Insiders Are Buying Lennar. Should You?

One of my all-time favorite investment quotes comes from famed Fidelity Magellan fund manager Peter Lynch: "Insiders might sell their shares for any number of reasons, but they buy them for only one: They think the price will rise."

Insider buying is an indicator you can use to screen for ideas. The most meaningful signal is when an executive or director buys shares on the open market just like you or me. It's too easy for management to build a sizable stake in the company by simply exercising stock options. On the other hand, when they open up their wallet and pay cold, hard cash for shares, that's important to notice -- especially if the purchase is large, which I loosely define at $500,000 or more.

By itself, insider buying is not a compelling enough reason for you to purchase shares. While management only buys if it thinks the stock will go up, you have to recognize that management may not be the best judge of what the company is worth. Even though they have an informational edge over you about the company's prospects, there is the risk that with a large part of their personal wealth on the line they have a biased view of the company's value and they are likely to overvalue the shares.

You can look for management buying as a signal that something good may happen for the company, but you have to take the next step of deciding for yourself if the stock is cheap. Two quick and dirty numbers you can look at are the company's free cash flow yield and where the stock is trading relative to its 52-week low.

The free cash flow yield is calculated by dividing the company's trailing-12-month free cash flow by its market cap. It is similar to the dividend yield with the difference being that it is measuring all of the excess cash generated by the company and not just the amount paid out to shareholders. As long as the company's prospects look stable, the higher the free cash flow yield the better. Renowned Fairholme fund manager Bruce Berkowitz uses a 10% free cash flow yield as a rough guide as to whether a stock is cheap.

The 52-week low is more of a measure of market sentiment toward the company than an indicator of value. Generally speaking, it's better to buy when the stock remains out of favor than after it has come roaring back from the bottom.

Source: Capital IQ, a division of Standard & Poor's and author calculations. All dollar amounts, except share price, in millions.

Lennar COO Jonathan Jaffe bought $1.3 million worth of stock on the open market in June at an average price just over $14. During the past three months, there has not been notable insider buying in this peer group of home builders outside of Lennar. While Lennar's stock has rebounded a little bit from its 52-week low, it is trading under where Jaffe backed up the truck. With a 17.7% free cash flow yield, Lennar is worth your research time. That said, all homebuilders are beaten down and hovering near their lows. Is it too early to get into housing stocks?

Foolish conclusion
A large stock purchase from an insider is even better than a hot stock tip. Someone who knows the company intimately has made the decision to put a significant portion of their wealth on the line. I would much prefer to buy shares of a company where management is investing alongside me than in situations where the only shares management owns were given out by the company. Remember, Fools, insider buying is not the only measure you need to look at. It is a starting point for you to do additional research on the stock. Have any thoughts on Lennar? Share with the community in the comments section below.