Breaking down insider buying

Insider buying is usually an unambiguous signal about how an insider feels about his company. After all, the primary reason that all investors buy stock is that they expect it to do well. If one insider is buying stock, that’s generally not a monumental event. But if several or more insiders are buying, those purchases should certainly catch your attention.

Insider buying is generally a positive omen and beneficial for the stock’s price. Also, when insiders buy stock, less stock is available to the public. If the investing public meets this decreased supply with increased demand, the stock price rises. Keep these factors in mind when analyzing insider buying:

• Identify who’s buying the stock. The CEO is buying 5,000 shares. Is that reason enough for you to jump in? Maybe. After all, the CEO certainly knows how well the company is doing. But what if that CEO is just starting her new position? What if before this purchase she had no stock in the company at all? Maybe the stock is part of her employment package.

  The fact that a new company executive is making her first stock purchase isn’t as strong a signal urging you to buy as the fact that a long-time CEO is doubling her holdings. Also, if large numbers of insiders are buying, that sends a stronger signal than if a single insider is buying.

• See how much is being bought. In the preceding example, the CEO bought 5,000 shares, which is a lot of stock no matter how you count it. But is it enough for you to base an investment decision on? Maybe, but a closer look may reveal more. If she already owned 1 million shares at the time of the purchase, then buying 5,000 additional shares wouldn’t be such an exciting indicator of a pending stock rise. In this case, 5,000 shares is a small incremental move that doesn’t offer much to get excited about.

  However, what if this particular insider has owned only 5,000 shares for the past three years and is now buying 1 million shares? Now that should arouse your interest! Usually, a massive purchase tells you that particular insider has strong feelings about the company’s prospects and that she’s making a huge increase in her share of stock ownership. Still, a purchase of 1 million shares by the CEO isn’t as strong a signal as ten insiders buying 100,000 shares each. Again, if only one person is buying, that may or may not be a strong indication of an impending rise. However, if lots of people are buying, consider it a fantastic indication.

  An insider purchase of any kind is a positive sign, but it’s always more significant when a greater number of insiders are making purchases. “The more the merrier!” is a good rule for judging insider buying. All these individuals have their own, unique perspectives on the company and its prospects. Mass buying indicates mass optimism for the company’s future. If the treasurer, the president, the vice president of sales, and several other key players are putting their wealth on the line and investing it in a company they know intimately, that’s a good sign for your stock investment as well.

• Notice the timing of the purchase. The timing of insider stock purchases is important as well. If I tell you that five insiders bought stock at various points last year, you may say, “Hmm.” But if I tell you that all five people bought substantial chunks of stock at the same time and right before earnings season, that should make you say, “HMMMMM!”

Picking up tips from insider selling

Insider stock buying is rarely negative — it either bodes well for the stock or is a neutral event at worst. But how about insider selling? When an insider sells his stock, the event can be either neutral or negative. Insider selling is usually a little tougher to figure out than insider buying because insiders may have many different motivations to sell stock that have nothing to do with the company’s future prospects. Just because the president of the company is selling 5,000 shares from his personal portfolio doesn’t necessarily mean you should sell, too.

Insiders may sell their stock for a couple of reasons: They may think that the company won’t be doing well in the near future — a negative sign for you — or they may simply need the money for a variety of personal reasons that have nothing to do with the company’s potential. Some typical reasons why insiders may sell stock include the following:

• To diversify their holdings: If an insider’s portfolio is heavily weighted with one company’s stock, a financial advisor may suggest that she balance her portfolio by selling some of that company’s stock and purchasing other securities.
• To finance personal emergencies: Sometimes an insider needs money for medical, legal, or family reasons.
• To buy a home or make another major purchase: An insider may need the money to make a down payment on a home or other real estate purchase, to fund college for a child, or perhaps to buy something outright (such as a car or snazzy vacation) without having to take out a loan.

How do you find out about the details regarding insider stock selling? Although insiders must report their pertinent stock sales and purchases to the SEC, the information isn’t always revealing. As a general rule, consider the following questions when analyzing insider selling:

• How many insiders are selling? If only one insider is selling, that single transaction doesn’t give you enough information to act on. However, if many insiders are selling, you should see a red flag. Check out any news or information that’s currently available by going to websites such as www.marketwatch.com, www.sec.gov, and finance.yahoo.com (along with other sources in Appendix A).
• Are the sales showing a pattern or unusual activity? If one insider sold some stock last month, that sale alone isn’t that significant an event. However, if ten insiders have each made multiple sales in the past few months, those sales are cause for concern. See whether any new developments at the company are potentially negative. If massive insider selling has recently occurred, and you don’t know why, consider putting a stop-loss order on your stock immediately. I cover stop-loss orders more fully in Chapter 17.
• How much stock is being sold? If a CEO sells 5,000 shares of stock but still retains 100,000 shares, that’s not a big deal. But if the CEO sells all or most of his holdings, that’s a possible negative. Check to see whether other company executives have also sold stock.

