Welcome to Inside Active, a podcast about active managers that goes beyond sound bites and headlines and looks deeper into their processes, challenges and philosophies and security selection. I'm David cone I, lead mutual fund and active research at Bloomberg Intelligence. Over the last decade, value investing has gone through long stretches of underperformance, while markets have been dominated by a
narrow group of large cap growth stocks. At the same time, one signal that's constantly drawn attention, especially during periods of volatility, is insider buying. Today, we're going to explore what happens when you combine those two ideas, value investing and insider
behavior into a systematic investment approach. Joining me as my guest today are John Spears and Jay Hill, who are both managing directors at tweety Brown Company and portfolio managers for the Insider Value ETF ticker COPY and the International Insider Plus Value ETF ticker ICPY. John, Jay, thank you for joining me today.
Thank you for having the opportunity to be with you.
David, Thank you very much for having us.
David, appreciate your interest.
So to start tweety Brown, you know as a long lineage rooted in Benjamin Graham. How is your definition of value evolved in today's market environment?
Well, Benjamin Graham defines in security analysis and in The Intelligent Investor he defines basically defines the intrinsic value is the value of the business. If all three of us owned a company and we hired Goldman Sachs to sell it, it'd be that estimated intrinsic value what we'd receive for if we sold the business. And there's another way of looking at value or undervaluation, and that is yield. J Hill at our firm, I think coined the phrase owner
earnings yield. So it'd be if you own the whole company, what kind of return do you get on your investment? How much cash could you take out of the business every year? So, and you can compare yields on all different kinds of things. That higher dividend yield is often considered to be a sign of undervaluation. Earnings yield of course you can compare of course to treasury bills. But that's those are the two I think the two big ideas when they add anything to that jay.
Yeah, just owner earnings yield. It's a term You're probably not going to find it in textbooks, but it's one that we use. And the numerator is what I guess the financial literature would call NOPAD. So after tax ebit Okay, so ebit times one minus the tax rate, and the denominator is the enterprise value right the market cap plus
the net debt is the simple definition. And the basic idea is if you bought the whole company and paid off all of the debt and then therefore you have ebit and no interest expense on an after tax basis, if you owned the whole company, how much money could you put in your pocket? And generally we're looking for owner earnings yields of eight percent or higher.
Okay, Now, if we go step further, you know what led you to combine inside of buying with value investing? And you know why do you think that combination is so powerful?
Well, the key thing I think is is self interest.
And we.
Have done a lot of empirical research and it examined a lot of empirical research, mostly from academia, and a big influence on our process in our empirical research was a book written by Nahat Seihan, who's a professor of finance. He's chair of the Finance Department at the University of Michigan, and he wrote a book called Investment, An Intelligence from Insider Trading, And in that book there is a long,
a long, turned back historical study that he describes. Initially, the study began in nineteen seventy eight and ended nineteen ninety three. And the fascinating thing is that he had a schedule in it where he took all the insider transactions and he looked at the stock price in relation to book value and earnings, and you rank the stocks
from cheapest to most expensive. And he found that the insiders who were opening up their own wallets and buying the stock when the stock was at the cheapest twenty percent of stocks ranked on price to book value, the cheapest twenty percent of stocks ranked on price earnings again from cheapest to dearest, that the excess return using an equal weighted index was a little bit more. It was around ten to eleven percent in both of those long run studies. And that just made our eyes pop out.
That's as you know, it's tough as the dickens to beat the market. The odds are against active management. Long run index funds tend to beat most active managers who are smart and working hard, et cetera. But here was this, here was this great study. So we've had separate individual
experience of getting ideas from watching insider trades. We've used this technique on a one off basis for fifty years, and so we thought we see if we could study this ourselves and think about looking at other investment carearacteristics beyond just price to book value and PE. And our studies began in nineteen ninety six and ended in twenty twenty two, and we found similar results the results that are described in that booklet called Insider Investment Factor. But
I think we sent to you. I think Conrad sent that to you has some tables, not only professor seance table, but our own research. The results were just as good as what he found, So that that just motivated us to got the idea that if we could package this and if it worked as well as the empirical data, if we put it in a portfolio and had the tax advantages of an ETF, it'd be an attractive thing both for our own money and for our outside clients money.
