Agora Financial’s Rude Awakening

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Laguna Beach, California

• $5 trillion worth of recovery hopes and dreams,
• Do as I say AND as I do: Insider buying a selling signals,
• Dysfunctional investor relationships and plenty more…

Eric Fry, reporting from Laguna Beach, California…

Most investors are trapped in a dysfunctional relationship with the stock market. No marriage counselor would EVER urge these two parties to remain together. The relationship is simply too unhealthy and destructive.

Reckless passions yield spontaneously to mutual contempt…which then, somehow, after some indeterminate period of time, rekindles a new reckless passion.

About this time last year, for example, investors and the stock market were fogging up windows like a pair of teenagers on Mulholland Drive. But the passion quickly soured. Just one month later, the two sides were making war, not love.

Investors smacked the stock market repeatedly – the market responded by pummeling investor capital into a pulp. The whole episode was very upsetting to watch. No matter how many parties tried to intercede, the abusive behavior continued.

Finally, by early March, neither side could seem to remember why they wished to cause the other one harm. Neither side had any fight left in them. So hostility yielded to cautious reconciliation, then to affection…and then, eventually, to red-hot passion.

Investors and the stock market have been in a “lip-lock” for months now. Investors have pampered the stock market with bouquets of “buy” orders, while the stock market has rewarded its paramours with a robust 50% rally (and about $5 trillion worth of recovered losses). Everyone is happy…almost.

This red-hot passion has the look of something that’s about to turn stone cold once again.

It’s true that the Dow has only backed off about one percent during the last few days, but a recent blizzard of lackluster economic reports worldwide has cast a chill across the Wall Street love fest. Some investors are starting to back away from their love interest and scurry into the comforting arms of cash.

This latest fling between investors and the stock market may not be over just yet, but your editor is worried about another painful breakup. He is worried that someone is going to get hurt. That’s what always happens.

At moments such as these – moments of extreme divergence between stock market trends (up) and economic trends (down) – the prudent investor may wish to recall that stocks don’t ALWAYS rally while the economy is stumbling. And therefore, the prudent investor may wish to consider the possibility that bad news is actually bad news…and not a mind-bending rationale to buy into a dangerous and overpriced market.

Apparently, corporate insiders have considered this very possibility…and are responding with “sell” orders. Insider selling, relative to buying, soared to a five-year high in August. Last month, insiders sold $3.0 billion worth of stock, or more than 33 times the $90 million they bought.

Such outsized selling by insiders does not guarantee a market selloff, but it argues for one. So let’s add this data point to the “Probably Not Good” column.

Over the long term, as Chris Mayer, editor of Mayer’s Special Situations, points out in the column below, insider ownership is an extraordinarily useful leading indicator of a stock’s performance. In other words, the higher the level of insider ownership, the better the stock tends perform over time.

To learn more about this fascinating insight, read on…

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Follow the Scent
By Chris Mayer

I often think of good investing as the accumulation of small advantages. You want as many of these advantages working for you as possible. So here is one that a lot of investors don’t pay any attention to — insider ownership — and it turns out that it has a big effect on returns over time.

A new paper by Ulf von Lilienfeld-Toal and Stefan Ruenzi states: “Firms in which the CEO voluntarily holds a nontrivial fraction of the company’s stock outperform the market significantly…. The effect is most pronounced among firms that are characterized by large managerial discretion of the CEO.”

They go on to conclude:

“We find that value-weighted portfolios consisting of S&P 500 stocks in which the CEO holds more than 5% or 10% of the firm’s outstanding shares generate statistically and economically significant abnormal returns of 9.2% p.a. and 13.0 percent per annum, respectively. For S&P 1500 firms, the effect is only slightly smaller, with abnormal returns of 8.5% per annum and 12.1% per annum, for a 5% and 10% cutoff for managerial ownership, respectively.”

One of the many problems with today’s market is the fact that the people running companies are not owners. A typical American CEO owns hardly any of the company he runs. Whatever shares he has he gets through stock options, which he does not pay for. In addition, he gets paid an enormous sum of money in salary and bonus.

I read proxy statements. Very few do. Most investors probably don’t even know what one looks like, which is a shame. And it explains why corporate execs lavish so freely on themselves. The owners aren’t paying attention.

Anyway, proxy statements reveal to you the compensation of the management team and directors. It also shows you how many shares each of them owns. I’m always amazed at what some of these guys make. And I always get a little annoyed when I see how little they have at risk in their own firms.

There was a time when this situation would not have been tolerated. There is a quote from Frederick Lewis Allen that I like, which I reprinted in my book Invest Like a Dealmaker:

“In 1900, capitalism was capitalism indeed. Businesses were run by their owners, the people who had put or had acquired capital with which to finance them… It would seem wildly irrational that a man should manage the destinies of a corporation while owning only a minute fraction of the stock, as so frequently happens today.”

After I listen to some presentation by a CEO telling me how great his stock is, I always wonder to myself: “Then why don’t you buy shares?” I never come up with a good answer. If a guy is gonna get all gung-ho on his stock, yet he doesn’t own any, then I’ve got a beef with him.

It is true that in our aging modern industrial society, it is hard for a CEO to own a large percentage of some of our multibillion-dollar corporations. But he should own enough relative to his own salary and net worth that it makes him sweat. And he should buy shares out of pocket, and not have shares handed to him for free.

Intuitively, I’ve long believed that companies with insider ownership do better. I agree with the old money manager Martin Sosnoff, who once observed, “My experience as a money manager suggests that entrepreneurial instinct equates with sizable equity ownership.”

Often, the most creative and value-creating moves are made by management teams who own shares. Conversely, the stupid and value-destroying moves are often made by managers who don’t own shares.

Thoughts like this are what led me to include “owner-operators” among what I look for when investing in a stock. Most of the stocks I have recommended over the years have had significant insider ownership. The people running the companies have their money at risk just like us.

It doesn’t mean that every stock with high insider ownership outperforms. It means that as a group, these stocks have done better than those with little insider ownership.

This trait is something to look for when investing in stocks.

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[Rude Endnote: Asian markets followed Wall Street marginally higher overnight while those in Europe rather languish. Japan’s Nikkei 225 jumped 1.76% while Hong Kong’s Hang Seng surged almost 2%. The Aussie All Ordinaries also ended higher, though only by 0.1%.

Over in Europe, the major measures were somewhat underwhelmed. Last we checked London’s FTSE was up less than 0.1% while and Germany’s DAX was lower by almost 0.4%. France’s CAC was relatively unchanged.

Over in the commodity pits, crude and gold remain trapped in their trading ranges of the past few months. A barrel of the black stuff goes for $72 while an ounce of the yellow stuff sells for about $946.

That’s enough for today.

Until next time…

Cheers,

Joel Bowman

The Rude Awakening
aussiejoel@the-rude-awakening.com