Stock Investing For Dummies, 5th Edition - Paul Mladjenovic (2016)

Part IV. Investment Strategies and Tactics

Chapter 20. Corporate and Government Skullduggery: Looking at Insider Activity

IN THIS CHAPTER

Using documents to track insider trading

Examining insider buying and selling

Understanding corporate buybacks

Breaking down stock splits

Watching Congress closely

Imagine that you’re boarding a cruise ship, ready to enjoy a hard-earned vacation. As you merrily walk up the plank, you notice that the ship’s captain and crew are charging out of the vessel, flailing their arms and screaming at the top of their lungs. Some are even jumping into the water below. Pop quiz: Would you get on that ship? You get double credit if you can also explain why (or why not).

What does this scenario have to do with stock investing? Plenty. The behavior of the people running the boat gives you important clues about the near-term prospects for the boat. Similarly, the actions of company insiders can provide important clues into the near-term prospects for their company.

Company insiders are key managers or investors in the company. Insiders include the president of the company, the treasurer, and other managing officers. An insider can also be someone who owns a large stake in the company or someone on the board of directors. In any case, insiders usually have a bird’s-eye view of what’s going on with the company and a good idea of how well (or how poorly) the company is doing.

In this chapter, I describe different kinds of insider activities, such as insider buying, insider selling, corporate stock buybacks, and stock splits. I also show you how to keep track of these activities with the help of a few resources.

Keep tabs on what insiders are doing because their buy/sell transactions do have a strong correlation to the near-term movement of their company’s stock. However, don’t buy or sell stock only because you heard that some insider did. Use the information on insider trading to confirm your own good sense in buying or selling stock. Insider trading sometimes can be a great precursor to a significant move that you can profit from if you know what to look for. Many shrewd investors have made their profits (or avoided losses) by tracking the activity of insiders.

Tracking Insider Trading

Fortunately, we live in an age of disclosure and the Internet. Insiders who buy or sell stock must file reports that document their trading activity with the Securities and Exchange Commission (SEC), which makes the documents available to the public. You can view these documents at either a regional SEC office (see www.sec.gov/contact/addresses.htm) or on the SEC’s website, which maintains the EDGAR (Electronic Data Gathering, Analysis, and Retrieval) database (www.sec.gov/edgar.shtml). Just click “Search for Company Filings.” Some of the most useful documents you can view there include the following:

· Form 3: This form is the initial statement that insiders provide. They must file Form 3 within ten days of obtaining insider status. An insider files this report even if he hasn’t made a purchase yet; the report establishes the insider’s status.

· Form 4: This document shows the insider’s activity, such as a change in the insider’s position as a stockholder, how many shares the person bought and sold, or other relevant changes. Any activity in a particular month must be reported on Form 4 by the 10th of the following month.

· Form 5: This annual report covers transactions that are small and not required on Form 4, such as minor, internal transfers of stock.

· Form 144: This form serves as the public declaration by an insider of the intention to sell restricted stock — stock that the insider was awarded, received from the company as compensation, or bought as a term of employment. Insiders must hold restricted stock for at least one year before they can sell it. After an insider decides to sell, she files Form 144 and then must sell within 90 days or submit a new Form 144. The insider must file the form on or before the stock’s sale date. When the sale is finalized, the insider is then required to file Form 4.

For a more comprehensive list of insider forms (among others that are filed by public companies), go to www.sec.gov/info/edgar/forms/edgform.pdf.

Companies are required to make public the documents that track their trading activity. The SEC’s website offers limited access to these documents, but for greater access, check out one of the many websites that report insider trading data, such as www.marketwatch.com and www.bloomberg.com.

The SEC has enacted the short-swing profit rule to protect the investing public. This rule prevents insiders from quickly buying the stock that they just sold at a profit. The insider must wait at least six months before buying it again. The SEC created this rule to prevent insiders from using their privileged knowledge to make an unfair profit quickly, before the investing public can react. The rule also applies if an insider sells stock — he can’t sell it at a higher price within a six-month period.

