Next week, I’m off to Switzerland for MOI Global’s Ideaweek. I’m looking forward to meeting with other investors and sharing ideas. You never know what you might learn or where such conversations may lead. “Travel,” as Keith Waterhouse wrote, “puts serendipity in motion. The art of making happy discoveries by chance is not entirely accidental: the voyager has set off in the first place.” (See his The Theory & Practice of Travel, a mostly funny book by a mostly witty writer).
I also plan to give a couple of talks. I’ll try to share some notes next week.
Today, we take a look at how to read the tea leaves of insider buying and selling. We’ll also pull a couple of interesting thoughts from the mailbag on two portfolio holdings: Air Lease and Interactive Brokers…
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How to interpret insider buying and selling?
It may seem obvious, but the research on insider buying and selling is kind of murky.
Here’s professor Aswath Damodaran on insider buying:
“Insider buying is a noisy signal – about 4 in 10 stocks where insiders are buying turn out to be poor investments, and even on average, the excess returns earned are not very large.”
Likewise, insider selling generally predicts to worse returns, on average. But not always.
For example, a study by James Scott and Peter Xu (2004) found only large sales predicted negative returns. Small sales, as a percentage of overall insider holdings, “not only did not predict poor performance but were correlated with significantly positive abnormal returns.” Go figure.
The problem with a lot of research on this topic, too, is it feels dated. The most cited research paper on insider buys and sells – per Google with over 10,000 citations – is from 1985. The way markets are today, I have a hunch even research from the early 2000s is probably too old.
When I think about interpreting insider buys and sells, I always think of George Muzea. He wrote a book called The Vital Few vs. The Trivial Many. I read the book when it came out in 2003 and it stuck with me ever since.
Muzea’s basic idea is super simple. He says it’s natural behavior for an insider to buy when a stock is down. And it’s also normal to take money off the table when a stock has had a great run. We shouldn’t give much weight to those signals.
What you want to look for is divergence. You want to pay special attention to insiders buying after a stock has already made a big move. On the flip side, look for insider selling after a stock has already been chopped up.
I always liked this insight from Muzea. But I haven’t looked at that book in ages. So, I just dusted it off to see how it holds up… Well, as it turns out, not that well. It’s an 80-page book that feels like 15-pages. It has lots of stuff that feels like filler.
As for Muzea himself: He started out as a broker, first at E.F. Hutton in 1966 and later Dean Witter. He also had his own TV show in South Florida from 1978 to 1985 called “The Muzea Insider Show.” And He started a consulting firm Muzea Insider Consulting, LLC. Somehow he managed to get George Soros and Stanley Druckenmiller as clients. In fact, Druck gives him a nice blurb on the book’s cover.
Anyway, the book is heavy on folksy anecdotes. I don’t denigrate his experiences. He seems to have done well. And I put more weight on experience over theory, usually. Still, I’d like to see more of a formal, large-scale study. Maybe Muzea has it and isn’t sharing. I don’t know.
So, absent any definitive answers from the research, I’ll go with my own intuition and experience. Here are a few suggestions:
1. Look for divergence. Insider buys after a big move. Insider sells after a stock has fallen. This is Muzea’s idea. I still like it.
2. Look for lots of insider buying or selling. If the chairman, CEO and CFO are all buying, that seems worth paying attention to.
3. Focus on key people. There always seems to be some selling, but I focus on key people such as the CEO and CFO.
4. Amounts matter. There is research that supports the idea that token buys or small sales from much larger holdings don’t matter much. Makes sense, too.
5. The signal is stronger for small caps. Some research shows insider signaling doesn’t work at all for large caps. Also makes sense. It’s easier for an insider to know what’s going on in a smaller company than, say, GE. I’m not sure even the C-suite knows what’s going on at GE.
