When the Smart Money Gets Smarter

Weekly Issue

Wall Street has an uncomfortable relationship with insider buying. The industry would prefer we ignore it entirely. After all, when corporate executives put their own capital at risk buying shares of their deeply undervalued companies, they are making a rather pointed statement about what Wall Street analysts are missing.

The academic evidence on this phenomenon proves far more compelling than the typical hand waving we receive from the sell side. Over the past 25 years, stocks with extensive insider purchases have outperformed those with extensive insider sales by nearly 8 percentage points annually.

When we combine this insider buying signal with deep value characteristics, particularly in stocks trading below tangible book value, the excess returns expand to 10 percentage points or more.

These are not rounding errors. These are batting averages that separate the professionals from the amateurs.

For investors focused on community banks and real estate investment trusts, this combination of insider conviction and balance sheet undervaluation offers a systematic approach to identifying opportunities that Wall Street has incorrectly priced.

The strategy performs with particular effectiveness during periods of market stress, precisely when our contrarian instincts tell us opportunity exists but our emotions counsel caution.

The combination of insider buying and below tangible book valuation creates what Benjamin Graham would have recognized as a classic margin of safety with an informational edge.

Corporate executives possess asymmetric information about their businesses. They understand credit quality, loan loss reserves, property valuations, and business momentum far better than any outside analyst. When these insiders choose to deploy personal capital at prices below the liquidation value of tangible assets, they are telling us something material about future prospects.

Research from the University of Illinois documented that portfolios mimicking insider purchases generated abnormal returns of 50 to 67 basis points monthly, translating to 6% to 8% annually above market benchmarks.

Tweedy Browne, the value investment firm with roots extending back to Graham himself, found that stocks in the cheapest 20% by price to book value where insiders were buying beat the market by more than 10 percentage points annually.

Stocks trading below tangible book value concentrate in asset intensive industries. For our purposes, this means community banks, insurance companies, and real estate investment trusts. These sectors depend heavily on tangible assets, balance sheet quality, and credit analysis rather than intangible assets or blue sky projections about future growth.

This is value investing territory, where we can see what we own and calculate what we are paying for it.

During periods of financial stress, the below book opportunity set expands dramatically. The 2008 through 2009 financial crisis saw major banking institutions including Citigroup, Goldman Sachs, and Bank of America trading well below tangible book. Regional banks trading at 50 to 70 cents on the dollar of tangible equity saw extensive insider buying.

Research from the Bank for International Settlements confirmed that insiders who purchased bank stocks during the crisis successfully predicted returns that were substantially larger and longer lasting than purchases during normal periods.

The COVID crash of March 2020 provided another episode. Real estate investment trusts plummeted as investors feared rent collection failures and property value destruction. Many quality REITs with fortress balance sheets traded at 40 to 50 cent discounts to book value. Insider buying accelerated dramatically.

Those securities generated 80% to 100% returns within 12 months as property fundamentals remained far stronger than panic pricing suggested.

The 2023 regional banking crisis created yet another opportunity set. The median price to tangible book for US banks dropped from 1.12 to 0.94 as Silicon Valley Bank and Signature Bank failures created indiscriminate selling across the sector.

Quality community banks with conservative loan books, ample liquidity, and strong capital ratios traded alongside troubled institutions. Insiders at the quality banks understood the distinction. Their purchases at these levels proved prescient as the sector rebounded sharply.

The research on which insiders to follow contains several surprises that contradict conventional wisdom. Analysis of over 1.5 million transactions revealed that chief financial officer purchases generate the highest predictive value, outperforming chief executive officer purchases by more than 2 percentage points annually.

CFO purchases averaged 21.5% annual returns compared to 19.3% for CEO purchases.

This CFO advantage reflects what researchers call the scrutiny hypothesis. Chief executives operate under constant media attention and public visibility. Their trading activity receives immediate analysis and commentary. This scrutiny limits their willingness to trade aggressively on information.

Chief financial officers possess equally detailed knowledge of financial forecasts, margins, and cash flows but operate with less public attention. They can act more opportunistically.

Directors rank second in predictive power, particularly for small cap value stocks. Outside directors bring fresh perspective and often serve on audit and risk committees where they see detailed financial information. Their purchases carry substantial weight.

Large shareholders, those owning more than 10 percent of shares outstanding, performed worst in the dataset, actually underperforming the market by nearly 2 percentage points. Their distance from daily operations limits their information advantage.

The most important distinction, however, is not between C suite and non C suite buyers but rather between opportunistic and routine trading patterns.

Research published in the Journal of Finance documented that routine trades, comprising over half of all insider transactions, show essentially zero predictive ability. These are programmatic sales under 10b5 1 plans or regular option exercises. They contain no information.

Opportunistic trades generate 82 basis points monthly in abnormal returns, translating to nearly 10% annually. These are the open market purchases made outside of regular patterns, often during periods of price weakness.

When multiple insiders purchase shares within a narrow window, typically two days, the signal strength increases substantially. This cluster buying phenomenon indicates widespread conviction among those with the best information.

Research documented that cluster purchases generated 3.8% abnormal returns over 21 trading days compared to 2.0% for solitary insider purchases.

Over 90 day horizons, the performance gap reached 2.5 percentage points.

For community bank investors, cluster buying often occurs following earnings disappointments or credit concerns that prove temporary. Multiple insiders see the same information and reach the same conclusion: the market has overreacted.

Their coordinated purchases at depressed prices below tangible book value combine informational advantage with deep value characteristics.

This is the sweet spot.

Purchase size shows surprisingly weak correlation with subsequent returns. The notion that bigger purchases indicate higher conviction finds little support in the data.

High return insider traders tend to trade infrequently in modest amounts rather than making large, attention grabbing purchases.

The key variable is whether the purchase is opportunistic and whether multiple insiders are buying, not the dollar amount of any individual transaction.

Following insider buying mechanically without regard to underlying financial quality creates a value trap problem. Research on low price to book stocks demonstrates that adding quality screens dramatically improves returns while reducing volatility.

The Piotroski F Score, a nine point measure of financial strength, improved low price to book returns by seven to 13 percentage points annually by filtering out companies with deteriorating fundamentals.

For banks specifically, we should require positive return on assets, improving or stable net interest margins, low nonperforming asset ratios below 2%, strong capital ratios with tangible common equity above 10 percent, and Tangible book value growth

For REITs, focus on debt to income, net asset values, operating cash flow, and funds from operations.

The idea is to make sure we are buying fortress balance sheets at distressed prices rather than deteriorating businesses heading toward terminal decline.

Insider buying at a troubled bank facing serious credit problems is not the same phenomenon as insider buying at a quality institution trading below book value due to temporary market pessimism or sector rotation.

The distinction matters enormously.

Combining insider buying with below tangible book value creates a systematic approach to identifying undervalued community banks and REITs that Wall Street has mispriced. The academic evidence spanning 25 years documents excess returns of 7 to 13 percentage points annually when implemented with proper filtering with measures of credit quality and financial strength

Most importantly, we must be willing to act when others are fearful, deploying capital during market stress periods when the opportunity set expands.

This is not market timing.

This is systematic value investing with an informational edge. When corporate executives with asymmetric information choose to buy shares of their own companies at prices below liquidation value of tangible assets, we should pay attention. They are telling us something Wall Street has missed.

The evidence suggests we should listen.