FIGHTING ACCOUNTING FRAUD: THE SARBANES-OXLEY ACT

Very often, a market that reaches a mania stage sees abuse reach extreme conditions as well. Abuse by insiders is a good example. In the stock market mania of 1997-2000, this abuse wasn’t limited to just insider buying and selling of stock; it also covered the related abuse of accounting fraud. (Companies like Enron in 2001 and Fannie Mae in 2008 come to mind.) The top management executives at several prominent companies deceived investors about the companies’ financial conditions and subsequently were able to increase the perceived value of the companies’ stock. The stock could then be sold at a price that was higher than market value. Congress took notice of these activities and, in 2002, passed the Sarbanes-Oxley Act (SOX). Congress designed this act to protect investors from fraudulent accounting activities by corporations. SOX established a public accounting oversight board and also tightened the rules on corporate financial reporting. To find out more about this act, you can either do a search for it at www.congress.gov or get details from sites such as www.sox-online.com and www.findlaw.com.

Looking at Insider Transactions

The classic phrase “actions speak louder than words” was probably coined for insider trading. Insiders are in the know, and keeping a watchful eye on their transactions — both buying and selling their company’s stock — can provide you with very useful investing information. But insider buying and insider selling can be as different as day and night; insider buying is simple, while insider selling can be complicated. In the following sections, I present both sides of insider trading.

Breaking down insider buying

Insider buying is usually an unambiguous signal about how an insider feels about his company. After all, the primary reason that all investors buy stock is that they expect it to do well. If one insider is buying stock, that’s generally not a monumental event. But if several or more insiders are buying, those purchases should certainly catch your attention.

Insider buying is generally a positive omen and beneficial for the stock’s price. Also, when insiders buy stock, less stock is available to the public. If the investing public meets this decreased supply with increased demand, the stock price rises. Keep these factors in mind when analyzing insider buying:

· Identify who’s buying the stock. The CEO is buying 5,000 shares. Is that reason enough for you to jump in? Maybe. After all, the CEO certainly knows how well the company is doing. But what if that CEO is just starting her new position? What if before this purchase she had no stock in the company at all? Maybe the stock is part of her employment package.

The fact that a new company executive is making her first stock purchase isn’t as strong a signal urging you to buy as the fact that a long-time CEO is doubling her holdings. Also, if large numbers of insiders are buying, that sends a stronger signal than if a single insider is buying.

· See how much is being bought. In the preceding example, the CEO bought 5,000 shares, which is a lot of stock no matter how you count it. But is it enough for you to base an investment decision on? Maybe, but a closer look may reveal more. If she already owned 1 million shares at the time of the purchase, then buying 5,000 additional shares wouldn’t be such an exciting indicator of a pending stock rise. In this case, 5,000 shares is a small incremental move that doesn’t offer much to get excited about.

However, what if this particular insider has owned only 5,000 shares for the past three years and is now buying 1 million shares? Now that should arouse your interest! Usually, a massive purchase tells you that particular insider has strong feelings about the company’s prospects and that she’s making a huge increase in her share of stock ownership. Still, a purchase of 1 million shares by the CEO isn’t as strong a signal as ten insiders buying 100,000 shares each. Again, if only one person is buying, that may or may not be a strong indication of an impending rise. However, if lots of people are buying, consider it a fantastic indication.

An insider purchase of any kind is a positive sign, but it’s always more significant when a greater number of insiders are making purchases. “The more the merrier!” is a good rule for judging insider buying. All these individuals have their own, unique perspectives on the company and its prospects. Mass buying indicates mass optimism for the company’s future. If the treasurer, the president, the vice president of sales, and several other key players are putting their wealth on the line and investing it in a company they know intimately, that’s a good sign for your stock investment as well.

· Notice the timing of the purchase. The timing of insider stock purchases is important as well. If I tell you that five insiders bought stock at various points last year, you may say, “Hmm.” But if I tell you that all five people bought substantial chunks of stock at the same time and right before earnings season, that should make you say, “HMMMMM!”

Picking up tips from insider selling

Insider stock buying is rarely negative — it either bodes well for the stock or is a neutral event at worst. But how about insider selling? When an insider sells his stock, the event can be either neutral or negative. Insider selling is usually a little tougher than insider buying to figure out because insiders may have many different motivations to sell stock that have nothing to do with the company’s future prospects. Just because the president of the company is selling 5,000 shares from his personal portfolio doesn’t necessarily mean you should sell, too.

Insiders may sell their stock for a couple reasons: They may think that the company won’t be doing well in the near future — a negative sign for you — or they may simply need the money for a variety of personal reasons that have nothing to do with the company’s potential. Some typical reasons why insiders may sell stock include the following:

· To diversify their holdings: If an insider’s portfolio is heavily weighted with one company’s stock, a financial advisor may suggest that she balance her portfolio by selling some of that company’s stock and purchasing other securities.

