Standing on the Shoulders of Giants

 | Dec 04, 2012 | 2:00 PM EST
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Those who know me well, know that I am something of a geek. I spend significant parts of my day reading, testing and reviewing information on everything from markets to baseball. I have also been known to sit down and read academic research on anomalies in the stock market that might help me make money for myself, clients and readers. One of my areas of interest has been insider buying as an indicator or catalyst in deep value situations. I have done a lot of work this year on top executive buying with positive results. In a recent discussion with some friends, I was reminded of the concept of cluster buying.

Cluster buying is the term used when several different company insiders buy stock within a very short period of time. The earliest study on this was done by two of the legends of our business and academic research. Victor Niederhoffer and Jim Lorie (if you are not familiar with these gentleman, break out your search engine and get busy reading) did a study back in 1968 titled "Predictive and Statistical Properties of Insider Trading" and found that stocks with three or more insider buys in a short period of time outperformed the overall stock market by a wide margin. Further research by Jeffrey Jaffe of Wharton, Nejat Seyhun of the University of Michigan and others has confirmed the effectiveness of insider cluster buying.

I find that this list confirms my current view of the world. Real estate is probably the single cheapest asset on the planet right now and insiders seem to feel the same way. Inland real estate owns shopping centers in the Midwest and has seen strong buying by officers and directors in the past month. Seven different insiders, including the CEO and CFO, have made open market purchases of the stock in the past month. Their centers are usually anchored by national retail chains such as drug stores and supermarkets. The company has been aggressively renewing leases in the past year and their strong presence in their key markets of Minnesota and Illinois allow them to do so at attractive rates. Management has also been working to restructure and reduce the cost of debt used to finance their properties. At the current quote, the real estate investment trust (REIT) yields an attractive 7.2%.

Mortgage REITs have much maligned in the financial press of late for what appear to be good reasons. The continual buying of mortgage backed securities by the Fed is pressuring spreads for these REITs and forcing many to lower dividends. Refinancing is also a risk as older high yield bonds are paid off and the proceeds have to be reinvested at lower yields. In spite of this insiders in the sector seem quite bullish over the past few months.

Armour Residential (ARR) is at the higher end of the risk and leverage spectrum with a debt to equity ratio of more than 8. Because of the high leverage the current yield on shares of the REIT is an eye popping 15.410%. In the past month, five insiders, including the CEO and COO, have bought the stocks. Hatteras Financial, which yields "only" 12% after the recent dividend cut, has seen three insiders step and buy shares in the open market. The insider buying in this sector flies in the face of many Wall Street downgrades and negative press attention, so it bears watching for contrarian opportunities.

The logical step from real estate is to those who finance all the properties. It is no secret that I love the prospects for bank stocks for the next several years and it appears insiders at many of these institutions agree with me. Many of the banks are too small to mention here, but a few are larger community banks that are worth considering.  I have mentioned MidSouth Bank (MSL) in the past and the stock is still a buy. The Louisiana based bank has 40 branches in itshome state as well as neighboring Texas. Right now, the shares trade at about 90% of book value and insiders like the price. Three different insiders, including the company's vice chairman, have purchased shares in the open market in the past month. Chemical Financial (CHFC) of Michigan has seen four insiders buying the shares right around book value in the past four weeks.

Many academics and investment practitioners have followed the ground breaking work of Lorie and Niederhoffer and it still works today. Cluster buying can help us identify undervalued stocks with the potential for outsized gains. Sometimes, rather than reinvent the wheel, it is good to stand on the shoulders of the giants who came before us.

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