Q: Why do you believe following insiders is a better investment strategy?
A : The Catalyst Insider Buying Fund was started based on a study that we did going back to 1974 in which we found that companies with at least three executives, who were buying at least 10,000 shares of their own stock with their own money, would beat the market by 11.5 percent on average in the following year.
We found firms with the most extreme insider selling activity would underperform the market by 4% on average in the following year. It didn’t seem to matter whether the stock market went up or down, the companies with the most insider buying would do better than the ones with the most insider selling.
Given that’s what we’ve been doing in the fund, I don’t think it’s too surprising that it has beaten its large value benchmark each year running since inception (2011, 2012, 2013).
That is really the philosophy behind the fund. We believe these companies are great to own when top executives of the company, who supposedly are the most informed about the company where they work, are willing to take more cash out of their pocket and invest in the company, when they already have their own salaries and stock options and livelihoods tied up in that particular company. They’re not going to purchase that stock unless they have very good reasons to have that confidence.
The insider buying activity is far more relevant than insider selling activity because buying is more representative of management confidence. Avoiding companies where there is heavy insider selling activity only helps us to avoid downside in the stock. We found we can get more of the upside of the market with less downside capture by avoiding those firms that have the most insider selling activity.
Q: Where does your investment process start?
A : Our investment process begins with the regulatory filings that the insiders must do with the Securities and Exchange Commission.
With the advent of the Sarbanes-Oxley Law, the time period to file with the SEC was cut down from up to two months to a maximum of 48 hours. We get all that data the moment the insiders trade their stock, and after they file all that information comes onto the SEC’s EDGAR website.
Q: How do you rank companies?
A : We rank these companies based on how many executives are buying or selling their stock, how many shares they’re buying or selling, how well those executives have timed the highs and lows of their particular stock price over the past decade, and then how highly ranked that executive is at that firm. For example the CEO, CFO, chairman and CIO all seem to have more alpha in their transactions than a director or a 5 percent-plus shareholder, who doesn't have as much direct insight into the day-to-day operations of that particular company.
Q: How does your investment process work? Do you focus on certain sectors or industries that are hard to evaluate?
A : We have found essentially that the harder an industry is to understand, the more meaningful the signal that the insider’s purchase or sale indicates, relative to the future performance of that firm.
For example, if you have a small cap biotech company in the product development stage and no revenue, whether the insiders are buying or selling that company is probably the most relevant indicator because there’s nothing else you can really track. What’s most relevant to that firm is whether that drug will get approved or not, and if that drug does get approved what the sales for that drug will be.
It is really hard for outside investors to understand that the insiders have a tremendous advantage. For example, larger firms like IBM may attract lot of attention from Wall Street analysts. Smaller firms generally lack analyst attention, so insider activity is one of the better barometers.
In addition, insiders at technology companies have a natural predilection towards selling because a high percentage of executive compensation is driven by stock options. The insiders are more prone to sell and it’s that much more significant if an insider is buying into a technology company than if they’re buying into a firm where there is no stock option related compensation.
However, we’re not trying to make sector bets for these industries, we simply let the insiders at these firms guide us as to which sectors to invest in, which companies to invest in within those sectors and which sectors to avoid. Interestingly, it can be a great macro indicator or sector indicator based on what’s happening with the insider activity at any given company as well.
By simply investing in the firms that have the most insider buying and avoiding the companies with the most insider selling or the industries and/or sectors with most insider selling, we can help to minimize the volatility in our portfolio and the drawdowns, and maximize our upside capture.
Q: Do you have a preference among companies where insiders are buying?
A : For us it is very simple. With two companies that both have good insider buying criteria we simply buy both. We want to own each of the companies which have heavy insider buying, because we really want the performance of the strategy to be reflected in our fund, rather than our idiosyncratic bets on particular stocks or particular industries.
Q: Can you give examples of companies that you invested in and also companies that you avoided?
A : In 2008 there was huge insider selling. At Bear Stearns, top executives were selling hundreds of millions of dollars worth of stock before they were rescued by JP Morgan. In 2000 you had huge insider selling in Internet stocks before they went under. In 2001 there was huge insider selling in Enron, and that company had some very significant problems.
This year we’ve had some great situations, companies like Keurig Green Mountain before they announced a distribution deal with Coca Cola. The stock went 30% up that day.
CIT Group, where CEO John Thain bought over $4 million worth of stock before announcing that they were going to acquire OneWest Bank in California. That made them large enough that the Fed determined that they are a systemically important institution. CIT stock popped 12%.
Executives at Kinder Morgan related entities had heavy insider buying led by Richard Kinder, the CEO of KMI. He bought over $50 million of stock and a director bought over $20 million of stock before the company announced that they were going to consolidate all of the Kinder Morgan related subsidiaries under KMI. Collectively their stocks popped 21% that day.
When you have all these executives buying in a really big way before a deal happens, it’s hard to imagine that they don't have some special information that enables them to create some extra alpha that the average investor isn’t really privy to.
Q: How early was insider buying going on before the deals were announced?
A : In the case of Kinder Morgan, they were buying the entire year preceding those transactions.
At Keurig Green Mountain, the most significant insider purchases were in August of 2012, when there were multiple directors and the president all buying a lot of stock between $21.57 and $24.09.
Insiders proceeded to sell thereafter in the $80s. In August of 2013 David Moran and some of these executives, including Lawrence Blanford, all started selling stock around $86 a share. Roll around to November 2013 and a number of these same directors all started buying again about November 25 and they were paying around $64.58 up to $69.51 a share at the time. Subsequently, the stock has rallied back up to $100.50.
