A Unique Way to Analyze “Insider Sentiment” and My No. 1 Pick to Profit from It

Last week, we booked a quick +52.4% profit on AeroVironment (AVAV).

I say “quick” because AVAV was in our Adventure Capitalist portfolio for less than seven months.

AeroVironment designs, develops, produces, supports and operates unmanned aircraft systems (UAS) and efficient energy systems (EES) in the U.S. and internationally.

Through intensive research, I found that this company was the best pure-play method to gain exposure to the fast-growing, drone technology space.

To refresh, I dissected the Reality Shares Drone Index (RSD) – the benchmark for the ETFMG Drone Economy Strategy ETF (IFLY).

Normally, you would think IFLY would be a great way to invest in drones. IFLY’s fact sheet states:

The ETFMG Drone Economy Strategy ETF was created to provide the market with a transparent vehicle to invest in the increasingly important drone tech sector. The fund seeks to provide investment results that, before fees and expenses, correspond generally to the price and yield performance of the Reality Shares Drone Index. The companies in this index are those which work to develop, research or utilize drones as a major part of their business model.

But, after my investigation, I determined this ETF wasn’t much of a so-called drone ETF after all.

You see, I screened all the index constituents by “percentage of total revenue from drones.”

Most investors would never attempt this task. These aren’t easy calculations to find. You can’t run a typical screen to get this data. It involves digging through each company’s annual reports or other financial information to find each index constituent’s true exposure to the drone industry. In my case, I did some of this work and enlisted the help of senior index analyst colleague, as well.

Here’s what I found:

There were 47 holdings in the index. Of which, 42 holdings (89%) got 5% or less of total revenue from drones … 39 holdings (83%) got less than 3% of total revenue from drones … and each of the top two holdings – the only real pure plays – got more total revenue (percentage-wise) from drones than all the other holdings (45) combined!

In the end, I recommended the stock with the most drone exposure in the stock market, AVAV. Roughly, 90% of AVAV’s revenue was drone-related.

I enjoy this kind of work. In part, because I know no one else is doing it and it can give my subscribers an information edge.

And this month, I’ve completed another index probe to laser in on one stock that could bring us fast gains again just like AVAV did.

I’ll walk you through the extra steps I took to narrow this index’s holdings down to the most opportune stock in a moment. But first, let’s review this standout ETF and the methodology behind its underlying index.

Get “In the KNOW” with this ETF

Former star Fidelity Magellan Fund manager Peter Lynch, who averaged 29% annual returns from 1977 to 1990, once said:

Insiders might sell their shares for any number of reasons, but they buy them for only one: They think the price will rise.

Lynch was referring to corporate insiders. A group including CEOs, CFOs, other high-level executives and anyone else with key company information before it’s made available to the public.

Lynch tracked corporate insider activity back in his heyday. He knew these insiders had an advantage over amateur and professional investors because they knew their companies and industries better than everybody else.

As an investor, no matter how much research you do … or how much financial news you consume … you’re always a step behind those “in the know.”

Imagine if you could peek through the keyhole – or listen through the old glass on the ear and wall trick – of a publicly traded company boardroom…

You might gain access to valuable information if you were privy to these closed-door conversations.

If you engaged in any of these shenanigans, you’d probably receive a security escort out of the building. And if you subsequently traded off non-public information, it’s much worse. That’s punishable by the SEC.

But, there’s a “legal” way to do the next best thing: Follow specific insider transactions.

Anyone can track insider buying because insiders are required by law to file a “Statement of Changes in Beneficial Ownership of Securities” (SEC Form 4) within two days of a completed transaction.

