How to Interpret Insider Transactions

 |  Includes: NUTR, SPRO
by: John DiStanislao
Insiders can only use public information but their advantage is the interpretation of this public data.

Every day there are thousands of insider trades, but most of this data is noise. The topic of insider trading has been studied and written about for many years in academia and for profit firms. Insider trading activity is not a magic potion. Many newsletters have failed to justify their existence and have folded by over relying or simply misinterpreting the information. But having said this, studies have shown correctly using insider trading activity does have forecasting value and can help in outperforming the market.

A summary of key points for using insider trading

  • There is a strong inverse relationship between the size of the firm and the usefulness of insider activity. Smaller companies provide more market outperforming information given they are less efficiently priced.
  • Insiders have a better understanding of the economics of their business and top executives (CEO, CFO) have the most accurate record. Large shareholders provide the least predictive value but shouldn’t be ignored in my opinion.
  • Purchases contain more information than sales. But multiple insider sales with a high short position can reveal potential company negatives.
  • Consensus activity increases the predictive information of the trades.
  • The size of the transaction is proportionally important.
  • Analyze open market transactions and ignore private transactions.
  • It seems logical Insider activity within certain industries such as biotechnology may provide more directional information. The thesis is management understands the science and future possibilities of new drug breakthroughs or ability to pass future FDA hurdles.
I ran a query for positive insider activity but added important value factors.

Some of the stocks I found:

Nutraceutical (NASDAQ:NUTR) has successfully created shareholder value with a sensible capital allocation strategy. ROIC before taxes has averaged an enviable 21.58% for the past 4 reported fiscal years but has fallen to 13.81% for the most recent year end. The drop is not due to the margin compression that has actually risen from 52.56% in 2004 to 54.40% 09/08. The lower ROIC is directly attributable to SGA increasing 31.87% from 2004 coupled with sales improving 18.56% forcing operating margins to decline. But based on ROIC NUTR solidly outperforms its publicly held direct competitors: Schiff Nutrition (WNI), Natural Alternatives (NASDAQ:NAII), NBTY (NTY), Natural Alternatives International (NAII) or Mannatech Inc (NASDAQ:MTEX). At this point the profitability for NUTR is significantly higher than its peers and represents a bargain price with a current EBITDA/EV at 25.20%. Historical it has managed to keep its capital structure clean with a relatively constant outstanding share count over the past several years. The solid financial health is supported by years of well managed strong FCF.

SmartPros (NASDAQ:SPRO).

Years of sustained significant free cash flow has provided capital for growth and an outstanding balance sheet. Revenues have grown 79% along with total equity since 2004 through small acquisitions and to a lesser extent organic growth. After tax ROIC has average 14.18% since 2004. Although barriers to entry are not insurmountable their growing library of educational solutions, customer base, professional relationships, and educational certification regulation make entry challenging. The current enterprise value is less than the market cap given the large cash balance versus total liabilities. The shareholder base is controlled 13% by senior management and 9.9% by the successful micro cap value institution Osmium Partners up from 5.1% reported on the 04/28/08 proxy.

PDC is not a traditional Graham and Dodd value stock but instead a cyclical growth stock contingent on the future demand and domestic drilling requirements for natural gas and oil. Natural gas has been trading at a 6 ½ year low and this has weighed on the price of PDC not seen since 2003. The low stock price has attracted insider purchases as the stock is a fraction of its 52 week high of $20.75 or a market capitalization of 1 billion. PDC’s success is directly influenced by the financial health and growth of domestic exploration and production companies.

The recent 350 million expended on 2008 acquisitions may have been poorly timed and is temporarily weighing on financial flexibility. An impairment charge was recorded for the recent quarter in the amount of 118 million. Management has taken the correct steps to reduce certain costs during the downturn in the industry cycle. As demand for domestic sources of Natural Gas increases and to a lesser extent Oil the full value of PDC will should be realized.

Full disclosure: I own shares of NUTR, SPRO and PDC.