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You Can't Become Rich In Your Pocket Until You Become Rich In Your Mind | ||||
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Investors who are interested in buying stocks that have suffered declines and seem to be at attractive price levels should monitor the trading of Value InsidersInsiders, The Vital Few THE SECURITIES AND EXCHANGE COMMISSION (SEC) HAS DEEMED OFficers and directors of publicly traded companies as corporate insiders. Individuals who are outsiders but have managed to accumulate 10 percent or more of a publicly traded stock are also insiders. The rules governing insider trading are clear and straightforward. Any change in holdings by an insider must be reported to the SEC within two business days of the transaction. Insiders are allowed to trade whenever they want; However, if it can be proved they took advantage of information that was not available to the public, they can be forced to turn their profits back to the company and be sued for treble damages in civil court. Under the Freedom of Information Act, the SEC is required to make this information available to the public. There are many ways to find out what stocks insiders are buying or selling, but before I discuss how to get the information, it is important that you understand how to use it. The key word that you will read many times in this book is divergence. Normal insider behavior would be to buy into price weakness and to sell into price strength. Just because they are corporate insiders does not necessarily mean they are savvy investors. A minority of insiders, mostly those with Wall Street roots, understand the investment communitys response to news and are very conscious of the future trend of earnings and other important developments they expect to report. The majority of insiders, however, do not have a clue as to what causes their companies stock prices to go up or down. This group is primarily focused on the inherent value of the stock relative to its current price. Regardless of whether corporate insiders are focused on news they expect to report or comparative values, all insiders understand the intrinsic value of their own companies stock. Intrinsic value is the price at which a company could be liquidated or sold to an interested buyer. When their companys stock approaches or drops below intrinsic value, insiders buy. The lower it goes, the more they buy. On the other hand, when stock prices rise above their perception of intrinsic value, insiders sell. The higher it goes, the more they sell. Since it is normal for insiders to buy as their stock goes down and sell as it goes up, what we want to look for are divergences from this normal behavior. Your eyes should become wide open when you see an insider, especially the Chief Financial Officer who normally sells stock only when the price rises, suddenly break this pattern by selling into price weakness. It usually means that the companys business conditions have deteriorated and that bad news is coming. On the other hand, you should really be impressed when you see insiders buy at higher prices than their earlier purchases. This usually means business conditions are at least as strong as they were when these insiders first bought, and in many cases, getting stronger. Better than expected news usually surfaces a few months later. My firm, Muzea Insider Consulting Services, analyzes insider trading for institutions. We have identified both of the insider groups discussed previously. We call the group that does not care about earnings visibility Value Insiders. These insiders concern themselves only with the book value in relation to their current stock price. Approximately 70 percent of all insiders fall into this category. Investors who are interested in buying stocks that have suffered declines and seem to be at attractive price levels should monitor the trading of Value Insiders. If a stock has real value at depressed levels and Value Insiders are not buying, use that as an alert to rethink your own assessment of value in the stock in question. On the other hand, insider buying would give you added confidence that your reasoning is sound and you can begin your accumulation without reservation. From a macro, or big picture, perspective it is important to know what Value Insiders are doing as a group. If the market has experienced a decline and they have not bought aggressively, clearly the decline has more to go. In my 37 years of following insiders, I have never seen an intermediate or major stock market bottom without aggressive accumulation of stocks in general by Value Insiders. The second group my company has identified is Catalytic Insiders. These insiders do not care about book value. Their main concern is with visibility and will buy only if they see good news over the next two quarters. If you are interested in buying a stock that is already in a clearly defined up trend, the actions of the Catalytic Insiders can be helpful. The investment community has labeled investors who buy stocks that are only in established up trends as momentum investors. Since these investors buy only stocks that are well off their lows and already have experienced a surge in prices and breakouts from bases, the risk is greater for this class of investor. At some point in time, there will be a final breakout in price that becomes the top for that cycle. The challenge for momentum investors is to not get caught in that last breakout in the price of their stock. Monitoring the actions of Catalytic Insiders can be helpful in this regard. If this group of insiders have bought the most recent basing pattern (a period of lateral price movement), it is highly likely that more good news is on its way and the subsequent surge in prices will not be a head fake. If, on the other hand, insiders who previously bought are not buying the new basing pattern, it would be wise for a momentum investor to not buy the next breakout of a base and to either sell into the new rally or at least place stops to protect their gains. From a macro point of view, monitoring both groups of insiders can be very useful in determining the degree of market risk at any given time. In an ideal world, Value Insiders provide us with a clue that the stock market has exceptional value. Then when Catalytic Insiders buy, that would be a sign that the turn is near. It is logical for the Value Insiders to come in first, but it is also possible that both groups both buy at the same time. This usually happens after a sharp market drop, such as what happened in October/November 1987. I have never seen a secular bull market that did not have both Value and Catalytic Insiders buying. Therefore, it is important to monitor their behavior. Since it is normal for Value Insiders to buy first, the major clue we get as to whether the ensuing rally is going to become only a trading event or the start of a new major up trend will be the actions of the Catalytic Insiders. On the other hand, if the Catalytic Insiders buy aggressively, then we can look for a major move in the economy, company profits, and the stock market. We would know the market is undervalued from the actions of the Value Insiders and when the buying of the Catalytic Insiders confirms that, the next up move is significant. Absent Catalytic Insider buying would indicate only a technical rally. The stock market could then be expected to drop back again to the previous level or close to it. Without Catalytic Insider buying, there will not be enough good