It looks like this:

Several academic studies have analyzed insider trades (specifically, insider buying) over the years:

  • “Predictive and Statistical Properties of Insider Trading”-Published in 1968 by James Lorie (University of Chicago) and Victor Niederhoffer (University of Chicago).
  • “Insiders and Market Efficiency”-Published in 1974 by Jeffrey Jaffe (University of Chicago).
  • “Special Information and Insider Trading”-Published in 1974 by Jeffrey Jaffe (University of Chicago).
  • “Market Efficiency and Insider Trading: New Evidence”-Published in 1988 by Michael Rozeff (SUNY at Buffalo) and Mir Zaman (University of Iowa).
  • “Why Does Aggregate Insider Trading Predict Future Stock Returns?”-Published in 1992 by H. Nejat Seyhun (University of Michigan).
  • “Are Insiders’ Trades Informative?”-Published in 1998 by Josef Lakonishok (University of Illinois at Urbana-Champaign, NBER) and Inmoo Lee (Dimensional Fund Advisors).
  • “Estimating the Returns to Insider Trading: A Performance-Evaluation Perspective”-Published in 1999 by Leslie Jeng (Boston University School Management), Andrew Metrick (The Wharton School, University of Pennsylvania, NBER), Richard Zeckhauser (John F. Kennedy School of Government, Harvard University, NBER).

The general conclusion is that insider buying tends to outperform the market by 6% to 10% per year depending on which study and time frame are observed.

The problem is, it takes a ton of time to compile and examine the data on thousands of stocks. Most investors don’t have the time, technology and resources to tackle a mission of this magnitude.

However, thanks to the advent of ETFs, there’s an easy solution available.

The Direxion All Cap Insider Sentiment Shares ETF (KNOW) launched on Dec. 8, 2011.

KNOW tracks the Sabrient Multi Cap Insider/Analyst Quant-weighted Index (SBRQAM). This index seeks to quantify the general sentiment among both traditional corporate insiders (e.g., corporate officers, directors, major shareholders, etc.) and the Wall Street analyst community.

Sabrient Systems, the quant shop who created the index, considers both groups to be “insiders” in a broad sense. Theoretically, both corporate insiders and Wall Street analysts have the most in-depth knowledge of a company, its industry and its competitors.

The index doesn’t rely on just these two important measures, though…. Here is its construction process.

Constituent selection process:

  1. The constituents of the S&P Composite 1500 Index are eligible.
  2. There are no sector or industry-weighting constraints.
  3. Elimination of stocks of companies with very aggressive accounting-based proprietary forensic accounting methodology.
  4. All but the final 100 stocks are then removed by screening public company filings relating to the frequency of insider trades, purchases of stocks and increases in holdings by a company’s insiders, as well as positive earnings analysis.
  5. The remaining stocks are ranked using a defensive methodology that identifies stocks that have performed well in weak markets, have a strong free cash flow yield and a strong dividend yield.

This methodology has resulted in outstanding performance for KNOW since its debut.

As you can see, KNOW has racked up market-beating returns. Since its inception, KNOW has outperformed the S&P 500 Index and S&P Composite 1500 Index by an average of almost 1.5% per year. On a calendar-year basis, KNOW has also beaten both those indexes in four of the last five years.

If you’re interested in an ETF with a solid history of outperformance and a unique strategy that has worked over time, KNOW may be your cup of tea. And you can add the ETF to your portfolio today.

But, as I mentioned before, I’ve done some extra work on KNOW’s underlying index and have come up with my favorite holding to buy…

Dissecting SBRQAM

Sabrient Systems was founded by former NASA engineer David Brown in 2000. David put together a team of math whizzes – a former civil/structural engineer from Chevron, an electrical engineer with a Ph.D. in economics, and a economist with a Ph.D. in electrical engineering, a mechanical/aerospace engineer from SAIC Inc., and various other computer scientists – with a concentration on quantitative research.

David also acquired Gradient Analytics, which added a group of forensic accounting specialists with skill in the examination of financial statements and accounting practices.

Over time, Sabrient Systems has built multifactor quantitative models that account for uncertainties. Like “insider sentiment.”

The SBRQAM index’s performance extends a few more years (no wonder Direxion decided to launch an ETF linked to this index)…

SBRQAM has almost doubled the returns of SPY (SPDR S&P 500 ETF Trust) and IWM (iShares Russell 2000 ETF) since 2007. The index, going year by year, has outrun SPY in nine of the last 10 years and IWM in seven of the past 10 years.

