Before I was a Fool, I spent my days poring over SEC filings. Sounds boring, but never was there a time when the mundane held so many secrets. One Friday afternoon in mid-2002, I casually agreed to break down the stock trades of Enron's top executives for CNN. What in the world was I thinking?
While we slept
By early 2000, keeping tabs on the options exercised and stock sold by corporate insiders was staggering (check out this piece for what I really think of options). That I was in the trenches poking around at least partially explains why finally reading Roger Lowenstein's bull market autopsy, Origins of the Crash, last weekend hit me on more than an intellectual level. It was like an old photograph, only not so pretty.
As for the Enron debacle, it's with no small shame that I recall hoisting one particularly colorful chart showing the correlation between the bulge of selling by Enron execs and that of corporate insiders as a group. My point was that one couldn't necessarily say that Enron execs were crooks just because they sold millions and millions of dollars in stock at the top. After all, everybody was doing it.
And everybody was. OK, we were depositing our checks and buying stock with what little was left over, but executives in the late '90s and early 2000 were cashing their checks and selling stock -- sadly, to us. For all the talk of exuberance and shenanigans, the late bull market was more than anything an orgy of insider selling, a systematic transfer of wealth from the least savvy investors to the most.
Value Tip 1: Smart money gets when the gettin's good.
Getting Inside Value
I've been chatting with my buddy the Admiral (a.k.a. Philip Durell) as he prepared to launch his new Motley Fool Inside Value newsletter service. It's hard not to marvel at how value stocks always seem out of favor and boring, yet they always seem to (no, not seem -- do) outperform all other groups. Working closely with Philip is what got me thinking about value today -- and the smart money.
The Admiral isn't convinced that we can profit from following the insiders -- especially when it comes to insider selling -- but he agrees we can learn something from watching them. Corporate insiders invariably unload high-multiple growth stocks after periods of rapid appreciation. I'll save that for Part 2 of this series. Until then, what do insiders buy? Stocks that are (1) unpopular on Wall Street; (2) trading at low multiples to book value and earnings; (3) coming off sustained periods of lackluster performance; and (4) not under accumulation by retail investors. In other words, insiders buy value stocks -- sadly, again, from us.
That's why the promise of insider buying as a harbinger of imminent good news goes largely unfulfilled. The smart money buys when pessimism and disinterest push their stocks below reasonable levels. Can they be early calling a bottom? Value investors often are. But insiders know value, and study after study confirms that corporate insiders outperform ordinary investors.
Value Tip 2: Smart money knows value.
Patience, patience, patience
Ironically, that's also why we scoff at the notion that insider trades are predictive: Corporate execs simply don't buy Krispy Kreme (NYSE:KKD) or Taser (NASDAQ:TASR) when they're red-hot, or ImClone (NASDAQ:IMCL) days before a drug is approved (they did, however, gobble some up for pennies in the late '90s, but that's a story for a past column).
The fact is, while they might keep the selling noticeably in check, as they did at Wal-Mart (NYSE:WMT) and Starbucks (NASDAQ:SBUX) during much of the bull market, insiders typically don't clamor for growth and momentum. Smart money clamors for value.
I think of two of my fondest bull-market buys. Medical waste management company Stericycle (NASDAQ:SRCL) was an odd bird, but Pulte Homes (NYSE:PHM) was part of a true sector phenomenon. What they had in common back in 1998 was good management, terrific balance sheets, and insiders that couldn't seem to get enough.
I even rang the CEO of rival builder Centex (NYSE:CTX), who was also buying. Why? To paraphrase: because investors were misreading the landscape and overlooking the obvious value in the builders. Take that with a grain of salt from a CEO. But the deeper I dug, the more he seemed to have a point. No wonder execs at Centex -- as across the sector -- were accumulating shares like mad.
True to form, the builders languished from mid-1998 through the end of the century. From January 2000 on, it's been lights out. Like a dope, I bailed in mid-2000, but had I not sold my Pulte at a satisfactory profit, I'd be sitting on a 500% gain. (I've a theory that I'd be better off if I had never sold a stock, but that's between you and me.)
Value Tip 3: Smart money buys ahead -- sometimes well ahead -- of the move.
Talking value with the Admiral
Which brings me around to Origins of the Crash, my pal Philip Durell, and Inside Value. I enjoyed the book, but I challenge Lowenstein's implication that '90s investors got wiped out by poor corporate governance or malfeasance on Wall Street. I prefer Philip's notion that they did themselves in by buying high-multiple growth socks with no margin of safety. To which I'd add: from the smart money.
We can argue all day about whether we can profit from watching the insiders. But we can pretty much agree that investors can profit from simply buying out-of-favor, low-multiple value stocks to begin with. The trick is finding true survivors selling at fractions of their intrinsic values. It's not always easy; it's sometimes not pretty, but it works.
Don't take it from me
Take it from Ibbotson Associates, the king of market data and analysis: For the period 1927-1999, value stocks returned 13.4% per year vs. 10.2% for growth stocks and 10.7% for the S&P 500. In 2002, a pair of professors at the University of Illinois updated the body of academic work to reflect the golden era for growth stocks in the '90s and likewise concluded, "A large body of empirical research indicates that value stocks on average earn higher returns than growth stocks."
Story stocks have their place (heck, I own a few myself). But I just can't imagine why well-meaning advisors continue to overload risk-averse clients with momentum growth stocks. Or maybe I can. We'll take that up, as well as how to spot value, in Part 2, where I'll address the much more disputed relevance of insider selling.
Until then, listen to the Admiral, and don't be the greater fool.
If you'd like to harness the power of value investing, take a 30-day free trial of Philip Durell's Motley Fool Inside Value . It's absolutely risk-free -- unlike buying high-multiple growth stocks.
Paul Elliott is a Fool writer and editor, and still owns a handful of ImClone. The Motley Fool has a disclosure policy.