news from companies to keep stocks moving higher. It is quite easy to identify both groups of insiders. Value Insiders buy only stocks that are at either the bottom one-third of their 52-week price range or at intermediate lows. The key to understanding Value Insider behavior is that they are looking for bargain prices in their companys stock. They are very patient and if you are going to follow them, you better have that quality as well. Otherwise, you might give up in disgust and sell just before the stock gets recognized and starts its up trend. The Catalytic Insider is also easy to follow. In my company, we have identified this group as Stud Insiders and Smart Insiders. However, you do not need the names of these insiders. Anytime you see an insider buying a stock that is already in an up trend, the insider buying is catalytic in nature. Any insider buying into price strength is good. However, if the buying is coming from operating officers, the probability of good news coming is further enhanced. There is nothing better that having one or more insiders buying into a stock that is in an up trend and already has institutional sponsorship. The good news often leads to institutional research analysts upgrades, which often precede additional spikes in prices. The Catalytic Insider is actually the momentum investors best friend. It is important to understand that insiders really have only about a six-month visibility on their companys prospects. They have a good handle on business conditions for about two quarters. However, beyond that they are guessing just like everyone else. I am amused when I read analyst reports basing price objectives on predicted earnings two years out. Understanding that insider visibility is only about six months, it is important to keep monitoring their activity in stocks you own. For example, you like a stock, it has insider buying, so you buy it. Six months later, the stock has moved up 25 percent and you observe there is additional insider buying. Great! That is a sign that more good news is coming and the stock probably has good prospects for the next six months. On the other hand, what would you do if the stock had moved ahead sharply, six months elapse, and there is no further insider buying or even some profit taking? A stock like this should be monitored carefully for signs of weakness. As long as the stock maintains its up trend, I would stay with it, but if it starts to stagger a bit, I would sell. A wise old successful investor told me years ago that one of his best methods of knowing when to sell was the actions of the stocks in his own portfolio. As the market would rise and he found new stocks to buy, he would pause when his next stop failed to go up. He would then buy another stock. If that one failed to go up or went down, he would sell all of his stocks. This may seem a bit extreme, but I do believe the action of your own portfolio of stocks can help you know when to sell. Knowing whether insiders did or did not buy more after their initial sixmonth entry point can be very helpful in this regard. There are many Internet web sites that allow you to check for insider trading in a stock. I recommend Yahoo!, which has a Finance option that allows you to select the insider option after you have entered a symbol. It is also free, and does a good job of presenting the insider data. I recommend you ignore everything except open market buying and selling. Any insider trades other than simple open market trading is too complicated and not worth the time required to analyze. It is also very useful to know the biography of insiders who are trading in a stock of your interest. When you are in Yahoo! Finance, select the Profile link and then select the option that provides you with the full list of insiders. Knowing how long an insider has been with the company, when he or she last traded, and what their position is could provide you with valuable clues as to just how important the trade is. Macro analysis is a top-down approach that consists of mainly two areas. The first is the determination of the degree of market risk or reward that exists at any given time in the market. The second is the analysis of sectors and industries. Many of my companys institutional clients are interested in clues about which sectors and industries corporate insiders favor or disfavor. Over the years, we have developed a number of proprietary techniques that aggregate all insider trading, and we have years of back data to compare. It is next to impossible for the average individual investor to duplicate the insider data that my firm has compiled over the past 25 years. Without back data, it is better not to attempt the analysis of insider trading to predict sectors and industries. Do not fret, however. Remember, 60 percent of your investing success is a function of knowing the risk/reward of the market at any given time. You will have that problem solved with the Magic T described in a later chapter. Twenty percent of your investing success relates to stock selection. This, too, is in the bag since you now have a method of checking insider trading in your stock, which should improve overall results when insiders and your own analysis are in synch. The last 20 percent of successful investing is checking the sector and industry where your stock resides. A smart way to gain insights here without quitting your full-time job (I am not sure that would help anyway) is to pay attention to your own reading and research. When you develop an interest in a sector or industry, write down the market leaders on a piece of paper, and check out the insider trading in these stocks. The existence or lack of insider buying will give you a good clue as to whether there is overall value. The best way, however, to gain sector and industry insights is to simply focus on the stocks you have already identified as buy candidates. You did your research and checked out the insider trading. Now all you have to do is get a list of other companies that are in the same sector and industry and check out their insider trading profiles. If you see similar insider buying, then you have an excellent confirmation that the stock you already like is more than just a special situation. If other companies in the same sector and industry also have good insider buying patterns, you now have that final 20 percent working in your favor. If the preceding seems like a lot of work, it is. Remember though, you are rewarded in life and in the stock market by what you ferret out yourself. Useful information is rarely given out for free; it has to be dug out. Information that comes easily, such as viewing financial media and buying a 50-cent newspaper is relatively useless, designed for the masses or The Trivial Many. I would like to make one final point. The concept of avoiding or selling any stock that has insider selling into price weakness is the most important lesson you can learn when it comes to following insiders. Investors could have saved enormous amounts of money over the years if they had simply followed this one, single insider analysis rule. If you learn nothing but this one insider concept from my book, I would be very pleased and gratified because I know I have taught you a technique that can help you avoid major losses in a declining stock. Avoiding big losers is even more important than picking winners, in my opinion, because losses not only destroy hard-earned stock market gains but have an emotional cost as well. |
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