[Disclaimer; This post represents my opinion and is not financial advise. Caveat Emptor!!]
It is difficult to determine if you should invest in a company simply because it is undervalued.
Any tom, dick or harry can arrive at a company being undervalued and there are many ways to do it. It’s primary 5 mathematics at best.
The hard part is deciding what to do once you have a company that is undervalued.
Do you invest or no? How do you make the decision?
When I am deciding, I typically look at it in reverse. First I look for insider buying, then I try to see if the company is indeed undervalued.
Insider trades are a huge part of how I find investment ideas. Insiders know more than you do. Period. Following them is almost always a good idea. But how do you discern good and bad insider buying signals? (for yes, there are good and bad insider signals to decipher).
An excerpt from the book Quantitative Value explains it well.
“”In addition to undertaking buybacks, managements can express their view on the under- or overvaluation of their stock through their own trading. The trading activity of “insiders” (corporate officers, directors, and large stockholders) has attracted the interest of both academics and practitioners for over 40 years. For our purposes, insider trading is the legal buying or selling by corporate insiders. It is well established through many studies that insiders are better informed and earn market-beating returns (you can access the study here). The conventional wisdom is that insiders have access to private information about the future prospects of stocks that outsiders do not have.””
Gray, Wesley R.. Quantitative Value (Wiley Finance) . Wiley. Kindle Edition.
We know the empirical evidence supports insider trading (legal ones mind you) as a signal that the stock will outperform.
Here’s the conundrum even among insider trading – even insiders can be wrong.
- Insiders can be buying regularly.
- Insiders could even be buying because the options he has been given are expiring and it makes sense for him to buy at a discount. Options in company shares are vested often times as part of an executive’s salary. It’s a sort of incentive to have them keep their interests aligned with company trajectory. “Do your best for the company so it goes up and everybody makes money. Don’t? Then you lose too.”
So even in the world where we have a list of cheap stocks and a list of insider buying, we are forced to evaluate the best way forward.
If you have…say…a $100,000, you could, you could reasonably buy the whole basket of stocks that are cheap and that had recent insider buying and you’ll probably make some money that way. (I recommend using the Piotroski F-Score for this approach since it catches stocks that have improved metrics recently). [Disclaimer; not financial advise]
But if you’re like me as a salaried worker, you want to focus your energies on the best investment opportunities available.
How do we do this?
There are 4 critical insider buying components to consider.
Critical Insider Component #1 – Clusters of Insider Buying
I said earlier insiders can be human. Insiders can be wrong too.
But when the CEO, the CFO, and all of the directors jump in, they’re rarely all wrong at the same time. It’s more likely than not all of them are seeing the same damned thing.
Can all of them be wrong? Sure.
Are the chances of that very high? I don’t think so and I’m willing to take the bet if you’re on the opposite side of it every damned time all other things equal.
This is particularly so if you’ve vetted the company’s management practices and their past performance (ie, do they take shareholder accretive actions or shareholder dilutive actions? do they dilute shareholders unnecessarily? are they scumbags?)
In almost all cases, I’m most interested in clusters of insider buying. That makes me sit up and take notice. The next thing to ask yourself is how much are they buying relative to their salary?
Critical Insider Component #2 – Amount paid for shares relative to executive disposable income
Disposable income is a real thing. Most executives and CEOs are salaried workers. That means they have expenses to pay, things to upkeep and general life to lead.
How much they use to buy shares in companies they work at should thus be an indicator of how much confidence or bullishness they have in the company. But how much is good and how much is bad?
Here’s an example.
Carlos Slim of PBF Energy recently spent about $35 million dollars buying shares in PBF Energy.
Under most circumstances, this would seem like a crazy strong signal to follow suit and buy shares.
But is it really?
How much money does Carlos Slim have for disposable income? Carlos Slim is a Mexican business magnate. The guy was ranked the richest person in the world from 2010-2013. How should you view $35 million spent by a billionaire?
Positively? Or a drop in the bucket next to his massive and very relative wealth?
When I’m looking at insider buying, I want to confirm the executive’s salary. I want to know he put a huge chunk of his own disposable income into the company. I feel no qualms calling up, emailing, or even getting to the local office and flat out asking to confirm things.
It’s my god damned money at stake and it’s not like money grows on trees.
If an executive is putting 90% of his disposable income into the company after years of zero insider buying, I want to know why as much as I can within legal boundaries.
Measuring the disposable income of an executive used to buy shares recently is even more important when you look at companies that are smaller in scale. Small companies typically don’t pay fat salaries (salaries can be found in the annual report btw). Microcaps (sub $300 million) companies don’t pay decent salaries most of the time. How much is the executive getting paid $5k a month spending to buy shares?
