Playing Chicken

The Oxford Club’s C. Alexander Green on turning an “unfair advantage” legally mandated by the SEC into strong personal gains.

PLAYING CHICKEN
by C. Alexander Green

Remember the old tough-guy rite of passage called “playing chicken”?

Where two young stags square off in a field or parking lot in their hot rods while dozens of friends and school chums stand cheering on the sidelines, goading their compatriots on. (What are friends for, after all?)

Young objects of affection would stand wide-eyed and trembling, sweaty hands clasped together. And then with a squeal of burning rubber or (depending on the location) a plume of straw and cow pies – these young gladiators suddenly barrel toward each other at full tilt, intent on proving virtue and manhood. How? By being the last to turn aside to avoid a head-on collision.

Maybe it’s because I come from a small town, but I never managed to embrace this ritual. Better to act as a strong shoulder to the objects of affection. After all, the true hero could wind up with a toe tag. Or, failing that, appear a less persuasive suitor with his new pug nose and broken teeth.

However, I confess I have been playing chicken lately. And quite profitably.

More specifically, I’ve been accumulating shares of the chicken king, Tyson Foods, which have bolted up 84% in the last nine months while the market averages withered away. But now, I’m flying the coop. The same tell-tale sign that told me when to buy Tyson is now sounding the alarm to sell. Let me explain.

I spent sixteen years on Wall Street as a research analyst, investment advisor, and registered portfolio manager. What I was fortunate to learn early in my career is that what has worked in the market in the past doesn’t generally work in the future. Gurus come and go. Trading systems lose their luster. Securities analysis evolves but rarely improves. And foolproof indicators, I’ve learned, are for fools only.

In truth, I’ve found only a couple of leading indicators that give a better probability than chance of leading to investment outperformance.

And – by far – the best of these leading indicators is heavy, widespread insider buying. Here’s why.

Insiders are the officers who run a company, the directors who oversee the officers, and 10% beneficial owners of the stock who are presumed to be more than ordinarily well-apprised of the company’s business and future prospects.

These individuals know virtually everything that can be known about the company they run. They know the pace of sales day to day. They know of new products in development. They know whether the company is a takeover candidate…or is already getting unsolicited offers. In short, they know everything that reasonably can be known about their company’s business prospects, employees, customers, suppliers, and competitors.

In short, they have an UNFAIR ADVANTAGE when they go into the market to trade their own company’s shares. After all, they know not only all the public information about their company…but a great deal of non-public information as well.

For this reason, the U.S. government requires all insiders to report their transactions to the SEC by the tenth day of the month following the month in which they buy or sell their company shares.

My philosophy is straightforward. There are plenty of reasons an insider would sell his own company’s stock that have nothing to do with its business prospects. He may be diversifying his portfolio, buying a big house, putting his kids in private school, or – for all I know – paying for the upkeep on his mistress. (Or, in fact, the company outlook may be lousy. Witness the $1.1 billion in insider sales at Enron in the twelve months before they filed bankruptcy.)

But, in my opinion, there is only one reason that multiple insiders back up the truck to buy their own company’s shares. Based on their “unfair advantage,” they think their shares are set to soar.

And while no system is foolproof, I’ve found more often than not they’re right.

Volumes of independent research validate this point of view. In fact, just a few weeks ago Business Week ran an article highlighting the same conclusion:

“A study by researchers from the University of California at Los Angeles and New York University shows that a group of insider buyers, most from tech and pharmaceutical companies, beat broad market indexes by an average of 9.6% in the six months following their purchases.”

Two important points here. First, 9.6% is just about the market’s average annual return over the past 100 years. Yet insiders are earning 9.6% MORE than the market’s return in just the first six months after their purchases. And, secondly, remember this is merely the AVERAGE gain after an insider purchase. What if you restricted your purchases to just those companies that were fundamentally sound, had a major catalyst for positive change and heavy insider buying too?

This is a question I’ve been researching for several years and my answer is “good things will usually happen.”

Let’s return to Tyson Foods for a moment. I know selling headless Rhode Island Reds is not as exciting as seeking a breakthrough in cancer treatment or the development of the next generation of semiconductors. But, damn, it can be profitable.

In fact, according to Investor’s Business Daily, the U.S. company showing the second-largest increase in profitability in the second quarter was – you guessed it – Tyson Foods. In fact, their earning per share in the latest quarter were up more than 350%. And the stock has soared 84% in the last nine months.

Who could have known in advance there were such huge profits to be had selling chicken?

The insiders at Tyson Foods, for one.

A little over a year ago, directors Joe and Wilma Starr bought 15,000 shares. Then last summer, as the stock languished in the single digits, other insiders started lining up at the trough. First, director Leland Tollett bought 25,000 shares. Then director Donald J. Tyson bought a few thousand shares. Shelby Massey, another director, picked up 10,000 shares. In September, officer Greg Huett bought 9,437 shares. And so on.

Let me remind you that this became public information not long after they made their purchases. No hindsight was necessary.

Investors who followed in their footsteps have seen the stock rise more than 80% since the September lows. And now that the stock has skyrocketed, insiders are no longer buying. In fact, the only insider transactions in the last three months are sells.

