I talked Tuesday about the statement made by Seth Klarman in his recent shareholder letter. Klarman casts great doubt on current market levels and strikes a very risk adverse posture on valuation.
Klarman is a smart guy and unlike a lot of prognosticators and predictors has the track record to back up his opinions. He is one of the rare 20% club who has been able to earn compound returns near that benchmark for an extended period. When I hear that he is holding around 50% in cash and is saying things like, "No one can know what the future holds, but any year in which the S&P 500 jumps 32% and the NASDAQ Composite 40% while corporate earnings barely increase should be cause for concern, not further exuberance", I have tendency to pay attention. Ignoring a smart guy with a record that indicates he knows what he is talking about strikes me as the greatest of follies.
Klarman does say that no one knows when the market will roll over and drop to a point that reflects economic reality. No one knows these things. Market movements are pretty much impossible to predict with any degree of certainty. When the stage is set, however, and the possibility of a decline is growing, it makes sense to increase your sense of caution. As Andrew Lo of MIT told us, our job as long-term investors is to survive until the long term.
So far this week I have pointed out stocks that have the potential to be earnings torpedoes and those that trade well above a rational assessment of intrinsic value. Both groups of stocks have the characteristics that tend to lead to poor performance, regardless of market movements. If there is a heightened risk of a serious decline, it just makes sense to avoid stocks that have the characteristics of poor performers.
I want to add another group to my list of stocks to avoid. If Klarman is right these stocks could lead the way lower and if he is wrong they will likely underperform the market at best.
Stocks with three or more insider sellings within a short period have been proven in theory and in fact to underperform the broader stock market. If the people running the company are selling the shares, it just doesn't make sense for us to want to own them under any circumstances. When the market is at precarious levels, as it appears to now, owning stocks that groups of insiders are selling may be well be a recipe for disaster.
Westinghouse Air Brake Technologies (WAB) is a great example of a stock that is seeing intense insider selling. In the past month 11 different insiders, including the Chairman, CEO, and CGO, have sold more than $21 million worth of their holdings. The stock has done very well in the past year, rising by more than 60%. The stock is up fourfold from 2009 when it was a book value bargain during the market collapse.
The people that run the company now seem to think the good news is priced into the shares and they are booking their profits. I am aware of the great story here with railcars for hauling oil from the Bakken and other shale fields are going to be in high demand, But at 27x earnings and 5x book value, you are paying for the story and a bit more at the current price.
A.O. Smith (AOS) is another stock with a really good story. The company makes water heaters and boilers for the residential and commercial markets and the predicted pick up in demand in these markets should be great for business. Earnings have recovered nicely over the past couple years and they just announced a dividend increase.
Smith's stock has risen by almost 40% over the past year. Even with the great building recovery story being circulated by Wall Street, the people running the company are taking some gains in the stock after the advance. Nine insiders, including the CEO, have been selling the stock in 2014. At 27x earnings and more than x book value the shares are hardly a bargain right now. If the insiders are selling why you would want to put this stock in your portfolio right now?
My screen shows that 92 companies have seen selling by three or more insiders in the past month. There are many indications that the market is on the high side of fair value and stocks with this type of selling activity are likely to underperform the market regardless of direction.
We may not be able to predict the market direction but we can avoid behavior that increases our risk. Avoiding stocks with insider cluster selling just makes sense right now.