We've said it over in Private Briefing many times: There are many reasons insiders sell shares of their company, but there's really only one reason they buy.
They believe their company's share price is headed higher - much higher.
And Eric M. DeMarco, CEO of high-level contractor Kratos Defense & Security Solutions, Inc (Nasdaq: KTOS), just bought 10,000 shares of his own stock.
The transaction took place Monday at $7.17 a share. Kratos zoomed nearly 9.2% yesterday to close at $7.74.
"BP, insiders are the ultimate arbiters of the future market value of a company," Money Map Press Chief Investment Strategist Keith Fitz-Gerald told me yesterday. "They enjoy the benefit of having the full purview of their company's future sales, future contracts, and future profits. They know what's coming down the 'pike.'"
Already a Winner
Keith has recommended Kratos to us on two occasions. The first was at $6.10 a share last June 6, on the eve of a cybersecurity summit between U.S. President Barack Obama and his counterparts in China. The stock zoomed as much as 51% after that and is still up more than 25%.
The second recommendation was made at the very end of 2013. Keith made Kratos his pick for the New Year in our special report: "Our Experts' Best Ideas for 2014."Even with yesterday's surge, we're roughly at breakeven on this newest recommendation.
But Keith believes that's about to change.
"BP, you've said it yourself: There's a huge body of work that shows that insider buying tends to be a bullish 'Buy' signal for stocks," Keith said. "And what a lot of investors don't consider is that this effect is much, much stronger with smaller-cap stocks than with their big-cap brethren."
Keith's right: We have talked with you before about this effect. In fact, just last month we told you that Jeffrey Immelt, the CEO of Private Briefing recommendation General Electric Co. (NYSE: GE), had just made a big purchase.
Insider buying is one of our favorite "Buy" signals.
In our 1998 Prentice Hall book Contrarian Investing: How to Buy and Sell When Others Won't and Make Money Doing It, my New York money-manager co-author Anthony Gallea and I found that insider buying on beaten-down stocks was the single-best "Buy" signal you're going to find.
The book is out of print now.
But the lessons still hold.
In fact, some very good research supports this.
In one paper, professors Carr Bettis, Don Vickrey, and Donn W. Vickrey found that "outside" investors who mimicked the moves of insiders would have outperformed other stocks of the same size and risk by nearly 7% per year - even after factoring in transaction costs.
In a second study, University of Houston Prof. R. Richardson Pettit and P.C. Venkatesh from the Office of the Comptroller of the U.S. Currency found that insiders tend to increase their net purchases up to 24 months before a stock generates an above-average return.
New research that's appeared since Prentice Hall published our book continues to make a bullish case for insider buying.
Independent researcher Market Profile Theorem (MPT) showed that insider trading trends signal an up-and-coming shift in market sentiment. To spotlight those trends, MPT analysts use a device known as the "Brooks Ratio," which divides total insider sales of a company by total insider trades (purchases and sales) and then averages this ratio for 2,500 stocks. If the average Brooks Ratio is less than 40%, the market outlook is bullish. But a ratio that exceeds 60% is bearish.
Obviously, MPT's research is focused on the overall market. But it lends credence to what Tony and I found for individual stocks.
And University of Michigan Professor Nejat Seyhun, author of Investment Intelligence from Insider Trading, came to the same conclusion that Tony and I reached: Stock prices rise more after insiders add to their holdings than they do after insiders sell.
The bottom line: Insiders make money from this legal type of "insider trading." And the returns they reap exceed those of the general market.
What makes DeMarco's Monday purchase so noteworthy is that it's not the only one he's made.
Back in December, we told you that DeMarco had also bought 31,273 shares of his company's stock at an average price of $6.40, spending about $200,150 to do so. Following the purchase, DeMarco directly owned 326,468 shares of Kratos stock with an approximate value of $2.1 million.
Monday's purchase at $7.17 means that he's adding to his position at increasingly higher prices.
We like that... a lot.
And with yesterday's move and close at $7.74, Kratos' shares have eclipsed their 50-day moving average of $7.68 and are closing in on their 200-day moving average of $7.79.
As the "technicians" among you well know, that's a bullish trend, too.
A number of Wall Street pros have grown tepid on Kratos here in recent weeks. In the near term, that's fine with us. It gives you a chance to add to your existing position, or to initiate a new one.
In the long run, Kratos is in all the right businesses. It's involved in drones, and in cybersecurity. And, most important of all, it helps the military manage its most sophisticated "warfighting" technology.
In the long run, that's a growth business.
DeMarco knows that. And so do we.
Now you do, too.
About the Author
Before he moved into the investment-research business in 2005, William (Bill) Patalon III spent 22 years as an award-winning financial reporter, columnist, and editor. Today he is the Executive Editor and Senior Research Analyst for Money Morning at Money Map Press.