How does one know that a cheaply priced stock is really a bargain? How does one determine that it is not a value trap? There are of course many different ways to do this: performing market research, testing the company’s products and performing other forms of due diligence. But there is another way that does not rely on an examination of anything to do with the company itself. Rather, it involves looking at who the major shareholders of the stock are.
Watch the insiders
Success in the investing game usually comes down to who has the superior information as it relates to the business. Generally speaking, the people with the greatest amount of accurate information are the executives and board of the company in question -- the management. In fact, it is for this very reason that securities regulators around the world require insiders to adhere to stricter rules than regular buyers and sellers.
Accordingly, when multiple insiders are selling their a stakes in a company, that is usually a good indication that the cheaply-priced stock is not the basement bargain that it appears to be. Conversely, if insiders are increasing their holdings, and are investing their personal capital into their business, that is generally a very good sign. Indeed, if the stock price is depressed and management are buying up shares, they are acting like value investors themselves -- scooping up the equity of a quality business while the market is devaluing it.
Institutional versus retail
Another thing that you may want to take note of is the mix of different types of investors. Institutions like hedge funds and investment banks tend to be much more well-informed than retail investors. This is not to say that individuals cannot make money in the market, but generally speaking, when there is a difference of opinion between retail and institutions, 99% of the time it pays to side with the big players.
Furthermore, you should do some research into what kind of people hold shares in your target company. For instance, it is usually a good sign if a well-known value investor is long an undervalued business, although you should always do your own due diligence and never blindly follow someone else’s lead.
Summary
Of course, these are but supplemental methods to augment the standard value investing toolkit, and occasionally, you may even see insider activity that is at odds with the actual prospects of the business -- for instance, if management is trying to artificially support the stock price by buying up shares. But more often than not, insiders will be acting in good faith, and will be attempting to profit from their cheaply priced stock. When in doubt, follow the smart money.
Disclosure: The author owns no stocks mentioned.
