Looking for Red Flags

 | Aug 06, 2012 | 3:03 PM EDT
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It was, as usual, a busy weekend around Chez Melvin. I sent my loyal spies out to investigate the economic situation. They report back that Disney World is busy, but that if language is a valid indicator there is a substantial amount of foreign visitors propping up the numbers. Other spies headed for the local malls and reported that traffic is spotty at best even on a Saturday afternoon during the Florida back-to-school tax holiday. Releasing the spies gave me time to catch the Orioles taking a series from the Rays and continue to evaluate insider trading as a predictor of stock price.

I have just started looking at the insider selling side of the equation. Insider selling is a lot trickier than insider buying as an evaluation tool. While there is only one reason to buy stock, insiders can have a myriad of reason for selling. They may have too much of their wealth in the stock and need to diversify as they near retirement. They could be making charitable donation, taking a dream vacation or going through a divorce that requires liquidity. Insider selling needs to be evaluated much more carefully.

The first test I ran was insider selling in at least $500,000 of stock in the open market. The results are intriguing, but no yet definitive as a stock selection tool.  First, as is usually the case, there is a lot more insider selling this year than buying, 817 stocks were uncovered and gainers led decliners by a narrow margin (427 stocks went higher after the insiders sold and 390 went lower). What is interesting is that the median return of the list is just 0.79%, well below the market return this year.

Even more interesting is that many of the year's biggest blow ups appear on the list. Green Mountain Coffee (GMCR) saw large insider selling before and during the recent stock decline. Insiders were also large sellers at Chipotle (CMG) before the earnings miss took the stock lower. Insiders at the stock I love to hate, Apollo Group (APOL), have also been sellers of stock. I could go on, but you get the point. While large insider selling  is not a definitive signal, it is a red flag that needs further investigation.

With that in mind it is interesting to see who has been selling shares of the companies whose fortunes they oversee in the past few weeks The largest sale is form my wife's favorite grocer. Jonathan Sokoloff, a private equity investor who is also a director at Whole Foods Market (WFM), sold $248 million worth of shares. There has also been a great deal of options-related selling by executives in the past few months as well. This is a great company, but with the shares up 75% the past year and nosebleed-type valuation, it might pay to be cautious with the stock right now.

At the end of last year I suggested that home builders would be a decent trade. They have been but in the latest sign that it is time to exit the group insiders at Toll Brothers (TOL) have been selling stock. CEO Robert Toll and director Bruce Toll have both sold large amounts of stock in the past month. The stock has shot up 64% in the past year as the building environment improved slightly and it is probably time to take profits in this stock. As Roger Arnold has warned Real Money readers, there is a substantial amount of housing inventory headed for the market form of delayed foreclosures that could hurt the demand for new homes.

Westinghouse Air Brakes (WAB) has seen its stock rise by about 50% of the past year. But with coal shipments and other rail traffic showing signs of weakness demand for railcars could start to slacken. The company had a great second quarter, but expects rail traffic to flatten and rail car deliveries to decline a little. The stock is trading at fairly healthy valuations given the cyclical nature of the industry right now. The President and CEO of Wabtec, Albert Neupaver, recently sold more than $10 million of stock in the open market. I am not sure I would short the stock, but if I was long I would be reducing my position in the shares.



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