This post was partly inspired by an email from a reader wondering about the insider sales at Air Lease (AL). In 2018, there were a number of small insider sales. None of these sales happened later than September. And none of the insiders sold stock for less than $43.50. Are we really going to worry that an EVP peeled off 10,000 shares from his 170,000 shares? Or the head of marketing sold 2,000 shares out of his 88,000 shares, netting about $87,000?
I’m not going to worry about that. Insiders own 9.3% of Air Lease, a stake worth about $380 million. Most of that is in the hands of our chairman Udvar-Hazy and CEO Plueger. They haven’t sold. Udvar-Hazy bought 5,000 shares in December. Not a signal there either.
But I’m not trying to press any stock on you. Don’t buy it unless you love it. Keep a high bar for what you own. It will do you good over the long run. Because the market will test you…
Conclusion
Insider buying and selling can be a good tool. However, the signal value of insider transactions seems noisy and is not as simple as it may seem.
I like to use insider buying to help find new ideas to look at. If I see a big insider buy, I take a look. Maybe it’s a sign something good is on the horizon.
*** Mailbag: Air Lease and Interactive Brokers
These two stocks have something in common. Can you guess what it is? I’ll give you the answer at the end of the mailbag…
First, Air Lease. A reader writes:
“Chris - you have hit all the points perfectly. About a month ago, I did some more work on it too:
At the end of 2014, book value was $27.07. Therefore, in less than 4 years, book has grown by 59%. At the end of 2014, the stock closed at 127% of book. Then:
2015 114%
2016 104%
2017 121%
A modest premium to book value makes sense to me because there is good visibility on book growing. I feel like a solid target price now is estimated year end 2019 book value, which should be ~$50.
I picked up a bunch more, like you, in the $32-33 range.”
Next up, Interactive Brokers. This is another stock we own. I recently tweeted about it after earnings:
“Another year, another set of strong results from $IBKR: Net rev up 28%, pre-tax profit up 38%, pre-tax profit margin of 63%, customer accounts up 24%, DARTs and client assets finish the year at records... and still a lot of room to grow. A long-term keeper.”
The stock sold off after earnings. Maybe because IBKR officially “missed,” by a few pennies, Wall Street’s estimate of earnings per share. All those bots went ahead and sold, I guess.
A reader writes:
“Yes, IBKR’s stock price since earnings is puzzling. We’ve owned it since April 2014 and the growth has been fantastic.
One thing I like to think about IBKR is to look at their profitability per new account. We live in a world where Wall Street highly values subscription models with high lifetime customer value. If I take the IBKR 2018 income statement, they reported $264 million in employee compensation and benefits. They reported another $96 million in G&A for a total of $360 million on those two line items. The rest of the costs are more like COGS in a normal widget business.
They added 115,000 net new accounts in 2018, and the average account did $3,225 in revenue (4Q annualized) at a 64% pretax margin. Thus, pretax profit per account was $2,064 using that 4Q annualized revenue figure.
If the entire $360 million of employee comp + G&A was actually marketing (impossible, but exaggeration to make a point), then the cost of signing up each new account was $3,130. That means the payback for marketing is about 18 months.
Of course, all of those costs weren’t marketing. At 75%, the marketing cost per account is $2,348 in 2018, which makes payback just over one year. At 50% of those costs, marketing cost per account was $1,565 for a payback in under one year.
I don’t think IBKR reports churn (and it doesn’t matter in my analysis since I’m using net new accounts in 2018), but that’s a pretty good business model.
In the context of the subscription excitement on Wall Street these days, I like to think that IBKR is operating a very profitable “subscription" model with a history of success. Most subscription-based businesses sell for very high multiples, and I suspect IBKR is better than most of those with less risk.”
Thanks for the note. That’s a creative way to look at it and I agree it shows off a pretty darn good business.
As for what Air Lease and Interactive Brokers have in common…
Hungarian immigrants founded both companies: Steven Udvar-Hazy for Air Lease and Thomas Peterffy for Interactive Brokers. Both were born in Budapest.
Send me mail at info [at] woodlockhousefamilycapital.com
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Published: January 31, 2019
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