A billionaire dropping $35 million to buy shares vs a guy whose total annual income is $60k dropping $1 million to buy shares send two very different signals. Learn to differentiate them. (having said that I don’t think Carlos Slim’s signal is weak. He’s a billionaire magnate. And he’s probably making the right call given what I know of IMO2020 and its effects on VLSFO prices. When you can turn trash into treasure through refining, its typically a winning game plan. The question is just by how much and for how long.)
Critical Insider Component #3 – Non-regular insider buying
Insider buying can be regular things. It might be part of their 401k plan (if he’s a US resident). It might be part of their own yearly dollar-cost averaging because they believe in the company.
What you need to watch out for is non-regular buying.
What the hell am I talking about?
Let’s work with an example here.
Let’s say a CEO has been with the company for the past 25 years. He’s bought $10,000 of shares every year for the past 25 years. This year, that amount jumps to $20,000. That’s a positive signal, but not a huge one.
What if he bought $1 million worth of shares this year? That’s big.
How does it stack up to what he’s getting paid?
If I can measure it against his disposable income for the past ten years and make a gauge, I can gain even more nuanced understanding of whether he spent a good amount of money (to him) on share purchases.
If the guy makes $10 million a year and only buys $1 million worth this year, he’s probably bullish but not very strongly bullish.
Remember, insider buying is relative to disposable income and regularity.
Critical Insider Component #4 – Strong insider share ownership PLUS RELATIVE PAIN
Captain of the ship sinks with the ship.
So people say.
The lesson here is how much of the companies do insiders own?
This is a metric we incorporate when it comes to Dr Wealth’s Intelligent Investor Immersive Programme. How far in the boat is management with common shareholders?
I’m of the view that the management of public companies are scumbags most of the time. You’d have to be disagreeable to a certain degree to be able to get to that level.
Even if you don’t agree with the psychological science of it, managers care about their wealth first. Not yours. If they own a whole bunch of the damn company they’re unlikely to want to blow it up. Their own relative wealth is included in it after all.
Once again relative wealth is important. If I own 50% of the company but that comprises only 1% of my total wealth, can I be said to be in the same boat as you?
Hell no. Be sure to measure the relative pain of insider share ownership. This requires a more methodical amount of research. What car does the mgmt drive? What is their relative wealth? Where do they stay? What have they done in the past? What roles have they had in the past? What can you surmise from their habits?
Money has a scent to it if you put your nose in. Posh clubs, Mercedes Benz, Lambo, Yachts. These tell you relative wealth. If the wealth is hidden, you’ll have a harder time but you can always guess given past salaries and occupations. Apply a generous discount/bonus and you can see where they are and guess how relative their shares are to their wealth.
You want an example? Ok. Look at Hyflux.
Earnings dropped across the board from 2013 to 2017. Steady drops. Dividends didn’t drop as much.
Since 2013 to 2017, Olivia Lum’s total shares held 267,351,211 shares. Here are the screenshots from the company annual reports.
Dividends paid out per share for 2013 was $6,149,077.853. The same amount was paid out in 2014.
That’s $12 million in 2 years.
She got paid $4,544,970.587 in 2015 and another $1,336,756.055 in 2016. All while earnings crashed and free cash flow went bloody negative. Her salary ranged between $750,000 – $1,000,000.
What does that tell you about the dividends issued?
Is her salary her salary? Or is the dividends her real salary?
Think she’s on your side? Believe in her story? Rags to riches?
Give me a break. Look at the numbers and use your head.
She got paid approximately 12 times her salary in 2 years via dividends which are tax free. If I total her dividends received, she got paid $17 million or thereabouts. That’s 17 times her salary in about 4 years. If I account for taxes, it gets worse.
Don’t forget when the company IPO’d, she got paid a bunch too.
Oh, and did I mention dividends don’t get taxed in Singapore?
Hell, if I was CEO, I’d prefer dividend payouts too.
What better way to get compensated as the CEO of a public company? Raise my salary? No thanks. Give me shares.
And give unto me the gift of dividends.
Who’s on the winning side? You? Or her? Is her pain relative to yours? All in, salary and dividends, she took home roughly $21 million more or less between 2013-2017. You want exact numbers, hire an accountant. What did you pay for the shares? How much of your wealth did you lose to this investment? Most people lost 90%. How’s that relative for you?
It’s all bloody relative. Having said all that, is Olivia Lum a total scumbag? I don’t know.
I’ll say this much.
She made large commitments to her company at a time when it was nothing. She raised funds by selling her condo unit for a profit, paid off her car loan and moved into a rented HDB flat in order to start the company. It’s all a good sign of a CEO who’s committed to the damn company.
