Insider Buying vs. Insider Incentives

A blog reader sent me this email:

“Do you ever pay attention to insider transactions when analyzing a company?”

I do read through lists of insider buys from time-to-time. I follow a blog that covers these kind of transactions. But, I can’t think of any situation where I incorporated insider buying or selling into my analysis.

 

 

Learn How Executives are Compensated

I can, however, think of situations where a change in how insiders were compensated was included in my analysis. For example, years ago, I was looking at a stock called Copart (CPRT). It had a high enough return on capital and generated good enough cash flow that it was going to have more cash on hand than it could re-invest in the business pretty soon. Up to that point, it had been able to plow a lot of the operating cash flow back into expanding the business. However, it seemed like they had gotten too big to keep that up. So, they were going to have to buy back stock, pay a dividend, do an acquisition, or let cash pile up on the balance sheet.

I saw that the Chairman and the CEO (two different people, the CEO is the Chairman’s son-in-law) were now going to be compensated in a form that meant the share price a few years down the road is what mattered (if I remember right: compensation would now be a big block of five-year stock options combined with an elimination of essentially all other forms of compensation for those next 5 years). I had also read an interview with the Chairman (it was an old interview I think) where he didn’t strike me as the kind of person who was going to venture out beyond his circle of competence if and when he had too much cash.

So, I felt the likelihood of big stock buybacks happening soon was high.

To answer your question: no, I don’t really pay attention to insider buying and selling. But, yes, I do pay attention to whether insiders own a lot of stock, how they are compensated (what targets the company has for calculating bonuses), etc.

I can think of one situation where both the company and the CEO were buying a lot of stock at the same time. And, I should have bought that stock. If I had, I would’ve made a ton of money. However, to be honest, even if the CEO wasn’t buying shares and the company wasn’t buying back stock I should’ve seen this was a stock to bet big on.

It was trading for less than the parts would’ve fetched in sales to private owners. It was an obvious value investment. And that’s probably why insiders were buying.

 

 

Insiders Are Like You – Only Confident

Insiders tend to be value investors in their own companies. So, I think outside investors assume that insiders are acting more on inside information and less on just pure confidence than is really the case. To me, insider buying often just looks like how an especially confident value investor would behave. It’s not that the insider has all this information you don’t – it’s more that (unlike you) the insider doesn’t assume the market knows something he doesn’t.

Part of what I’m basing this on is discussions with insiders about transactions in their own companies. I know some people who have worked at public companies and bought and sold shares of those companies while they were there. Generally, they’ve explained why they bought stock in their company’s shares by saying that the market price moved a lot while nothing inside the company seemed to be changing. Almost always: they’ve described the purchase of shares in the company they worked at as the most “obvious” investment decision they ever made. That’s the word they tend to use: “obvious”.

 

 

Read the 14A

I always read the 14A. The 14A is a proxy document that includes a list of major shareholders, shows how much top executive are paid, discusses the bonus plan (if there is one), etc.

So, I am aware of whether management is paid in cash or stock and what the targets are in the bonus plan. I’m also aware of who the major shareholders are. If I don’t recognize names on that major shareholder list, I’ll try to track down who they are. Sometimes, I also do a little research into when major shareholders bought their stake and whether they’ve ever talked about the business.

I wrote a report on Breeze-Eastern (now part of Transdigm). And, in that case, the major shareholder list made me think the company was more likely than most to sell itself within the next couple years.

That’s not inside information. Who the shareholders were, what they had said publicly, etc. was all out there for anyone to look at.

On the other hand: I have gotten information about a possible sale other folks did not have in two cases. In both cases, someone who interacted with the CEO from time-to-time was sure the company would soon be sold. In both cases, I received that “information” – I’d call it pure rumor – years ago. And, in both cases, the company has still not been sold and the stock does not trade at a higher price now than it did then.

So, the information “everyone knew” was worth more than the information only I knew. The fact of the shareholder list was more useful than the gossip out of headquarters.

All of this research is much easier to do than it sounds. Like I said, facts everyone knows are at least as valuable – I find them more valuable – than gossip only a few people have heard. And the 14A includes sufficient detail to do internet searches on every executive and every major shareholder.

Like 10-Ks, you get better at reading 14As the more you’ve seen. I’ve certainly read hundreds by now.

When I look at any stock: I always read the 10-K and I always read the 14A. Other things like the latest 10-Q, the company’s investor presentation, a recent earnings call transcript, etc. are more optional.

The two documents I consider mandatory reading in all cases are the 10-K and the 14A.

Also, if there’s a “going public” document of some kind (either an IPO or spin-off) that is mandatory reading as well.

 

Read the Merger Document

I’ll take this opportunity to mention that the two documents every investor should be reading (but probably isn’t) are both 14As. By “both” I mean the 14A that is filed in regard to the upcoming annual meeting and the 14A that is filed after the announcement of a merger, going private transaction, etc. looks ready to end the company’s time as a public company.

Generally, the press and analysts and investors basically stop following a public company once it agrees to a merger everyone knows is going to go through.

I want you to be the exception to that rule. Keep following a company till after it is no longer publicly traded.

There will be a wonderful document you want to read that provides:

1.       A “fairness opinion” which will likely include a list of past transactions in the industry and what multiples they were done at.

2.       A “background of the merger” section that will provide a sort of narrative timeline of board decisions, negotiations, etc. from the time someone first considered selling the company to the time the deal went through.

The best source of information about what a public company in an industry is worth is usually this document explaining how a once public peer of the company sold itself.

Here is an example of the merger document Harris Teeter filed in connection with its sale to Kroger (KR). Note here that Harris Teeter actually filed some of the most important parts of this document as a later amendment. For example, the table of EV/EBITDA ratios of past transactions in the supermarket industry was filed in a later amendment.

So, when I say “read the document”, I mean dig through all the amendments too.

This is one of those times where I’m telling you there’s an important piece of information that is very easy to obtain and read – and yet most people aren’t doing it.

It’s public information. But, most investors who could benefit from reading these documents have never read them. So, it might as well be private information.