Time to move on.

I hope I haven’t made this sound too easy. Because like most things in life, it’s not.

I spend several thousand dollars a year to subscribe to a service that allows me to monitor the daily electronic filings at the SEC. I then spend hours more each week looking at each insider’s track record and doing a thorough fundamental and technical analysis of each stock that looks interesting.

I wade through an avalanche of meaningless information. Like small purchases from new officers or directors who are just trying to show they’re a “member of the club.” Or insider purchases that are made solely because of option compensation.

That’s not real insider buying. Real insider buying is multiple insiders buying a large quantity of the stock with their own money at current market prices.

That kind of information can give you a promising lead. And some of these leads have turned out to be quite rewarding. Despite the swan dive on the Nasdaq and S&P 500 year-to-date, so far this year a trading service I run, The Insider Alert, has already locked in double- digit profits in New York Community Bancorp, US Oncology, Bio-Reference Labs, Household International, Capital Bancorp and others. Every one of these stocks had sound fundamentals and, of course, heavy insider buying before we made our purchases.

Recently, however, insider buying has slowed to a trickle. That’s no surprise. Insiders, by definition, are unusually well informed. And with the economy poised on the brink of a double-dip recession, most insiders don’t feel like sticking their necks out.

However, that makes all the more valuable the information we can garner about the ones who are. For instance, right now there is a tremendous amount of insider buying going on in a mid-cap company I’m recommending that is a major provider of drug discovery and development services to pharmaceutical and biotechnology companies.

In the current market environment, where investors are concerned whether consumers will keep spending, the economy will keep growing and the Fed will keep its foot off the brakes, a company like this is a shelter from the storm. That’s because the health care industry is relatively immune to the vicissitudes of the economy.

This company is financially strong too. It has very little debt and more than $131 million in cash on hand. And the company has averaged 23% sales growth and 69% earnings growth over the last five years. My research suggests that earnings growth going forward is likely to be strong as well.

More importantly, SEC filings show the insiders are buying with both hands. The chief executive bought 100,000 shares in May. His total purchase came to more than $2.4 million. The Chairman and Director bought 10,000 shares as well, a commitment of nearly a quarter of a million dollars.

I like this combination. A recession-proof business, financially sound and growing much faster than average. With a serious endorsement from the man at the top, as well as other insiders.

In short, I’m done playing chicken. But when you follow the insiders, you find there are always other birds to be plucked.

Warm regards,

C. Alexander Green, for The Daily Reckoning
June 19, 2002

PS. With the markets acting the way they have been lately, I’ll take every edge I can find. And, in my opinion, heavy insider buying like this is as good as it gets.

Hey, the Dow managed to go up 2 days in a row! Glory hallelujah.

But if it heads down tomorrow, Americans know just what to do: buy a house. John Silvia, chief economist for Wachovia Securities, as reported in Money, says that “demand for new housing is being helped, not hurt, by a weak stock market, as consumers are investing in upgrading their homes rather than in stocks.”

Okay, maybe stocks don’t go up each and every year… but houses do, don’t they? Readers who feel the urge to move from stocks to residential real estate are invited to visit our office in Baltimore – about which I have written more than once. It was rebuilt at enormous cost around the turn of the century. It has rare mahogany woodwork, ornate plaster ceilings, and an incomparable view of Mount Vernon Square…looking right across the park at a Frick mansion. It was also the residence of the U.S. Ambassador to Belgium, Theodore Marburg, a man who later helped Woodrow Wilson draft the League of Nations convention – right there in the library. Who would have doubted then that it was a good investment?

Location is everything. In 1900, the building was in the world’s most dynamic economy…in the heart of one of its most dynamic cities – with railroads, shipyards, steel mills…all the trappings of a modern industrial dynamo. But by the 1920’s the good families were moving to the suburbs…and in-town houses peaked out. Prices went down in real terms for at least the next 80 years.

Might today’s real estate investors be disappointed too?

“Consumers have been powering the economy,” says Barron’s headline story this week, “spending on everything from giant TVs to gardening gear to additions for their homes…But how much longer can this go on?”

We recall from yesterday’s letter that Japanese consumers kept right on spending after the stock market headed down in 1990. After a two-decade boom, they had a hard time imagining that things could change. But the boom was over. And attitudes in Japan gradually adjusted. Today, Japanese householders are as famously tight with their money as Americans are loose.

The boom is over in America too, we believe. Sooner or later, Americans will realize it.

Eric, what’s the story from Wall Street?

******

Eric Fry in New York…

– A bear-market rally is like a rickety rope bridge suspended over a lake of fire (think: “Shrek”). Investors who dare to cross it must ask themselves, “Will the bridge support the weight of millions of bullish investors all clamoring to get across at once? Or, at the very least, will it hold up long enough for me to get across?” We timorous investors simply stand on solid ground and watch.

– Support for the current rally appears to be fraying already. The Dow managed a 19-point gain yesterday to 9,706, but the Nasdaq slipped 10 points to 1,543. All hope is not lost, however. After the close of trading, Oracle wowed the Street with an earnings report that exceeded the greatly reduced forecast of Wall Street analysts.

