Why Buy What They Are Selling?

 | Dec 05, 2012 | 1:00 PM EST
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The use of insider data to find profitable buying opportunities is pretty well documented. It is one of the stock market anomalies like price to book value and momentum that has stood the test of time. The Niederhoffer and Lorie study that I mentioned yesterday came out almost 45 years ago and the data are as relevant today as they were then. Many anomalies are arbitraged away almost as quickly as they appear, but these data lasted. I suspect this is because they have to do with corporate valuation levels and human behaviors, which are two constants of the market arena.

Another anomaly that has lasted is the flip side of insider buying. Individual insider sales of stock are almost random in nature. A director or officer selling a block of stock indicates almost nothing about the future of the company or its stock price. The fact that an officer needs to raise cash to pay for his daughter's dream wedding or to diversify his holdings is not in and of itself predictive. However, the same studies that confirm the predictive nature of insider buying tell us that when several insiders sell in a short period of time, the stock is probably going lower. It I highly unlikely that a group of insiders all decide to diversify at the same time, or are all building dream houses in the same short time span. It indicates that they are aware of declining business trends or an overvaluation of their company's stock price.

When I looked for stocks with insider selling, some interesting names appeared on the list. Sturm Ruger (RGR) has seen its stock surge as gun sales have strengthened in the past several years. Fear mongering about the administration's anti-gun policies have helped to lift revenues and profits at the company. After years of stagnant sales and earnings, gun manufacturers have seen a rush of people buying them in the past few years. Sales and profits have skyrocketed and the stock is up more than twelvefold from the 2008 low. Insiders seem to think the stock may be ahead of itself as four insiders have sold stock in the open market in the past month. The sales were significant, with some insiders reducing their holding by 30% or more. That is not diversification; it is profit-taking. Investors would be wise to do the same at these levels.

Another interesting name on the list is asset management and mutual fund provider Eaton Vance (EV). The company has done very well in the past year as its strong lineup of fixed income funds have attracted positive flows from investors. The company has made some acquisitions to give them greater equity exposure but the firm is known as a faced income shop. Its flagship equity product, Large Cap Value Fund, has been a laggard and is showing equity outflows of late. The stock is trading at 52-week high right now and insiders seem to feel it is fully valued at this level. Six officers and directors have taken profits in the past month by selling stock into the open market.

The most selling in the past six months has been in shares of orthotic and prosthetic patient care provider Hanger (HGR). Seven insiders, including the CFO, have sold their shares in recent weeks. The company reported rising sales in the third quarter but fell short of the always highly accurate analysts' estimates. In spite of that, the stock is still close to its 52-week highs and insiders are cashing out. The company president and chief operating officer reduced his holdings by 20% and one of the directors sold about half of his shares.

Insider selling is not a guarantee that a stock will go lower right away. However, there is a strong statistical tendency for stocks with clusters of selling by officers and directors to decline. It just does not make sense to me to buy something the people running the company are selling. No matter how good an analyst or observer I may be, there is no way I can know as much as those who are on the inside of a company's day-to-day operations.

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