I don't know if you know this but we were fortunate to have about fifty million of our principles and employee wealth invested in in copy and in a little bit less or less so an I coopy combining, and it's at least fifty million.
So that's David. What I would add to that is we found that when you combine quantitative cheapness with material free will insider buying, that that combination be both just cheap stocks on a standalone basis or just looking at insider buying in isolation, it's the combination that created the outperformance. And that's really what excites us. We think that the if you own enough of these that the law of
large numbers the group averages tend to outperform. There will be several individual instances of individual companies where it doesn't work, but a large group of these held in a portfolio we think provides the opportunity for significant outperformance.
If we single out just the inside apart. Though, what do you think is you know, you mentioned, you know, you've seen all this research that shows it works, But what do you think it's you know, where's the edge coming from? Is it just people want to follow what the insiders are doing?
Yeah, I mean, I think it's undeniable. No one can dispute this that insiders know the business better than anyone else. They know it better than their investment bankers. They know it better than sell side research analysts, they know it better than buyside analysts. And insiders have the unique ability
to influence outcomes. They can create their own catalysts, right, so, insiders have the ability to implement a new cost cutting program, or introduce new products, or have insight into when industry fundamentals maybe bodding them out and might be set to improve. They also have the ability to, you know, spin off
of a business that they think is undervalued. And they also have the ability in some cases to put the whole company up for sale and sell one hundred percent of the business to a to a knowledgeable buyer.
They can also initiate a dividend increase, and they can initiate a share buyback program. In many instances, we see share buybacks and insider purchases, and we've done studies that we've done empirical studies on share buybacks, which seem to us to be an extension of the idea of insiders having insight information and taking advantage if the evaluation is low enough to enhance the value per for the remaining shareholders after the purchases are made and the share account is reduced.
Yeah, I was gonna ask about buybacks in a little bit, but I still want to kind of say on the theme of the insider activity and how do you kind of separate, you know, meaningful insider activity from any potential noise because there are a lot of insider transactions.
There are, indeed, it's a blizzard of information. Well, one of the first things is the size of the transaction. We just thought that a transaction size of at least one hundred thousand dollars would show some conviction. And again going back to delving into whether or not the insiders are required to buy their own shares, having you know, have a certain amount in relation to their salary. That's
that's common at companies. But we look into that, we'll go into the public documents and see if the if the purchase is voluntary free will they don't have to do it, so they're taking advantage of the price they see, they like the investment. There's only one reason why insiders by by their own stock. It's it's just to make money they think it'll go up. So that's that that reduces the the quantity of of of things that are of interest to us.
Another way to say that, David, is if we find that the insider by is not free will, meaning it was required to meet a minimum ownership guideline, that doesn't count the field.
Is the field is reduced by requiring voluntary or not requiring that they be free will purchases and that we have cheap valuation.
So there's part of kind of a behavioral process in this, or I should say behavioral factors. Do you see, you know, insiders effectively acting as contrariancs during periods of market stress. Does that kind of show up in your process?
Absolutely? Absolutely. Insiders often buy after a bad earnings call. You'll see sometimes these You'll look at HP and Bloomberg and you'll see that, you know, the stock was trading at ten the day before the earnings announcements, now it's at eight, and there is often a behavioral contrarian reaction to that sort of thing. There. Many of the many of the purchases are after the end of a quarter. In addition, just general market moves when the market as
a whole is going down. Our experiences that insider transactions go up.
David, We have a great recent example of this. There's a company called ak LKQ that distributes after market and collision auto parts. And this is a company that in twenty twenty five had a bad quarter, stock collapsed. Three insider stepped up purchased about eight hundred thousand dollars worth
of stock at an average price of thirty two. This was in August of twenty twenty five, and then in January of twenty twenty six, company put out a press release saying that the board is conducting a strategic review of the company and looking to potentially sell the whole business.
Now, this is a you know, mainly quantitative process. Can you walk us through what you screen for? You know, what has to be true for a stock to get on your radar?
