Corporate insiders are bullish on small-cap stocks and those trading for low price/earnings and price/book ratios. That bodes well for small-cap value stocks.
This comes at a time when insiders are neutral on the overall stock market’s prospects over the next 12 months. That’s a significant improvement from where they stood in January, when they were more pessimistic than they had been in a decade.
We're talking about the company's officials, directors, and major shareholders when we say "corporate insiders." Any transactions affecting their company's stock must be reported to the Securities and Exchange Commission almost immediately. On the idea that insiders know more about their company's future than outsiders, many on Wall Street pay particular attention to patterns in insider transactions.
Nejat Seyhun, a University of Michigan finance professor and one of academia's leading authorities on insider trading, has discovered that this theory has to be revised based on his research. Though officials and directors are worth paying attention to, he claims that the greatest shareholders do not have any special knowledge of where their firms' stocks are headed.
Seyhun excluded the transactions of these major shareholders from the most recent insider data in Barron's research, allowing us to focus on the actions of the more insightful officers and directors.
Seyhun's data is depicted in the accompanying graph. From September 1 to September 24, 25.2 percent of all publicly traded businesses with any insider transactions had more shares bought than sold by these astute insiders. Though that figure may appear to be shockingly low, it is actually pretty near to the historical average. Because a large portion of an insider's pay is in the form of stock grants, the average insider sells more than he or she buys.
Whether you see the glass as half full or half empty determines how you react to this information. On the one hand, the insider buy ratio is far lower today than it was in March of last year, when it peaked at 62.4 percent. It is, nevertheless, higher than the 17.4 percent level reached earlier this year.
Insider data was cut and diced by Seyhun to acquire insight into the types of stocks that insiders choose. His findings were as follows:
1) Insiders, on average, are favoring smaller stocks over larger ones. The insider buy ratio for small-cap stocks is 52.6%, for example, versus just 8.6% for large-caps.
2) Insiders are favoring stocks with lower (or even negative) price/earnings ratios. The insider buy ratio for stocks whose P/E ratios are between 0 and 15 is 38.3%, on average, and for stocks with negative P/Es (those losing money, in other words), the comparable ratio is 29.6%. For stocks whose P/Es are above 30—growth stocks that are investor favorites—the insider buy ratio is just 11.7%. The S&P 500’s current P/E ratio is 31.1.
3) Insiders are favoring stocks with lower (or even negative) ratios of price/book value. Book value is an accounting measure of a stock’s net worth; a lower ratio means the stock is out of favor while a higher ratio means the stock is very much is in favor. For stocks with price/book ratios between 0 and 5, the insider buy ratio is 34.2%, and for those with negative price/book ratios (that is, negative net worth), the comparable ratio is 30%. For stocks with price/book ratios above 10, the average insider buy ratio is 7.2%. The S&P 500’s current price/book ratio is 4.74.
These findings show that smaller-cap firms and those trading for low P/E or price/book ratios are more likely to be undervalued.
However, in an interview, Seyhun was keen to point out that this result does not imply that you should avoid large-cap stocks or those with greater price-to-earnings or price-to-book ratios. He points out that, while insider buying is less common these days, it still happens. And, according to his research, when it occurs, it's worth paying attention to. That's because the insider signal we get when we concentrate on a single stock is stronger than the average for a big group of stocks.
Energy-related industries, notably Integrated Oil and Gas, Downstream and Midstream Energy, and Upstream Energy, had the greatest insider buy ratios in recent months. Exxon Mobil (ticker: XOM), Energy Transfer (ET), and Transocean were the companies in each of these industries with the most net insider purchases over the past 12 months (RIG).
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