Analyzing Insider Buying and Selling

 | Jul 09, 2013 | 2:00 PM EDT
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I have been doing a lot of work with insider activity this week. I have revisited the papers of such luminaries as James Lorie, Nejat Seyhun and Josef Lakonishok on the subject.

There is a definite tendency for stocks with insider buying activity to produce excess returns. As with all studies of this type, there is an issue with the size of the sample group. Although the group may indeed produce excess returns, it may be impossible for any individual, or even a fund, to own them all due to restrictions involving the size of the account or the size of the company.

I have spent some time fiddling with various fundamental factors to see if I can find ways to reduce the size of the group and to improve the returns. I am not great academic or statistician, but left alone with enough data and a good calculator I can usually come to some reasonable, accurate conclusions. I have found that many classic value factors, when combined with insider trading, do reduce the sample size and maintain or improve over all returns.

There is a cause-and-effect question that I have not answered yet, but in the grand scheme does it matter if the insider buying or value factors are most important? To a professor, perhaps, but I just care that it does find candidates for profit.

One combination that I favor is stocks with a low enterprise value/earnings before interest, taxes, depreciation and amortization ratio that also have a decent return on equity. These are the measures my private equity friends tell me are most important in the way they value companies. I find it significant when insiders like stocks that might also appeal to buyout investors. To gain some idea of how well it works, consider that the stock with the most positive insider activity and these characteristics is Dell (DELL), a company in the process of a bidding war to go private.

Exelis (XLS) is in an industry that I expect will see an enormous amount of consolidation over the next few years. With defense spending cuts planned over the next decade, it will just make sense for smaller companies in the industry to combine or be purchased by an industry leader to achieve cost savings. A recent Forbes magazine article suggested that Excelis would be among the first to go as their electronics business is attractive, but spread across so many different missions and agencies that it is not going to be cost effective.

The company has a return on equity of more than 20% and the EV/Ebitda ratio of just 4.6. It is not that appealing on an asset basis at more than 2x book value. But the current price-to-earnings ratio is just 8.8 and the stock fetches about 5x free cash flow. The $600 million plus debt on the books might scare away a private equity buyer, but a strategic buyer in the form of a larger defense contractor looking to expand its electronics business would fund a lot to like about this company. At least one insider likes the future of the company as a director recently added to his holdings by purchasing $139,000 worth of stock in the open market.

Energy XXI Ltd (EXXI) is an oil and gas company that operates in the Gulf of Mexico as well as on land in Louisiana and Texas. The company has been growing by acquisition and operations and has grown reserves from 53 million barrels of oil equivalent to almost 120 million BOE in just two years. According to the company, the total value of the reserves is more than $37 a share while the stock price languishes in the $24 area.

They have been backing it up with cash as several executives have been buyers of the stock this year. The company has a return on equity of 13 while the EV/EBitda ratio is less than 4. They have joint ventures in the Gulf with several major oil companies and I would not be surprised to see that someone decided to increase their domestic oil and gas reserves by simply buying the company.

Insider buying and selling works on its own. I am intrigued to see if we can improve it by using valuation and credit evaluation to further tweak the results.

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