Well, sure, Well, first it has to be a transaction of at least one hundred thousand dollars, and second, it has to be a free will you know, voluntary purchase. They have to be opportunistically buying the stock. And then third we have a proprietary score, we call it the value score, and it has to be above a certain level. So that that narrows the field and when it is when the value score is above a certain level, those are the ones we focus on and we will do
an in person tweety Brown analysts review. Tweety Brown analysts are generalists, a great deal of experience. I don't know anyone who knows more about the uniform rental businesses than Jay Hill and has had insights about how you buy. You buy a uniform rental company and and you can get rid of all the sgn A because you just moved that capacity into an existing plant. Anyway that there
will be an experienced analyst take a quick look. Typically it doesn't take more than a day or two at at the particular business and with a lot of diverse knowledge of you know, we've studied banks, We've studied oil
and gas pipelines, oil and gas companies. UH. One one of our analysts is experienced and looking at pharmaceutical companies and getting ideas that get sort of assessing where they are and in UH trials with with the Food and Fruit and Drug Drug Administration, so things like that will look will look for instances in the in the in the pharmaceutical business where they're spending UH as a percentage of sales, a lot of money on R and D, and we could think of some of that as being
investment types spending that reduces reported profits but does not necessarily reduce the value of the company if it we're sold.
The only other thing I would add to that, David, is we're looking at least that inception when we're thinking about putting a new portfolio into one of these two ETFs that we want to pay roughly the same price that the insiders paid.
Interesting, yeah, yeah, that's very important. Yeah.
Yeah, So there is a you know, once the stock passes that quantitative screen that there is sounds like there is a fundamental qualitative aspect of this where you know, it's not just a pure quant portfolio. There needs to be an analyst actually kind of digging into the stock once it gets past that screen.
Right right, Bob Wykov calls it quantamental.
That's good. I like that.
So yeah, and the machine when we get we get this feed of insider purchases from countries around the world and obviously including the United States, but UK companies in Europe who shares trade in the Euro, other companies in Europe that have their own own currency, Switzerland, Canada, South Korea, We've done some in Philippines, Taiwan, Singapore, Australia, We'll wait to look at a Mexican company, South Africa, so a
lot of a lot of different places. And then once we get that information about the insider purchase, we put it in, We put it in the meat grinder in the and and the meat grinder does a lot of calculations, that's more than thirty different calculations and comes up with its value score. And that's that's where we focus. The human human part human research.
Port of the judgment involved here is that the analyst goes back and make sure is that our proprietary scoring system is working with good data to making sure that the data is solid, that it's not garbage in, garbage out, so verify the data, verify that the stock.
Is truly cheap.
And then when we have that.
Material free will purchase in excess of one hundred thousand with a minimum value score, then that's a candidate to go into copy or eye copy.
And really the rebuttable presumption is that unless we see something, you know that the data is wrong or in some instances we'll do will delve further into the if the company has above average leverage, will delve into the the covenants and UH and depending on the particular business, the particular industry, will will look at different kinds of disclosures in public documents that pertain to an analysis of a bank or an oil and gas company or whatever.
The other thing, David were human judgment I think played some role is sometimes there's a company that meets all the criteria, but there's a conflicting signal. A common conflicting signal would be, hey, there's insider buying, but there's also been material insiders selling.
Yeah, mixed, a mixed signal. It doesn't hit you in the face. Now, some with some companies in the United States, you will some of the data serves as we'll report sales, but we have a we we can investigate sales pertaining
the option exercise. So sometimes we'll we'll overlook the sale if the if the insider is exercising the stock option way earlier, way way before, way before it the end of the option period, and and this is increasing ownership, so they're really in a way buying it by exercising the stock might have to sell some shares to beat Yeah, So we'll we'll delve into things like that.
And you and earlier touched upon share buybacks, and so I'm just curious of how you distinguish between, you know, value creating buybacks or just pure financial engineering.
Yeah, that's that's it's the value score has to be cheap, has to be cheap. I think most share buybacks are in companies that really are not super cheap. They're not high score, high value score type companies. And of course many, many big companies will buy back their own own stock to offset dilution from exercise of options. Anything to add to that, Jay.
