Making decisions on whether to buy or sell a company’s stock is difficult without having firsthand information. Some of the most valuable information, however, is available in the form of the Securities Exchange Commission (SEC) reports on corporate officers’ (insiders’) stock transactions. (The SEC requires they report when they buy, sell or gift their own corporate stock.) These officers are considered privy to information not generally available to the public and, by and large, they are more knowledgeable investors. Managements often know best when their stock is under- or overvalued by the market.

Following the SEC insider transactions literally can often lead to trouble as insiders do not all have the same degree of business judgment or experience. However, when one reviews the management track record and the historical market valuation levels, then corporate insider activity can be very useful.

In the accompanying database (a composite of cash flow, asset values, revenues, return on equity and earnings for the past 10 years) are the performance measurements of some 5,000 companies. Only 10 percent of the issues qualify for conservative portfolios. Most are not Standard & Poors 500 stocks. The data illustrate that consistent performance over time results in a better-than-average stock growth (e.g., Wal-Mart, Philip Morris, Browning-Ferris, Flowers Industries and Eldon Industries).

Do not invest in either new issues or younger companies; only if managements can be identified as having successful past business experience. For example, David Murdock of Castle & Cooke has completely turned his company around in the last five years.

By identifying performance-oriented management and observing them buying their own stock, one can get his best investment ideas. You are not buying a company so much as you are buying a management team. When you buy a portfolio of managements who have returned to stockholders better than 25 percent compounded annually for more than 10 years, then your investment success is likely to be more than just satisfactory.

Taking this concept a step further, I group the SEC insider trading reports by industry and managerial track record. This results in several good market and group indicators as a background to individual stock selection. One of the most fascinating of these results is the Smart Money Ratio Indicator (SMR). This is an eight-week moving average of the ratio of sells/ buys (S/B) of my top 200 best-managed 4 companies. A level of 10 or higher is a market sell signal while a 4.25 or less is bullish. Three weeks prior to the crash of 1987, the SMR gave a sell signal; it gave an outstanding buy signal in November 1987 and has remained bullish for the past 18 1 months.

The buying and selling by corporate insiders reported to the SEC of the best-managed companies is much more sensitive to the stock market than that of insiders from companies with poorer management track records. When used in conjunction with group indicators, your market focus becomes more accurate, since the fortunes of one group are often dependent on the fortunes of another. 

A CASE IN POINT

Combine the group activity with careful stock selection and asset pricing. Try to buy within 15 percent of what has been a historical low versus book value, cash flow, revenues per share, etc. In January 1988, the S/B ratio for the money center banks was 0.10 (i.e., 10 buys for each sell).

This was incredibly bullish and the stocks were very undervalued. At Citicorp, J.D. Farley bought 10,000 shares at $193/8 on November 18, 1987. Later, on October 19, 1989, John Reed purchased 100,000 at $243/4 to $25. Citicorp is currently at $31. Bankamerica was near $8 to $9 at this time, and directors John R. Grey, Roy L. Ash, C.R. Dahl, Cornell C. Maier, Ruben F. Mettler and Philip Hawley were actively buying. Bankamerica is now more than $321/2.

The papers also looked attractive, so I bought Stone Container near $19 (ad justed for 3 for 2 split, and currently at $301/2), along with Roger Stone and other officers. I also bought Ford Howard Paper at $34 (LBO $55), and James River at $24 (currently at $463/4). Jack Welch bought 20,000 shares of GE at $39 on May 11, 1988. GE is now priced near $563/4. D.K. Chapman bought 12,000 shares of American Brands from May 1988 through December 1988 in the range of $45 to $55 (currently at $73).

Directors William S. Anderson, John D. Macomber and John G. Medlin, Jr. bought RJR Nabisco during the period from March 1988 to July 1988 at $46 to $50, and RJR was taken over for $109 in the first quartet of 1989. These are a few examples of successful investments.

Along with successes, there are always examples of disappointments. For example, Lomas Financial was recommended November 1987 at $17, again recom?

mended November 1988, and sold March 1989 at $11 before it fell to its current price near $3. Precision Castparts and Stone Container were purchased at $33 in June 1988, and I continue to add to positions (Precision Castparts currently $333/4). USG was acquired at $71/4 September 1988 and sold at $53/4 March 1989 (currently $43/8).

Factors beyond the control of even good managements can influence corporate performance over the short term. For example, the dollar rose sharply due to the Chinese disorders in the second quarter of 1989.

WARNING SIGNALS

Near-term performance expectations must be clearly defined. If an issue threatens to under-perform, sell it quickly-ask questions later. In any one period this may occur in 30 percent of the issues selected. Typically, I diversify, using 20 or more positions as a means of risk management.

A portfolio’s performance is also enhanced by avoiding the trouble spots or areas of underperformance. Excessive insider selling is a warning signal. The utility, bank and computer group indicators have been particularly reliable. For instance, in May and June 1988, indicators suggested that July would be a difficult time for high technology stocks. It turned out to be a disaster with some stocks losing 50 to 60 percent of their value. A similar signal was given this June, and technology stocks again suffered.

Insider selling is not nearly as useful as their buying. Insiders sell for many reasons, some of which include new homes, college educations for their children, and the belief that their stock price will fall. Only active selling in a group and the market are reliable general indicators. Where the insiders are buying often identifies those market sectors which by comparison are likely to underperform. For example, active buying in tobacco, food and utility stocks (disinflation stocks) is a negative signal for energy and precious metal stocks (inflation stocks).

The one caveat in all investing is that you have a reliable method of assessing the management team. Good management will consistently make money for shareholders regardless of industry. Good managements make and need no excuses.