For those new to the investment world, any mention of the word “insider” is often met with mistrust and negative stereotypes. This is fair, considering there’s a long list of famous insider trading cases.
However, while insider trading should be condemned, insider activity is something all savvy smallcap investors should closely follow.
It’s an aspect that many overlook. Our own polls have shown that around a quarter of investors don’t bother to follow insider activity. And this is much higher for those who don’t follow investment news.
In addition to using our previously mentioned criteria on what to look for in a stock, we highly recommend adding the following considerations.
Insider buying = good
The biggest, positive indicator is insider buying. This doesn’t mean that insiders are buying based on material knowledge only they are aware of (insider trading); rather, it means they are buying because they have faith in the company and are confident in its future, and may believe the stock is undervalued. It’s as simple as that.
One of the greatest investors of all time, Peter Lynch, was noted as saying that “insiders might sell their shares for any number of reasons, but they buy them for only one: they think the price will rise.”
In Canada, you can check insider buying activity through the System for Electronic Disclosure by Insiders (SEDI), which is a notoriously frustrating tool. But if you are persistent, you will have access to a broader understanding of how company leaders are behaving. And the good news is we are working on a new solution for this, so stay tuned….
In addition to general insider buying, you can go one step further.
Look for specific insiders
Did you know that CFOs often make more on their investments than other management? In fact, research shows they make about 5% more. This makes perfect sense when you consider that CFOs understand numbers and what a sustainable business model looks like. If they are buying, take note, because not all insider buying is as strong of a signal as is CFO buying.
It’s also important to see if Board members are buying. With smallcaps, it’s particularly important to have a Board with an invested interest, and you should look out for at least one Board member with capital market expertise, as well as one with a sizable investment in the company (they are often the same person). The Board of Directors have a fiduciary responsibility to look out for shareholders’ interests, but they tend to work a little bit harder when they are some of the significant shareholders and their own money is at stake.
Further, look for Board members who are experts on the company’s product, service, or industry. For instance, if a Board member who is an accomplished scientist is buying a lot of his or her company’s shares and the company is in the biotech business, this is an endorsement—by an expert—in the company’s potential success.
The same goes for legal counsel, as they have a good understanding of the company direction and any issues that may hamper growth.
Watch for buying patterns
A pattern of insider buying before financial news is a good thing. Companies have specific blackout periods before material financial news like quarterly results, and insider buying before these periods often hints at what’s to come. While insiders don’t have the numbers during these periods, they know in advance if business is good.
The more (generally) the better. If there are multiple inside buyers in a smallcap, it supports an optimistic outlook. And when it comes to liquidity, the more insiders who own shares the tighter the float, which supports a potentially more explosive share price gain when buying demand picks up.
While there isn’t any “bad” type of insider buying, you should take note if the buying is the result of converting debt, or exercising options etc. This is less a statement in support of the company’s future and more an action that can have myriad reasons behind it.
Look for NCIBs
A Normal-Course Issuer Bid (NCIB) is when a public company repurchases shares of its own stock at the market price. This tightens the float and can lead to an increase of share price.
NCIBs are not only a sign that the Board thinks the stock is undervalued, but are also something that can rarely be done if a company is not profitable, and management and the Board don’t believe there is a bright future. We constantly look for them, as they are a strong indicator that a company is trading at a discount.
It’s a bold statement by the Board as they are signalling to the market the best return on capital at that moment is buying back their own shares. Effectively, the Board believes the best investment is in itself, to turn $1 into $2, or more.
However, not all NCIBs are the same. Be aware of companies that announce NCIBs, but never act. It can be used as a promotional tool, whereby an announcement of an NCIB is viewed by many as a positive indicator, but the company doesn’t take actions to execute on buying back stock, or perhaps only buys back a small token number of shares. Similarly, another promotional gimmick to caution, is when a company uses a press release to announce that insiders are buying (not always, but certainly a more promotional event).
Taking a close look at the makeup, actions and incentives of management is also important. For instance, you want to know about options vs shares. Quite often, management receives options as an incentive. While there is absolutely nothing wrong with them, they can be converted to shares, and this further dilutes the float.
There’s also the percentage of insider ownership, which is completely relative to a company’s size. For instance, a billion-dollar company with 5% insider ownership is good, as is a $20 million company with 20 – 40%+.
The higher the insider ownership the better for smallcaps as it demonstrates belief in the company. It also tightens the float and makes it harder for institutional money to come in, which puts positive pressure on the future share price.
While insiders who own too much can make the company too risk adverse, the flip side is that, if they have all their eggs in one basket, you can assume they’re going to do everything in their power to make the company succeed.
Also, look into who’s who. Unfortunately, there are unscrupulous individuals in the smallcap space (and every industry for that matter). Some of them may have just made bad moves with one or two companies, while others are career leeches, going from company to company and sector to sector, promoting the latest fad to make a quick buck.
There’s no effective way to uncover who these people are, other than doing your own due diligence. But once again, if the company you are looking at meets the other investment criteria—and especially if it’s profitable and growing —chances are you have little to worry about, if the rest of management stacks up.
Insider selling—not necessarily bad
Unless you plan to live off dividends, in which case we do not recommend smallcaps, you can assume that everyone’s goal—including insiders—is to eventually sell.
Selling naturally creates downward pressure on a stock price, and of course if it’s steady and building it should set off alarm bells. But it’s also important to remember that insider selling isn’t always bad.
It may be hard to believe, but insiders are also humans with human lives. And a lot of things happen that can lead to selling. This can be everything from unexpected emergencies to upcoming retirements.
Our recommendation is to be aware of selling and look for discouraging patterns. Insider selling can hint at a larger problem, or it can just be a member of the management team exiting his or her position for legitimate reasons and have no reflection on the outlook for the company.
Keep it simple
Overall, if you remember one thing it’s that insider buying is almost always positive.
We have rarely seen an insider using their own capital turn out to be a negative, other than when they buy and the stock still goes down. And when this happens it’s often because the business fails to execute on its plans, or negative market forces that are out of a company’s control.
Of course, understanding insider activity is just one tool at your disposal. Don’t treat it as the only indication you should buy, but look for these bullish signals when doing your due diligence. We follow a number of companies that are showing strong signs of insider buying, and we will continue to employ this indicator in our analysis.
We highly recommend that you look to add insider activity as one of your due diligence criteria. It’s always helpful to know what management are thinking about their own company shares. Insider buying is not always a guarantee of a higher shares price, but in our experience, it certainly increases the chances of a winning investment.