· To finance personal emergencies: Sometimes an insider needs money for medical, legal, or family reasons.

· To buy a home or make another major purchase: An insider may need the money to make a down payment or perhaps to buy something outright without having to take out a loan.

How do you find out about the details regarding insider stock selling? Although insiders must report their pertinent stock sales and purchases to the SEC, the information isn’t always revealing. As a general rule, consider the following questions when analyzing insider selling:

· How many insiders are selling? If only one insider is selling, that single transaction doesn’t give you enough information to act on. However, if many insiders are selling, you should see a red flag. Check out any news or information that’s currently available by going to websites such as www.marketwatch.com, www.sec.gov, and finance.yahoo.com (along with other sources in Appendix A).

· Are the sales showing a pattern or unusual activity? If one insider sold some stock last month, that sale alone isn’t that significant an event. However, if ten insiders have each made multiple sales in the past few months, those sales are cause for concern. See whether any new developments at the company are potentially negative. If massive insider selling has recently occurred and you don’t know why, consider putting a stop-loss order on your stock immediately. I cover stop-loss orders more fully in Chapter 17.

· How much stock is being sold? If a CEO sells 5,000 shares of stock but still retains 100,000 shares, that’s not a big deal. But if the CEO sells all or most of his holdings, that’s a possible negative. Check to see whether other company executives have also sold stock.

· Do outside events or analyst reports seem coincidental with the sale of the stock? Sometimes, an influential analyst may issue a report warning about a company’s prospects. If the company’s management pooh-poohs the report but most of them are bailing out anyway (selling their stock), you may want to do the same. Frequently, when insiders know that damaging information is forthcoming, they sell the stock before it takes a dip.

Similarly, if the company’s management issues positive public statements or reports that contradict their own behavior (they’re selling their stock holdings), the SEC may investigate to see whether the company is doing anything that may require a penalty (the SEC regularly tracks insider sales).

Considering Corporate Stock Buybacks

When you read the financial pages or watch the financial shows on TV, you sometimes hear that a company is buying its own stock. The announcement may be something like, “SuperBucks Corp. has announced that it will spend $2 billion to buy back its own stock.” Why would a company do that, and what does that mean to you if you own the stock or are considering buying it?

When companies buy back their own stock, they’re generally indicating that they believe their stock is undervalued and that it has the potential to rise. If a company shows strong fundamentals (for example, good financial condition and increasing sales and earnings; see Chapters 8 and 11 for details) and it’s buying more of its own stock, it’s worth investigating — it may make a great addition to your portfolio.

Just because a company announces a stock buyback doesn’t always mean that one will happen. The announcement itself is meant to stir interest in the stock and cause the price to rise. The stock buyback may be only an opportunity for insiders to sell stock or it may be needed for executive compensation — recruiting and retaining competent management are positive uses of money.

The following sections present some common reasons a company may buy back its shares from investors, as well as some ideas on the negative effects of stock buybacks.

If you see that a company is buying back its stock while most of the insiders are selling their personal shares, that’s not a good sign. It may not necessarily be a bad sign, but it’s not a positive sign. Play it safe and invest elsewhere.

Understanding why a company buys back shares

You bought this book because you’re looking at buying stocks, but individuals aren’t alone in the stock-buying universe. No, I don’t just mean that mutual funds, pensions, and other entities are buyers; I mean the companies behind the stocks are buyers (and sellers), too. Why would a public company buy stock — especially its own?

Boosting earnings per share

By simply buying back its own shares from stockholders, a company can increase its earnings per share without actually earning extra money (see Chapters 8 and 11 as well as Appendix B for more on earnings per share). Sound like a magician’s trick? Well, it is, kind of. A corporate stock buyback is a financial sleight of hand that investors should be aware of. Here’s how it works: Noware Earnings, Inc. (NEI), has 10 million shares outstanding, and it’s expected to net earnings of $10 million for the fourth quarter. NEI’s earnings per share (EPS) would be $1 per share. So far so good. But what happens if NEI buys 2 million of its own shares? Total shares outstanding shrink to 8 million. The new EPS becomes $1.25 — the stock buyback artificially boosts the earnings per share by 25 percent!