– It seemed to trouble no one that Oracle’s year-over- year revenues fell 16%, or that it earned $200 million less than last year’s $855 million result.

– The numbers were better than expected, and that was enough to inspire a frenzy of buying in after-hours trading. Offsetting Oracle’s respectable result, however, AMD, Apple, and Ciena all issued earnings warnings after the close of trading. Net-net, the rope bridge may not hold up much longer.

– Compared to the structurally unsound stock market, the housing market is a majestic Golden Gate Bridge to profit. Despite a bear market in stocks; despite withering corporate profits; despite an economic recovery that never acts fully recovered, the housing market remains unscathed. It climbs from strength to strength. U.S. housing starts in May soared a breathtaking 11.6% (seasonally-adjusted) – the largest monthly percentage gain since July 1995. (Remember though that April starts were somewhat less-than- breathtaking – down 7.3%). Building permits also bounced, rising by 2.6% in May.

– What should we investors make of the strength in the housing market? Is it showing the rest of the economy the way out of recession? Or is it simply the latest one of America’s serial financial bubbles? Or, perhaps the housing bull market is but one very visible augury of a coming inflation.

– Of course, the housing market’s “strength” may not be all that it is cracked up to be. That’s because the housing market owes much of its vigor to the ever- increasing leverage that is coursing through it, courtesy of the mortgage lenders. Pumping easy credit into a financial market has a funny way of making sane prices turn a little crazy. And mortgage credit has never been easier to obtain. To approve a “0%-down” mortgage, most lenders seem to require little more than a pulse and a pay stub from 1995.

– “Housing payments, as a percentage of disposable personal income, are at their highest level since the Federal Reserve began tracking the statistic – up 45% since 1980,” the Wall Street Journal observes. “And the trend is likely to continue…Lenders, including J.P. Morgan Chase (there’s that name again!), now permit some well-to-do borrowers to apply up to 50% of their income to their regular mortgage payment. A decade ago, the norm was 28% to 32% of income.” (Question: How “well-to- do” is a borrower if he must use 50% of his income just to pay his mortgage?). “The average down-payment from a first-time home buyer dropped to just 3% in 1999 versus 10% a decade earlier, according to the national Association of Realtors.”

– Not to worry, though, Brad Blackwell – an executive with Wells Fargo – tells the Journal: “We have a much better understanding of risk today.” That’s a relief. For a moment I was concerned that a mortgage lender somewhere might be making a bad loan or two.

– Back on Wall Street, Lehman Brothers announced yesterday that its profit fell 31% in the second quarter. Lehman’s earnings have dropped five out of the last six quarters. “The earnings slide coincides with securities firms’ worst year for revenue since 1997,” Bloomberg News reports.

– The renowned investment bank suffered weakness across the board. Mergers and acquisitions activity slumped 18%, while net revenue from buying and selling equities plunged 47%. As a result, return on shareholders’ equity fell from 23.4% to 14.1%. (ROE-fiend, and editor of The Fleet Street Letter, Lynn Carpenter would not like those ROE numbers very much at all!)

– But don’t think for a minute that Richard Fuld, Lehman’s chief executive officer, doesn’t feel the pain borne by shareholders. His take-home pay tumbled 43% last year to a mere $16 million. Hopefully, the Fuld household will get by until Lehman’s earnings recover.

******

Back in Paris…

*** Yesterday, I met with Jean-Pierre Gaillard, a man who might best be described as the Louis Rukeyser of France. He’s on television every day…updating the French on the stock market.

*** “What’s going on in America?,” he asked me. Then, he gave his own view: “U.S. stocks are a lot more expensive than they are here. The average P/E in France is only about 14. It must be at least twice that much in the U.S. I think French stocks will start going back up in September. I don’t know about the U.S.; why would anyone buy them at these prices?”

*** I recall having lunch with my old friend Harry Schultz at least a year ago. “Buy gold shares,” he advised me. “If you don’t do anything else…buy the gold shares. They’re going up.”

*** How did ‘Uncle’ Harry know?

*** On average, gold shares rose nearly 100% over the last 12 months. But Harry believes this is only the beginning. From a recent article, written with James Sinclair:

“That potent ingredient [for the gold market] is the Mother of All short positions in market history; the size of the gold short spread derivative position. The unique characteristic of that position is not only its size but also its ownership. The gold producers are responsible for only 11% of this mammoth short position. 89% of the $280,000,000,000 (figure from the IMF & BIS reports) is from sources that have nothing whatsoever to do with gold production. These rogue sources are borrowing money, using the mechanism of gold about which they understand little. It also represents pure short spread positions of the carry trade. Due to the fact that the notional value of the derivative $280,000,000,000 becomes real value at a gold value of $354, we can expect risk control programs to be buyers of gold whenever the momentum indicators turn positive and the market is over $305.

“We now have a golden convocation of all the technical and fundamental factors that constitute a long term bull market in gold plus a potent ingredient (the derivative short spread position) that offer us years of a positive gold market.”

*** Addison & Company have also prepared a special report on the gold bull market, which takes a closer look at these derivatives positions and what they portend for the gold price…