I showed you the methodology behind all this earlier. Remember, beyond actual insider buying, it lumps in Wall Street analyst positive revisions to earnings estimates and a defensive overlay.

So, I decided to fine-tune this methodology and kick out the Wall Street analyst estimates and defensive factors to isolate “true” insider activity. That means I focused on the number of insiders buying company stock on the open market (taking money out of their own pockets to buy company stock – not option exercises) and the magnitude of the increase in an individual’s beneficial ownership for the most recent month (October).

With some assistance from contacts at Sabrient Systems, here’s what I came up with:

The table above shows the top 25 stocks out of 100 stocks in the index sorted by “insider score” (second column from the right). This scoring is calculated by using the number of open-market insider buyers + the percentage change in ownership.

I also included the weight in the SBRQAM (far right column). As you can see, a stock that has the highest insider score doesn’t receive the highest weight in the index due to the other factors involved.

Just like we did with AeroVironment back in April, we’re going with the No. 1 stock on this list. While AeroVironment gave us the greatest exposure to the drone industry, Tiffany & Co. (TIF) is the highest-scoring stock in terms of insider buying.

An Iconic, High-end Jeweler

Tiffany is a leading global retailer, designer, manufacturer and distributor of fine jewelry and gift items.

Charles Lewis Tiffany founded the company in 1837. Over its 180-year history, the company has developed into an iconic luxury brand known by the world’s consumers.

The Tiffany brand includes jewelry, watches, sterling silver merchandise, china, crystal, stationary, fragrances and other accessories.

The company has a global reach. In terms of net sales:

  • Americas (47%)
  • Asia-Pacific (24%)
  • Japan (13%)
  • Europe (12%)
  • Rest of the world (4%)

Global consulting firm Interbrand ranks Tiffany as the world’s fifth most valuable luxury brand.

The company’s strong brand recognition has allowed Tiffany to maintain consistently high margins and returns.

For example, the company has a gross margin of 62.5%, an operating margin of 18.3% and a profit margin of 11.4%.

And return-wise, the stock has been an outstanding performer over the long run. Going back to its 1987 IPO, TIF has returned a cumulative 5,660% vs. S&P 500’s 1,750%.

Again, Tiffany caught my eye as several insiders were scooping up shares in the last month. Four insiders bought company stock in October and their percentage change in ownership increased by more than 135%!

While that’s the primary reason I’m adding TIF to our Adventure Capitalist portfolio this month, the stock has other things going for it, too.

Multiple Catalysts

These are a few of the additional catalysts that could send this stock higher:

1) Christmas is right around the corner. People have already started to spend on Christmas presents. Actually, Black Friday and Cyber Monday – two of the biggest one-day shopping celebrations – are less than two weeks away.

The company does well during the holiday season. So, does the stock. Take a look at TIF’s seasonal cycle from 1987 to 2017:

The stock typically moves higher in November and December.

2) A big-time activist at work. Although the company’s sales have decelerated some in recent years, activist investor JANA Partners’ got involved with Tiffany’s earlier this year. JANA Partners appointed three new directors who have experience growing and operating similar companies. These three board members should help to accelerate growth and improve margins.

JANA Partners, with 5% ownership of outstanding shares, could also push for an acquisition. LVMH and Richemont have previously shown an interest in buying Tiffany.

Jewelry businesses, whether private or public, tend go through consolidation over time. If Tiffany follows that path, JANA Partners will likely goose an acquisition price even higher.

3) Management shake-up. The company recently announced the appointment of a new CEO, Alessandro Bogliolo. He previously worked at luxury retailer Bulgari for 16 years. Most recently, he was the CEO of denim brand Diesel.

At Tiffany, Bogliolo wants to speed up the pace of new product introductions for the company and to increase e-commerce sales.