• Do outside events or analyst reports seem coincidental with the sale of the stock? Sometimes, an influential analyst may issue a report warning about a company’s prospects. If the company’s management pooh-poohs the report but most of them are bailing out anyway (selling their stock), you may want to do the same. Frequently, when insiders know that damaging information is forthcoming, they sell the stock before it takes a dip.

  Similarly, if the company’s management issues positive public statements or reports that contradict their own behavior (they’re selling their stock holdings), the SEC may investigate to see whether the company is doing anything that may require a penalty (the SEC regularly tracks insider sales).

Understanding why a company buys back shares

You bought this book because you’re looking at buying stocks, but individuals aren’t alone in the stock-buying universe. No, I don’t just mean that mutual funds, pensions, and other entities are buyers; I mean the companies behind the stocks are buyers (and sellers), too. Why would a public company buy stock — especially its own?

Exploring the downside of buybacks

As beneficial as stock buybacks can be, they have to be paid for, and this expense has consequences. When a company uses funds from operations for the stock buyback, less money is available for other activities, such as upgrading technology, making improvements, or doing research and development. A company faces even greater dangers when it uses debt to finance a stock buyback. If the company uses borrowed funds, not only does it have less borrowing power for other uses, but it also has to pay back the borrowed funds with interest, thus lowering earnings figures.

In general, any misuse of money, such as using debt to buy back stock, affects a company’s ability to grow its sales and earnings — two measures that need to maintain upward mobility to keep stock prices rising.

Say that Noware Earnings, Inc. (NEI), typically pays an annual dividend of 25 cents per share of stock and wants to buy back shares, which are currently at $10 each, with borrowed money with a 9 percent interest rate. If NEI buys back 2 million shares, it won’t have to pay out $500,000 in dividends (2 million multiplied by 25 cents). That’s money saved. However, NEI has to pay interest on the $20 million it borrowed ($10 per share multiplied by 2 million shares) to buy back the shares. The interest totals $1.8 million (9 percent of $20 million), and the net result from this rudimentary example is that NEI sees an outflow of $1.3 million (the difference between the interest paid out and the dividends savings).

Using debt to finance a stock buyback needs to make economic sense — it needs to strengthen the company’s financial position. Perhaps NEI could have used the stock buyback money toward a better purpose, such as modernizing equipment or paying for a new marketing campaign. Because debt interest ultimately decreases earnings, companies must be careful when using debt to buy back their stock.

Ordinary stock splits

An ordinary stock split — when the number of stock shares increases — is the kind investors usually hear about. If you own 100 shares of Dublin, Inc., stock (at $60 per share) and the company announces a stock split, what happens? If you own the stock in certificate form (which is very rare now), you receive in the mail a stock certificate for 100 more shares. Now, before you cheer over how your money just doubled, check the stock’s new price. Each share is adjusted to a $30 value.

Not all stock is in certificate form. Stocks held in a brokerage account are recorded in book entry form. Most stock, in fact, is in book entry form. A company issues stock certificates only when necessary or when the investor requests it. If you keep the stock in your brokerage account, check with your broker for the new share total to make sure you’re credited with the new number of shares after the stock split.

An ordinary stock split is primarily a neutral event, so why does a company bother to do it? The most common reason is that management believes the stock is too expensive, so it wants to lower the stock price to make the stock more affordable and, therefore, more attractive to new investors. Studies have shown that stock splits frequently precede a rise in the stock price. Although stock splits are considered a non-event in and of themselves, many stock experts see them as bullish signals because of the interest they generate among the investing public.

Reverse stock splits

A reverse stock split usually occurs when a company’s management wants to raise the price of its stock. Just as ordinary splits can occur when management believes the price is too expensive, a reverse stock split means the company feels that the stock’s price is too cheap. If a stock’s price looks too low, that may discourage interest by individual or institutional investors (such as mutual funds). Management wants to drum up more interest in the stock for the benefit of shareholders (some of whom are probably insiders).

The company may also do a reverse split to decrease costs. When you have to send an annual report and other correspondence regularly to all the stockholders, the mailings can get a little pricey, especially if you have lots of investors who own only a few shares each. A reverse split helps consolidate shares and lower overall management costs.

A reverse split can best be explained with an example. TuCheep, Inc. (TCI), is selling at $2 per share on the Nasdaq. At that rock-bottom price, the investing public may ignore it. So TCI announces a 10-for-1 reverse stock split. Now what? If a stockholder had 100 shares at $2 (the old shares), the stockholder now owns 10 shares at $20.

Technically, a reverse split is considered a neutral event. However, just as investors may infer positive expectations from an ordinary stock split, they may have negative expectations from a reverse split because a reverse split tends to occur for negative reasons. One definitive negative reason for a reverse split is if the company’s stock is threatened to be delisted. If a stock is on a major exchange and the price falls below $1, the stock will face delisting (basically getting removed from the exchange). A reverse split may be used to ward off such an event. The bottom line is that a reverse split is ultimately a negative event and investors should avoid the stock.

If, in the event of a stock split, you end up with an odd number of shares, the company doesn’t produce a fractional share. Instead, you get a check for the cash equivalent. For example, if you have 51 shares and the company announces a 2-for-1 reverse split, odds are that you’ll get 25 shares and a cash payout for the odd share (or fractional share).