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When Insider Buying Doesn’t Really Matter

By Jordan Wathen – Mar 27, 2014 at 1:34AM

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Insider buying matters, but token purchases of externally-managed companies are a non-starter.

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 (NLY 3.16%) 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 (PSEC 1.03%) 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 (BRK.A 0.07%) (BRK.B 0.18%) 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.  

Jordan Wathen has no position in any stocks mentioned. The Motley Fool recommends Berkshire Hathaway. The Motley Fool owns shares of Berkshire Hathaway. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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