Q: What is your buy-and-sell discipline?
A : We will buy a stock as soon as we've seen three executives buy 10,000 shares or more, where at least one of those executives buying was a C-suite officer. Then we will get out of that stock as soon as we see that the executives who were buying are starting to sell, or, if it’s been a year and a day and they’re not buying any more, we will start to sell that stock.
Or if the stock quickly rallied from let’s say in the $40s to the $70s and insiders aren’t buying any more in the $70s, we don’t want to own it just because they used to like to buy it in the $40s. So for us it’s really about continually rebalancing the portfolio to make sure we own a portfolio of stocks that has had recent insider buying by top executives.
Q: This seems to be a very short term driven strategy and you may give up a large rise in the stock down the line. How do you deal with that?
A : We don’t try to second-guess the insiders’ decisions. If they’re buying a company, we want in on it; if they’re selling that stock, we don't want to own it.
That will definitely mean that we’ll miss out on some situations where we otherwise would have done well. However, we think that in the aggregate if we maintain our portfolio purely focused on the companies that have the most recent significant insider buying and hold those companies for at least a year to get the optimal tax treatment, we’ll do the best. By not inserting our personal predilections into the companies and not second-guessing the insiders and thinking that we know more than they do, and by simply owning a widely diversified portfolio of companies that have heavy insider buying at any particular moment, we think we’ll do the best.
Q: Do you believe in diversification?
A : We have sector limits in the sense that we won’t go over 25% holding in any one particular sector at any given time, however, we don't want to try to put ourselves into a sector and own that sector simply because they have a representation in the S&P 500.
We simply choose to own a portfolio that's diversified into sectors where insiders have confidence and avoid all the others and/or overweight the sectors that have the most insider buying in order to avoid volatility, get less downside capture and greater returns.
Q: What is your benchmark for the fund?
A : We tilt a little bit towards value however we’re happy to invest in growth companies if the insiders are buying there, so it’s not really a choice between growth and value. We’re just trying to invest in companies where insiders have the most confidence, but generally that will tilt a little bit towards value as insiders generally like to buy their companies when they’re cheap and sell them when they’re expensive. Compared to the S&P 500 Index, the fund is about 112 basis points ahead of the benchmark annualized over the past three years.
Q: How many holdings do you end up having?
A : Right now we have 43 stocks in the portfolio, which is relatively typical. It will vary based on the degree of insider buying and/or selling activity at any given moment but that’s in the normal range. The number of holdings could vary anywhere from 30 up to 150.
Q: Does insider behavior differ from small cap companies to large cap?
A : There’s much more significant insider buying in small cap companies on a relative basis than there is in large cap companies, in part because large cap companies generally have more stock option related compensation than smaller firms do and more executives are working at larger firms.
Small firms will frequently also have a more significant activity at their particular company because they are more pure line businesses whereas there are more multi line businesses traditionally in large firms. If you have a large conglomerate there is less potential for alpha in that firm, because it’s not one particular piece of information that drives their trends nearly as much as it would be in a smaller firm that purely has one simple business line.
The strategy works best in small caps, it works well in mid caps and it works well in large caps as well, but the larger the company is the less influence there is from the insider activity. However, you get more consistency in terms of the outperformance in larger firms than you do in smaller firms.
Q: What do you do when something is not working?
A : We get out fast. As soon as we see that some terrible event occurred at that company that insiders weren’t aware of or there’s some significant lawsuit or just some significant external event that’s completely irrespective of insider activity that invalidates our signal, or if an insider starts to sell when they were buying previously our goal is to get that stock out of our portfolio as quickly as possible so that we can minimize the impact of that stock on our performance.
Q: So you follow insiders, end of story.
A : Exactly. Our thesis is that nobody knows more about a company than the executives of that firm could possibly know, because any information that anyone else gets on that firm is really secondhand information that’s ultimately coming from those insiders and whatever those insiders provide the public. We think the most valuable investment signal that you can get on any firm is the purchase and/or sale of that firm’s stock or by the top executives at that firm. We’ve done over 20 back tests on multiple different strategies and we haven't found a single one that has more alpha than insider activity.
Q: In addition to the Catalyst Insider Buying Fund, invested in large caps, the Catalyst Small-Cap Insider Buying Fund* also utilizes the same strategy. What are the assets under management in the two funds?
A : They are about $420 million in the large cap fund and slightly over $100 million in the small cap fund.
Q: How do you define risk and then what kind of risks do you monitor?
A : The way we primarily define risk is the potential for a significant drawdown and/or permanent impairment in our investors’ capital. That’s really what we’re trying to avoid in the most significant way is a permanent impairment in investor capital.
We think investors can survive a five-to-ten percent down move in the market; however, we don't think that investors can really stomach the idea of a 35-40% type of drawdown. In 2008 for example there was extreme insider selling across the market with very little in the way of insider buying activity, which turned out to be a great macro indicator.
We put on a significant cash position in our small cap insider buying fund. In that year we had up to 68% cash at the peak. That's really the type of risk we are trying to avoid. I think investors can look at it from another standpoint which is risk-adjusted performance and/or Sharpe Ratio.
How much return is an investor getting per unit of standard deviation they’re taking in their portfolio? Our goal is really to maximize that Sharpe Ratio that we’re generating for investors and to keep it over a one, so for every unit of risk that they are taking, they are getting more than one unit of return.
{{* The Small-Cap Insider Buying Fund previously looked at earnings yield, return on capital and insider buying but now exclusively focuses on insider buying.}}
