WS: BUY STOCKS LIKE STEAKS, V (11 Oct 2006)

BUY STOCKS LIKE STEAKS, V

A leading indicator of whether the fortunes of a company are about to turn for the better can be found by watching for insider purchases. Senior management and directors are usually the first to know that operations are improving and earnings may be rising. If they begin to buy stock in the open market, it is a safe bet that things are getting better.

Company employees from senior management on down, often buy and sell shares in the companies where they work (except that they may not do so during lock periods before earnings are reported or if they are aware of non-public information). Regulations exist to prevent insiders from unloading shares onto the public before bad news is released. But the regulation that benefits us the most is not the one that requires company insiders from selling but the one that requires that all transactions be reported within two business days. Any time an insider buys or sells stock, it is public information within 48 hours. This allows us to invest our money very close to the same time that the people running the company decide to invest theirs.

There are a lot of reasons insiders may sell shares in their company. They may wish to diversify their holdings, plan their estate, buy a dream house, or pay off a soon-to-be ex-spouse. For these reasons, sales by insiders are not as strong an indicator as their buys. There is only one logical reason for insiders to reach into their wallets and buy stock in the open market. They think the stock price is going higher.

I pay close attention to insider buying because these people have intimate knowledge of the business and the prospects for improvement in current conditions. They run the company. They often have insights into new marketing programs, improving industry conditions, undervalued assets held by the company, and the potential for future financial transactions that improve the health of the business. If they think business is about get better or the stock is underpriced, it makes sense to investigate further.

Not only does this conclusion make perfect sense, once again extensive research bears it out. Stocks bought by insiders outperform the market by at least a two-to-one margin, and this applies around the world. Insider buying of stocks selling at low multiples of earnings or below asset value is even better. Consistent purchases by insiders is an even better indication-- with below-book-value stocks. And, you guessed it, stocks with high valuations and insider selling tend to underperform by a wide margin.

There is another way that corporate insiders can send a signal that better times may be ahead. When the board of directors of a company decides to buy back its stock in the open market, it may well be a sign that they believe the shares are undervalued and do not adequately reflect the future prospects for growth. They feel that the best return on corporate cash is by buying up their own shares in the marketplace. If they are correct and are buying the shares at a discount to what they are worth, then per share value for other shareholders increases. Any share buybacks done below book value will increase the per share book value of the remaining shares. With so many potential benefits from a share buyback, it makes sense to look closely at companies announcing stock buybacks that appear to be cheap relative to earnings or assets.

Corporate insiders, whether spending their own or the corporation's money, usually make a significant statement when they buy shares in the companies they run. They tend to buy for the long term, not the short term. Many research studies verify that insider buying and share buybacks tend to occur in stocks with a low price compared with earnings, a low price-to-book value, and a price that has fallen quite a bit. In other words, insider purchases are often a signal to the kinds of companies we seek for the shelves of our value investing store because they often have the other traits that make them strong candidates.

There is another type of insider that we should look for. Investors who accumulate 5% or more of a company's shares must file with the regulatory body (SEC in the U.S., SGX in Singapore) and make public information about their holdings. They must also state whether they bought the shares purely as an investment or if they intend to lobby for changes or seek control of the company (more so in the U.S.). Many of these larger investors have successful track records, and it's worth noticing if they have a large position in a stock that appears undervalued. Knowing that a very successful investor is interested is a reason for us also to take a look.

The activist investors who are looking to influence or change management are also worth tracking. Not all the activist investors are successful, but their presence offers us one more screen for value opportunities. They act as another influence on the management of an undervalued stock to increase value or risk losing their jobs. If the stock is already selling at a low price to earnings or assets, then the presence of a successful activist may give us a strong reason to take a look.

Sometimes the only thing standing in the way of a cheap stock and a profit for an investor is a catalyst that can make the market take notice. Both insider buying and activist investors can provide the push that makes the market realize a good value.



Credits: Much of this article, with modification, is extracted from The Little Book Of Value Investing by Christopher Browne, 2007.



POSTED :11 Oct 2006