Since Bogliolo’s CEO appointment in July, TIF has risen +13%. He officially stepped into the position just a few week ago on Oct. 2. Now, he can legitimately make improvements and potentially win over shareholders and future shareholders even more so.

4) More immune to getting “Amazoned” than other retailers. Tiffany is more immune to the threat of online competition due to the strength of its brand and the fact that it’s a luxury player.

There’s also the realization consumers generally like to shop in a physical store for high-end purchases. And often in the case of a luxury jeweler, shoppers will have the gift recipient (i.e., spouse, fiancé, girlfriend/boyfriend or relative) by their side.

Plus, customers worry about buying fake Tiffany merchandise if they don’t buy direct from the company. For instance, Costco recently got whacked by a $19.4 million judgment (which, it owes Tiffany) for trademark infringement after selling knock-off rings.

Of course, there are still pressures. The company is making progress in online sales. (Last quarter, online sales were 6% and growing.)

5) Getting paid to wait. Tiffany has paid a dividend since 1988. The company has raised its annual dividend for 15 straight years. This year, the board raised the quarterly dividend from 45 cents-per-share to 50 cents-per-share – a solid 11.1% increase. There’s plenty of room for more increases with a payout ratio of 50%.

The next quarterly dividend payment should be announced in the next week and it will be paid in early- to mid-January 2018. The stock yields 2.1%, which is higher than the S&P 500’s 1.9%.

With the recent insider buying and these extra catalysts, we could see a nice rise in TIF’s price in the next couple months.

In the short term, (by year-end or early 2018), I think a +10% to +25% gain is possible.

Longer term, TIF has a good chance in the neighborhood of 50% to 100% over the next few years.

Action to take:

CheckmarkBuy Tiffany & Co. (TIF) under $98 a share.

CheckmarkOnce establishing a full position, set a 35% hard stop.

Portfolio Updates

November Hasn’t Been an Ideal Month, But We’re Still Beating the Market …

Our portfolio is down -5.3% in November. Intrexon (XON)Safeguard Scientifics (SFE)and Adient (ADNT) have been our biggest losers this month (down -22.6%, -12.9% and -11.1%, respectively). But, we’ve also had some decent winners in the first weeks of November. Radware (RDWR) is up +11.6%, JD.com (JD) is up +3.8% and PayPal (PYPL)is up +2.8%. All three stocks are handily outperforming microcaps in general (iShares Micro Cap ETF (IWC) -3.2%.

Obviously, we’re not in any of these positions for a couple week time horizon. Looking at 2017, we’ve closed out big winners: AeroVironment (AVAV) +52.4%, Glu Mobile (GLUU)+81.4%, Myers Industries (MYE) +39.8%, Camtek (CAMT) +50%, Encana (ECA) +83% and Lear (LEA) +25.5%.

All in all, it has been another banner year (remember, our portfolio was up +40.8% in 2016 vs. SPY’s +12.0%). Our “Position Tracker” shows we’re up +19.8%, which is well ahead of SPY (+16.9%) and IWM (+7.2%).

Bonus Plays are Outperforming, Too …

A year ago, I attended The MicroCap Conference in Philadelphia via a special invitation. And in my conference notes, I gave out my “Sweet 16” microcap picks from about 70companies that presented.

I want to update you on the outperformance …

From Oct. 16, 2016 (the day my notes went live) to Nov. 14, 2017:

  • 11 of 16 picks (69% win-rate) have generated positive returns.
  • Biggest individual winners:
    • Hempco Food and Fiber (HEMP.V) +248.2%.
    • 22nd Century Group (XXII) +90%.
    • Grande West Transportation Group (BUS.V) +83.5%.
    • ProMIS Neurosciences (PMN.TO) +70.4%.
    • Cancer Genetics (CGIX) +67.2%.
  • Average return of +27.6% for all 16 picks. That crushes large caps (SPY, +20.7%), small caps
    (IWM, +14.4%) and microcaps (IWC, +13.7%) over that period.

Hopefully, you have taken advantage of these extra picks!

Best,

Grant Wasylik