When Insider Buying Doesn’t Really Matter

Photo: Robert Sheie

Insider selling happens for any number of reasons. Insider buying only happens for one: insiders want to make money.

At least, this is what we're told.

In the case of externally managed companies, it isn't so simple.

Valuing insider optimism
In August, Annaly Capital Management (NYSE: NLY  )  was in trouble. The stock was falling. Rates were rising. And Annaly had cut its dividend several times over the past year. Denahan Wellington-Norris, Annaly's CEO, invested nearly $2 million to buy shares of Annaly Capital on the open market. 

It was a brave move at the time -- a vote of confidence in Annaly's ability to generate returns for investors. It was what many shareholders wanted to see: A message from shareholders that maybe the market had mispriced Annaly's stock.

Since then, shares have mostly...well, not performed, neither moving up nor down after adjusting for dividends.

More recently, S&P and Russell announced they would remove business development companies from their indexes. Publicly traded BDCs sold off over a period of two weeks. On the day BDCs would suffer their first drop from S&P's indexes, Prospect Capital (NASDAQ: PSEC  ) CEO John Barry made a market purchase of $1.1 million of his company's stock. It was a vote of confidence at a time many wondered how much impact selling pressure would have on BDC stocks.

It's too soon to make a say how his purchase will pan out.

Why I'm critical of insider buying
Prospect Capital and Annaly Capital couldn't be more different. Prospect makes high-interest loans to middle-market companies. Annaly Capital invests in mortgage-backed securities.

But that's where the differences end. Both pay a huge dividend. Both operate to serve individual investors. And both collect huge management fees for managing their investors' money.

Prospect Capital charges investors 2% of assets plus 20% of returns. Annaly Capital charges 1.05% of adjusted shareholders' equity. These fees really add up. Prospect Capital's latest quarterly results revealed it paid its advisor some $48 million in combined management and incentive fees in a single quarter. Its own presentations show it only has 97 employees.

Do the math. Prospect Capital's advisor is raking in more than $496,000 per quarter, per employee. Financial professionals are highly paid, but the typical structure is that most of the compensation goes to the most senior employees and executives. 

How invested are you, really?
One thing that makes Berkshire Hathaway (NYSE: BRK-A  ) (NYSE: BRK-B  ) great is that Warren Buffett has always had most of his net worth tied up in the company. His income and net worth, besides his $100,000 annual salary, comes principally from Berkshire Hathaway. His interests are aligned with shareholders.

Investors should put insider buying in perspective. Wellington Denahan was the second-highest paid woman in 2011, earning at least $35 million at Annaly Capital. John Barry's salary, though not disclosed, is likely in the 8 figures. Their insider buys are quite small relative to their annual salaries. Their financial well-being is driven by their salaries, which are determined, first and foremost, by the fees generated by their funds.

Prospect and Annaly managers have an incentive to grow fees. Growing fees is as simple as raising new capital, which typically happens by selling stock above book value. The only time management can grow fees, then, is when shares trade above book.

And that's why I'm critical of insider buys in externally managed companies. For a token price, insiders can create confidence in their company's stock, allowing them to continue to raise new capital on which fees can be earned.

It's cynical, sure. But the bottom line is that a token, one-time stock purchase doesn't change the fact that fees, not investment gains or losses, are the single most important metric for executives of externally managed companies. 

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  • Report this Comment On March 27, 2014, at 12:47 PM, jmkdog wrote:

    You cannot spin insider open market purchases as "not mattering".

    In regards to John Barry's recent buy and previous purchases of over 40 million dollars worth of stock. Your article makes no sense at all. Dilution with equity raise, costs due to growth, costs due to operations effect each shareholder whether you are the CEO or Joe Blow. That is the point really.

    The INSIDER risks his money, which is the same mighty dollar I risk on this equity. We at a moment are eye to eye both putting our pants on one leg at a time.

    Trying to dummy down insider buys because of fees,salary or bonuses fails to recognize the fact that REAL MONEY that could be spent on yachts and private jets is being sunk into the common. Are you suggesting a guy puts up 42 million dollars, is doing so for show?

    He could have easily sold and added to his stockpile of dollars but..........Not a single share has been sold here only BUYS and it matters

  • Report this Comment On March 27, 2014, at 1:41 PM, TMFValueMagnet wrote:

    Jmkdog,

    I'm just suggesting that insider ownership means more than insider buying. All else equal, I'd prefer a manager have a significant part of their income/net worth in a company. Most externally-managed CEOs make far, far more from keeping the doors open than they would ever collect from investing in their own funds.

    Last I looked, Prospect Capital wasn't exactly leading in insider ownership as a percentage of the market value, or in total dollars. http://www.fool.com/investing/general/2013/11/17/do-your-inv...

    Externally-managed funds have their obvious agency costs. I don't think pointing that out is a bad thing. Investors should know.

  • Report this Comment On March 27, 2014, at 5:56 PM, JohnQReagan wrote:

    Thank you! I've been saying this for ages. I can't remember the countless number of stocks that have tanked even though insiders bought big. You have to look at more than just the purchase.

    - Did they hedge their bet? Do you know if they also bought puts to cover? How would you know?

    - Is this a Pump where they buy to drive the price back up and hope and pray it works?

    - Did they buy big, but for years they've received 'free or discounted stocks' as part of their compensation? Would those stocks cover a 50% loss on this purchase?

    - How do you know they won't sell off those stocks as the price runs up, before the bad news hits and the stock tanks?

    Insider buys are not a guarantee of anything. Maybe when Grantham came up with that quote an insider had ethics, but today, it's a Gordon Gekko world. Get used to it.

    Here's a simple Finviz screener for stocks $10 and under and just above their 52 week low with heavy insider buying... Notice 'HEAVY BUYING". You can lighten that up, or change to 10% of 52 week lows and get more hits :

    http://finviz.com/screener.ashx?v=211&f=sh_insidertrans_...

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