Follow the Pack

 | May 08, 2013 | 11:30 AM EDT
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In addition to tracking the buying and selling activity of a company's top two executives (as I wrote about on Tuesday), I also pay attention to cluster buying by officers and directors in their companies' stocks. This type of activity has been associated with positive returns and outperformance for years and is one of the few market anomalies that has not been arbitraged out of existence over time.

Officers and directors participate in the board meetings, see the reports and hear the plans for the future of the business. When several of them are buying shares of stock on the open market, it just makes sense to pay attention. James Lorie and Victor Niederhoffer first documented the impact of cluster buying in the 1960s and many have found it to be a winning strategy.

I compiled a list of companies with recent heavy insider buying. The heaviest buying in a single company the last few months occurred in March when 20 insiders at California Water (CWT) added shares to their stakes in the company a price that was a little higher than the current one. The water investment theme has been heavily promoted over the past few years and California could well be ground zero for water related profits in the years ahead. The company also provides water and related services in New Mexico, Washington State and Hawaii.

I am in general agreement that water will eventually become a growth industry, but the stock is not really cheap enough for me to buy – it is currently trading at 1.5x book value and has an enterprise value/earnings before interest, taxes, depreciation and amortization (EV/EBITDA) ratio above 8. The stock is on my watch list with other water related stocks. Growth or thematic investors may feel differently and want to follow insiders into the stock at this price.

Walter Energy (WLT) is a beaten-down material name that is seeing strong buying by officers and directors. The company provides metallurgical coal to steel companies and is struggling. Several insiders, including the CEO, CFO and general counsel, have been buying the stock recently. The shares currently trade lower than where they purchased their shares just a few days ago. The company is losing money at the moment and the stock is bouncing along five- week lows. In fact, it is not too far above the five-year lows set back in 2009.

Coal and steel will comeback at some point, and insiders are indicating they think Walter will survive and thrive over time. Trading at 1.1x tangible book value, the stock is very close to being cheap enough for me to add to my growing list of materials holdings.

I find it very interesting that insiders at Silver Bay Realty Trust (SBY) have continued buying shares of the REIT following its initial public offering (IPO). Officers and a director bought the initial offering heavily, but several have continued to add to their positions -- including the CEO. This stock sits firmly on top of my "please pull back soon so I can buy" list of stocks.

The REIT owns 3,405 single family rental properties in California, Texas, North Carolina, Arizona, Ohio and Florida. The shares currently fetch 1.6x tangible book value, so I cannot break standards and chase the stock. However, I really want to own some of this company. Housing is in the early stages of recovery and is probably going to hit a bump or two since demand has been artificially deflated by institutional buying in rental properties. Silver Bay insiders clearly think their strategy of buying homes below replacement cost will pay huge dividends and they have backed up their conviction with cash.

As was the case with the list of top executive buying, the cluster buying list shows significant activity by insiders in energy, banking and insurance, as well as the real-estate related sectors. Felcor Lodging (FCH) has been a favorite holding in my longshot portfolio for some time and insiders continue to buy the stock. Huntington Bancshares (HBAN) has been a solid holding and three insiders have made open market purchases recently. Three insiders at oil-and-gas company Apache (APA) have added to their stakes in the company in the past few weeks. These beaten-down sectors make up a significant percentage of my portfolio, so I am pleased to see insiders sharing my long-term optimism.

Insider cluster buying can be both a confirming factor of long-term value and a catalyst for unlocking that value. I find it hard to believe that more traders and shorter-term investors do not focus entirely on insider activity to formulate their universe. What could be more valuable than a list of stocks that have a strong historical tendency to go up more than the market over the next six to 12 months?

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