I respect that.
But dynamics change once a company goes public. Things change when you go from private to public.
Stop getting all caught up in the story.
Use your head!!
When you invest, make damned sure you’re on the same side and make sure their pain is relative to yours. You can’t judge competence with as much precision (more on that next time) but you sure as hell can judge pain!
#5 – A willingness for the company management to buy shares when they’re cheap and sell when they’re expensive
When relative valuations get expensive, companies can and probably rightly should sell shares to fund expansions and acquisitions. I’ll leave you the story of Teledyne to understand just how powerful this is for public companies and how much benefits it can bring to shareholders.
“The companies in which we have our largest investments have all engaged in significant stock repurchases at times when wide discrepancies existed between price and value. As shareholders, we find this encouraging and rewarding for two important reasons—one that is obvious, and one that is subtle and not always understood. The obvious point involves basic arithmetic: major repurchases at prices well below per-share intrinsic business value immediately increase, in a highly significant way, that value.
The other benefit of repurchases is less subject to precise measurement but can be fully as important over time. By making repurchases when a company’s market value is well below its business value, management clearly demonstrates that it is given to actions that enhance the wealth of shareholders, rather than to actions that expand management’s domain but that do nothing for (or even harm) shareholders.”Warren Buffett, Shareholder Letter, 1984
Henry Singleton is most notable for two achievements: building Teledyne from scratch into one of the most profitable and successful stocks in the United States at the time he stepped down 29 years later, and for his “almost arrogant scorn for most conventional business practices.”
Warren Buffett has described Singleton as a “managerial superstar,” saying that he had “the best operating and capital deployment record in American business.”
That is high praise indeed, coming from one of the world’s greatest capital allocators. Singleton founded Teledyne in 1960 with just $225,000. He continually adapted his capital management strategy to the prevailing climate on Wall Street. In the conglomerate era, he used Teledyne’s soaring stock to make cheap acquisitions and raise earnings per share. In the 1970s, when the stock slumped, Singleton bought back Teledyne’s undervalued stock hand over fist.
Investors, heeding Singleton’s signal that the stock was cheap, made out like bandits. Teledyne stock, which had sold for less than $14 in 1972, the year of Singleton’s first buyback, was by 1987, when adjusted for splits and distributions, worth well over $930 a share.
The gain in Teledyne stock following the buyback represents a total return of more than 6,500%, or a compound yearly return of more than 32 percent.Gray, Wesley R.. Quantitative Value (Wiley Finance) . Wiley. Kindle Edition
$10,000 invested in 1972 would have grown to $650,000 by 1987. Think about having that kind of life-changing wealth for yourself for a minute and you’ll understand why I wrote this article.
- Is there clustered buying from company executives?
- If yes, are executives paying abnormally high amounts of money relative to their disposable income?
- Are the current insider purchases you are looking at historically regular or irregular?
- Is there strong amounts of insider share ownership and is their pain relative to their total wealth? Or nay?
- Has the management been willing to buy back shares when cheap and sell shares when they are expensive? ie, are they focused on shareholder wealth or their wealth?
Want to invest in something? Run through this exercise. Find out where insiders are buying in clusters, relative to disposable income, relative to pain, relative to insider ownership. Talk to them. Ask them questions. Call or email. It’s your damned money. Figure out what’s going on.
You will not, and can not figure everything out from the balance sheet (though you certainly can figure out a good deal). Instead of looking at their history, look at their actions and use that to figure out where to go.
Ask questions. Use your head. If the stock fails this tests, dump it. Find another one. The goal is to investigate the business and its management. Not fall in love with them. Use a system. Keep your biases at bay.
I wish all of you good hunting in 2020 and the years ahead.
Notes: I credit Alvin Chow and Dr Wealth with the fundamentals I have learned. I can say with good grace that if it wasn’t for my employment with them, I probably would still be as disenchanted and as blur about the stock market as I was in 2007. When I count my blessings, I count being able to work at Dr Wealth twice.
I can’t recommend enough you attend the course if you’re willing to pay up and shortcut the learning curve of how to value and look at companies. While on the taboo subject of paid investment courses, there is an interesting dynamic I have noticed – people are very willing to spend thousands of dollars on an education so they can work for someone else but won’t spend thousands of dollar on an education to free themselves.
Human irrationality at its finest.
Perhaps this is the saddest part of our lives, that the system we have built requires us to be inhuman about our money so that we can be more human about our freedoms. Reminder – don’t be human when it comes to your money. Be mechanical. Be robotic. Be disciplined.