. A director recently picked up 25,000 shares of New York based Astoria Financial (AF), another stock I have owned for some time now. First Bancorp (FBNC) is growing though acquisition and FDIC assisted purchases of failed banks. The credit picture is improving and the CEO seems to believe better days are ahead for the North Carolina based bank. He recently went into the market and increased his personal stock holdings by 10%.

Positive news about strong sales of Gorilla Glass recently led to a nice pop is shares of Corning (GLW).  I still like the stock and so do as least one insider. One of the directors recently opened his checkbook and bought 170,000 shares of the stock. This company is in all the right industries for the next several years as their glass products are used in smart phones, flat screens, tablet computers, biotech research and clean air technology. The stock is cheap and the company is poised to be a growth leader over the next five to ten years. I am happy to see that the folks running the company agree with my positive outlook for the company going forward.

Two insiders including the CEO have been buying shares of leading grains processor and transporter Archer Daniels Midland (ADM). The shares have been trading right around book value and some insiders seem to think that is cheap enough to be attractive as a long term investment. Rising global demand for food will eventually drive earnings and the stock price of this company much higher and it is one my buy list for a substantial market decline. If I could get the stock at less than 80% of tangible book value in a protracted market decline I would be a wildly enthusiastic buyer.

The exercise of combining perfect stocks and insider buying didn’t provide much in the way of new information or opportunities but it did confirm that we are on the right track with many of our investments. The people running our many of our portfolio companies like them as much as we do.

The use of insider data to find profitable buying opportunities is pretty well documented. It is one of the stock market anomalies like price to book value and momentum that has stood the test of time. The Niederhoffer and Lori study came out almost 45 years and the data is as relevant today as it was then. Many anomalies are arbitraged away almost as quickly as they appear but these last. I suspect this is because they have to do with corporate valuation levels and human behaviors which are two constants of the market arena.

Another anomaly that has lasted is the flip side of insider buying. Individual insider sales of stock are almost random in nature. The fact that a director for officer sold a block of stock tells almost nothing about the future of the company or the stock price. The fact that an officer needs to raise cash to pay for a dream wedding for his daughter or to diversify his holding is not in and of itself predictive. However the same studies that confirm the predictive nature of insider buying tell us that when several insiders sell in a short period of time the stock is probably going lower. It is highly unlikely that a group of insiders all decide to diversify at the same time or are all building dream houses for their wives in the same short time span. It is an indication they are aware of declining business trends or an overvaluation of their companies stock price.

When I sat down and looked for stocks with insider selling some interesting names appeared on the list. Storm Ruger (RGR) has seen it stock surge as gun sales have strengthened in the past several years. Fear mongering about the administration’s anti-gun policies have helped to lift revenues and profits at the company. After years of stagnant sales and earnings the rush to buy a gun the past few years have seen sales and profits sky rocket and the stock is up more than 12 fold from the 2008 low. Insiders seem to think the stock may be ahead of itself as 4 insiders have sold stock in the open market in the past month. The sales were significant with some insiders reducing their holding by 30% or more. That is not diversification it is profit taking. Investors would be wise to do the same at these levels.

Another interesting name on the list is asset management and mutual fund provider Eaton Vance (EV). The company has done very well in the past year as their strong lineup of fixed income funds have attracted positive flows form investors. They have made some bolt on acquisitions to give them greater equity exposure but the firm is known as a faced income shop. The flagship equity product Large Cap Value Fund has been a laggard and is showing equity outflows of late. The stock is trading at 52 week high right now and insiders seem to feel it is fully valued at this level. Six officers and directors have taken profits in the past month by selling stock into the open market.

The most selling in the past six months has been in shares of orthotic and prosthetic patient care provider Hanger Corporation. 7 insiders including the CFO have sold shares in recent weeks. The company reported rising sales in the third quarter but fell short of the always highly accurate analysts’ estimates. In spite of that the stock is still closer to 52 week highs than lowers and insiders are cashing out. The President and chief Operating Officer reduced his holdings by 20% and one of the directors sold about half his shares.

Insider selling is not a guarantee that a stock will go lower right away. However there is a strong statistical tendency for stocks with clusters of selling by officers and directors to decline. It just does not make sense to me to be a buyer of something the people running the company are selling. No matter how good an analyst or observer I may be, there is no way I can know as much as those on the inside of day to day operations.

Originally published as a series on Real Money.Com

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