Cheap Stocks Insiders Love

Most of us like to believe life is fair. But, in reality, very few market transactions are fair. Economists believe almost all transactions involve asymmetric information. In most transactions, one party knows more than the other party. For example, when consumers are buying a used car it seems fair to assume the seller knows more about the car than the potential buyer. This problem is so well known many states and the federal government have taken steps to level the playing field.

Their efforts to create fairness are called “lemon laws” and usually require sellers to compensate buyers of used cars that repeatedly fail to meet minimum standards of quality and performance. The federal government passed a lemon law in 1975 and many states have supplemental legislation. The laws may not be perfect and there are times when they fail to protect consumers. But, lemon laws are an attempt to fix the well-known problem of information asymmetry in the used car market. Disclosures are also required for mortgages, many consumer finance products, real estate and other important markets.

Information asymmetry also extends to the financial markets. Potential investors have only limited information about a company. The only information generally available to investors is the information management chooses to disclose. There are a number of laws and regulations that define what information management must disclose but there are always questions about whether those rules cover every possible situation. In reality, the rules cannot cover every conceivable situation but most management teams attempt to ensure investors have access to all information that is relevant to the company’s future.

Despite the rules and the sincere desire of many managers to disclose information, some information is kept secret. This should include business plans that provide a competitive edge to the company. Because 100% disclosure is impossible, there will always be some degree of information asymmetry in financial markets. Management will always know more than investors.

Because of this, Congress has long sought to reduce the potential impacts of the problem. Corporate insiders, defined as the company’s officers and directors along with beneficial owners of more than 10% of the company’s stock are required to report any changes in ownership. This rule has been in place since 1934 when Congress passed the Securities Exchange Act of 1934. The Securities and Exchange Commission (SEC) have updated the rules over the past 70 years and forms are now available immediately to investors over the internet.

Insiders are required to report their transactions on several different forms. Two are important to individual investors. The initial filing is made on an SEC Form 3. Any new insider or an insider making their first stock purchase is required to file this within 10 days of becoming an officer, director, or beneficial owner or within 10 days of their first buy.

Changes in ownership are reported on Form 4 and must be reported to the SEC within two business days. Form 4 is used to report additional buys and all sales.

These forms are available on the SEC web site and at a number of other web sites. Many data services track these filings because they can provide important information to investors.

Remember, no one knows a company better than an insider. They have more information than individual investors and they have secret information about business plans. Insiders often see internal projections and may know about potential changes in the trends in sales and earnings before analysts are able to piece together the information.

When an insider makes a purchase, they are committing their personal funds to invest in the company. They may be acting on information they have access to that is not yet publicly available. Likewise, when they sell they might be reacting to business developments that are not yet apparent in publicly available information.

Because the information about insider transactions is available to the public, it can be used to identify potential investments. But, we need to be careful in interpreting these filings.

While an insider may be selling ahead of bad news, they might also be selling to diversify their wealth. For example, Mark Zuckerberg, the CEO and founder of Facebook, automatically sells millions of dollars’ worth of stock in his company every month. This is commonly done and it is prudent since the founders deserve to diversify their wealth.

Insiders might also sell to raise cash to buy a house, finance a child’s education or any other major expense. For this reason, insider selling is not always bearish.

The same is true of buying. Not all insider buying is a bullish opinion of a stock. It could be a planned acquisition strategy or even a deliberate attempt to deceive investors by appearing to be bullish.

Understanding this, it can be best to evaluate insider transactions with some guidelines. Clusters of activity, several insiders taking the same action at about the same time, is most likely more meaningful than isolated buys or sells. This week, we looked for clusters of buying activity.

Specifically, we searched for companies where at least three separate buys were reported. We also required the number of shares bought by insiders to exceed the number of shares insiders sold. We also required the stocks to be members of the S&P 600 index so that we could focus on small cap stocks, the type of companies that insiders could understand very well. It can be more difficult for insiders to fully understand the operations of a global conglomerate and insider buying in these companies may not be as significant as it is in small caps. Finally, we limited our search to stocks trading at a low price, less than $15 a share, because low-priced stocks can deliver large gains.

We found four companies:

Fred’s, Inc. (Nasdaq: FRED) sells general merchandise through its retail discount stores and full-service pharmacies. As of January 28, 2017, the company operated 628 retail stores, including 55 express stores and 3 specialty pharmacy-only locations; 362 pharmacies; 3 specialty pharmacy facilities; and 16 franchised stores in 15 southeastern states. The company also owns and operates Getwell Drug & Dollar, which offers an expanded over-the-counter medication selection, individualized patient care, and more than 1,700 $1 items.

FRED offers a dividend yield of about 1.7%, providing a small payment to investors as they await potential gains in the stock price.

Synchronoss Technologies, Inc. (Nasdaq: SNCR) provides cloud solutions and software-based activation for connected devices worldwide. The company’s products and services include cloud-based sync, backup, storage and content engagement capabilities, broadband connectivity solutions, analytics, white label messaging, and identity/access management that enable communications service providers, cable operators/multi-services operators, original equipment manufacturers with embedded connectivity, and multi-channel retailers, as well as other customers to accelerate and monetize value-add services for secure and broadband networks and connected devices. The company’s products and platforms are designed to enable multiple converged communication services to manage across a range of distribution channels, such as e-commerce, m-commerce, telesales, customer stores, indirect, and other retail outlets.

SNCR is trading at about 10 times estimated earnings, a discount to its peers and the broad stock market.

Rent-A-Center, Inc. (Nasdaq: RCII) leases household goods to customers on a rent-to-own basis. It offers products, such as consumer electronics; appliances; computers, including tablets; smartphones; and furniture, including accessories under rental purchase agreements. The company also provides merchandise on an installment sales basis; and offers the rent-to-own transaction to consumers. It operates retail installment sales stores under the Get It Now and Home Choice names; and rent-to-own and franchised rent-to-own stores under the Rent-A-Centre, ColorTyme, and RimTyme names.

RCII is trading at a price to earnings (P/E) ratio of about 12 based on next year’s expected earnings, one-third below the industry average P/E ratio.

Quorum Health Corporation (NYSE: QHC) provides hospital and outpatient healthcare services. Its general hospital and outpatient healthcare services include general acute care, emergency room, general and specialty surgery, critical care, internal medicine, obstetric, diagnostic, psychiatric, and rehabilitation services. The company also offers its healthcare services through its hospitals and affiliated facilities, including urgent care centers, diagnostic and imaging centers, physician clinics, and surgery centers.

QHC is trading at about 60% of its book value and is at a discount to its peers based on the price to sales ratio.

Any or all these companies could be long-term winners based on the belief of the insiders who know the companies best.