The important point to keep in mind about stock buybacks is that actual company earnings don’t change — no fundamental changes occur in company management or operations — so the increase in EPS can be misleading. But the marketplace can be obsessive about earnings, and because earnings are the lifeblood of any company, an earnings boost, even if it’s cosmetic, can also boost the stock price.

If you watch a company’s price-to-earnings ratio (see Chapter 8, Chapter 11, and Appendix B), you know that increased earnings usually mean an eventual increase in the stock price. Additionally, a stock buyback affects supply and demand. With less available stock in the market, demand necessarily sends the stock price upward.

Whenever a company makes a major purchase, such as buying back its own stock, think about how the company is paying for it and whether it seems like a good use of the company’s purchasing power. In general, companies buy their stock for the same reasons any investor buys stock — they believe that the stock is a good investment and will appreciate in time. Companies generally pay for a stock buyback in one of two basic ways: funds from operations or borrowed money. Both methods have a downside. For more details, see the section “Exploring the downside of buybacks,” later in this chapter.

Beating back a takeover bid

Suppose you read in the financial pages that Company X is doing a hostile takeover of Company Z. A hostile takeover doesn’t mean that Company X sends storm troopers armed with mace to Company Z’s headquarters to trounce its management. All a hostile takeover means is that X wants to buy enough shares of Z’s stock to effectively control Z (and Z is unhappy about being owned or controlled by X). Because buying and selling stock happens in a public market or exchange, companies can buy each other’s stock. Sometimes, the target company prefers not to be acquired, in which case it may buy back shares of its own stock to give it a measure of protection against unwanted moves by interested companies.

In some cases, the company attempting the takeover already owns some of the target company’s stock. In this case, the targeted company may offer to buy those shares back from the aggressor at a premium to thwart the takeover bid. This type of offer is often referred to as greenmail.

Takeover concerns generally prompt interest in the investing public, driving the stock price upward and benefiting current stockholders.

Exploring the downside of buybacks

As beneficial as stock buybacks can be, they have to be paid for, and this expense has consequences. When a company uses funds from operations for the stock buyback, less money is available for other activities, such as upgrading technology, making improvements, or doing research and development. A company faces even greater dangers when it uses debt to finance a stock buyback. If the company uses borrowed funds, not only does it have less borrowing power for other uses, but it also has to pay back the borrowed funds with interest, thus lowering earnings figures.

In general, any misuse of money, such as using debt to buy back stock, affects a company’s ability to grow its sales and earnings — two measures that need to maintain upward mobility to keep stock prices rising.

Say that Noware Earnings, Inc. (NEI), typically pays an annual dividend of 25 cents per share of stock and wants to buy back shares, which are currently at $10 each, with borrowed money with a 9 percent interest rate. If NEI buys back 2 million shares, it won’t have to pay out $500,000 in dividends (2 million multiplied by 25 cents). That’s money saved. However, NEI has to pay interest on the $20 million it borrowed ($10 per share multiplied by 2 million shares) to buy back the shares. The interest totals $1.8 million (9 percent of $20 million), and the net result from this rudimentary example is that NEI sees an outflow of $1.3 million (the difference between the interest paid out and the dividends savings).

Using debt to finance a stock buyback needs to make economic sense — it needs to strengthen the company’s financial position. Perhaps NEI could have used the stock buyback money toward a better purpose, such as modernizing equipment or paying for a new marketing campaign. Because debt interest ultimately decreases earnings, companies must be careful when using debt to buy back their stock.

Stock Splits: Nothing to Go Bananas Over

Frequently, management teams decide to do a stock split. A stock split is the exchange of existing shares of stock for new shares from the same company. Stock splits don’t increase or decrease the company’s capitalization; they just change the number of shares available in the market and the per-share price.

Typically, a company may announce that it’s doing a 2-for-1 stock split. For example, a company may have 10 million shares outstanding, with a market price of $40 each. In a 2-for-1 split, the company then has 20 million shares (the share total doubles), but the market price is adjusted to $20 (the share price is halved). Companies do other splits, such as a 3-for-2 or 4-for-1, but 2-for-1 is the most common split.

The following sections present the two basic types of splits: ordinary stock splits and reverse stock splits.

Qualifying for a stock split is similar to qualifying to receive a dividend — you must be listed as a stockholder as of the date of record. Keep good records regarding your stock splits in case you need to calculate capital gains for tax purposes. (For information on the date of record, see Chapter 6. See Chapter 21 for tax information.)

Ordinary stock splits

An ordinary stock split — when the number of stock shares increases — is the kind investors usually hear about. If you own 100 shares of Dublin, Inc., stock (at $60 per share) and the company announces a stock split, what happens? If you own the stock in certificate form (which is very rare now), you receive in the mail a stock certificate for 100 more shares. Now, before you cheer over how your money just doubled, check the stock’s new price. Each share is adjusted to a $30 value.

Not all stock is in certificate form. Stocks held in a brokerage account are recorded in book entry form. Most stock, in fact, is in book entry form. A company only issues stock certificates when necessary or when the investor requests it. If you keep the stock in your brokerage account, check with your broker for the new share total to make sure you’re credited with the new number of shares after the stock split.

An ordinary stock split is primarily a neutral event, so why does a company bother to do it? The most common reason is that management believes the stock is too expensive, so it wants to lower the stock price to make the stock more affordable and therefore more attractive to new investors. Studies have shown that stock splits frequently precede a rise in the stock price. Although stock splits are considered a non-event in and of themselves, many stock experts see them as bullish signals because of the interest they generate among the investing public.

Reverse stock splits

A reverse stock split usually occurs when a company’s management wants to raise the price of its stock. Just as ordinary splits can occur when management believes the price is too expensive, a reverse stock split means the company feels that the stock’s price is too cheap. If a stock’s price looks too low, that may discourage interest by individual or institutional investors (such as mutual funds). Management wants to drum up more interest in the stock for the benefit of shareholders (some of whom are probably insiders).

The company may also do a reverse split to decrease costs. When you have to send an annual report and other correspondence regularly to all the stockholders, the mailings can get a little pricey, especially if you have lots of investors who own only a few shares each. A reverse split helps consolidate shares and lower overall management costs.

A reverse split can best be explained with an example. TuCheep, Inc. (TCI), is selling at $2 per share on the Nasdaq. At that rock-bottom price, the investing public may ignore it. So TCI announces a 10-for-1 reverse stock split. Now what? If a stockholder had 100 shares at $2 (the old shares), the stockholder now owns 10 shares at $20.

Technically, a reverse split is considered a neutral event. However, just as investors may infer positive expectations from an ordinary stock split, they may have negative expectations from a reverse split because a reverse split tends to occur for negative reasons. One definitive negative reason for a reverse split is if the company’s stock is threatened to be delisted. If a stock is on a major exchange and the price falls below $1, the stock will face delisting (basically getting removed from the exchange). A reverse split may be used to ward off such an event.

If, in the event of a stock split, you end up with an odd number of shares, the company doesn’t produce a fractional share. Instead, you get a check for the cash equivalent. For example, if you have 51 shares and the company announces a 2-for-1 reverse split, odds are that you’ll get 25 shares and a cash payout for the odd share (or fractional share).

Keeping a Close Eye on Congress

The latest sensation in the world of insider trading has been how congresspeople of both parties have reaped fortunes by doing something that’s illegal for you and me — but was legal for them! For those folks who’ve wondered how someone can spend millions to get a “public service” job and then retire a multimillionaire, now you have a clue: congressional insider trading.

Congressmen and women, as you know, pass laws for a variety of matters. They know which companies stand to lose or benefit as a result. They can then invest in the winners and/or avoid (or go short) the losers. (When you go short on a stock, you make money by selling high and then buying low; to get a good idea about how short selling works, see Chapter 17.) Many were able to easily reap million-dollar gains because of this privileged perch they stood on.

Some folks in Congress made outrageous profits from shorting strategies during the 2008 crash when they learned of pending financial developments behind closed doors before the public (and most investors) found out. It’s maddening that these politicians profited (legally!) from activities that you and I would have ended up in jail for doing.

From the furor in late 2011 over this incredible corruption came a new law passed in early 2012: the Stop Trading on Congressional Knowledge (STOCK) Act. Hopefully it will do the trick, but the real lesson for stock investors (and voters) is that we must always be vigilant about what insiders (both corporate and political) are doing. The act is officially called H.R. 1148, and you can look it up at places such as www.opencongress.org and find other sources through your favorite search engine. Also keep track with some of the resources mentioned in Appendix A.