Yeah, just in other words, by definition, what we believe share repurchase makes the most sense when you're buying backstock when when the company is inexpenser and by definition a company that has a high value score looking at those thirty metrics, it's cheap. It's likely in the bottom two death sisles ranked against all companies in terms of cheapness.
So the odds are that are a significant share repurchase with a company that has a high value score, that's value, a creative share repurchase, that's the type of share repurchase we think makes a lot of sense and adds value per share to the non selling shareholders.
Yeah, I mean if you've got if you've got a company that let's let's make the mass simple. It earns one hundred dollars and it's got one hundred shares, so it's it's earning a dollar a share. Now, leaving aside financing costs or loss of interest. If the company buys back ten percent of its shares, Let's say, if I've none, doesn't have to borrow any money. They just do that. You'll have ninety shares divided into one hundred in earnings, so your your your earnings per share are going to
go up about eleven percent just by doing that. So it can it can really make a huge difference if if the company is cheap. And there's one that we recently went in the portfolio company called Verssan Media, VS and Tea, and it came across the insider buy a wire when director and a nine year director of Comcast, his name is David Novak, who had been previously the founder of Young Brands. He bought he opened up his wall and bought about five point two million dollars worth
of stock. And I think that their buyback program is twenty percent of the outstanding shares. I don't know over what period, but that's a very significant amount. And the stock is at five and a half times earning, so call it a twenty percent earnings yield. So, assuming the business doesn't fall apart, it's in broadcasting, the own cnpc ms. Now they own rotten Apples and what's the fan Dango and they own a bunch of stuff. Yeah, the golf channel,
right right, yeah, sports channels exactly. So if the business doesn't, if the earning power doesn't fall apart, that those buybacks at such a low valuation could be very accreative.
I mean, okay, okay, I do want to ask you about, you know, the portfolio, and you know, if we just look at copy, you know, it's really diversified, about maybe one hundred and seventy holding somewhere around. Then how do you balance diversification with conviction?
I would say we don't have that much conviction in individual names. I mean, I'm saying I'm saying that myself. Jay, there's certainly stocks that each of us like more than others that are in the portfolio. But the whole big strategy idea is to try to mimic the studies which we're all equal weighted studies, and the averages that are reported for those studies are all equal weighted, and at least in a Seihun study they used they used an
equal weighted index to measure out performance. But again it's a law of the Irige numbers idea that hopefully if we have a big sample of these, we'll get we'll get it'd be great if we'd get anything near what the studies have shown. In the studies, of course, are just they're factor studies. The studies are not portfolios. They're just how this stock with this characteristic and you've got a lot of how that did on average, So.
It's the portfolio in terms of you know, position sizing, it's equal weighted.
It's equal weighted. So in copy there's roughly, you know, like you said, one hundred and eighty to one hundred and ninety nains, each new position comes in at roughly fifty basis points. And then in eye copy, which is the international component of copy, so non US stocks and I copy, that's about one hundred and twenty stocks. So each new position is roughly a seventy five basis point position.
You talked about, you know, diversification. We don't have any set in stone rules, but I think in general we don't want any more than twenty to twenty five percent in any one particular industry. And also we don't outside of the United States, So the United States is a separate category. It's the largest capital market in the world. But in other countries, we want no more than twenty
percent in any particular country. And again that's not set in stone, but those there's parameters that we've set in place that we think add to diversification.
So do you do rebalancing to keep the portfolio equal weighted, you know, over a certain time periods.
Well, no, I would, I would say we're doing we're doing valuation improvement. Well, well we'll a stock that has a higher value score can get a higher values score excuse me exactly, as a lower value score gets a lower value score as a result of increase in the in the price of the stock goes up, so the valuation is not as cheap or the earnings the fundamentals fall apart. So those and we're always trying to get new cheaper stuff into the portfolio, stuff with higher value
scores in and we will sometimes replace it. Well, but if something as a high value score goes in and a lower value score goes out, so we're opportunistically refreshing the inventory.
Yeah, David, I mean you asked about sell discipline, and effectively, each new idea that passes our criteria right material free will insider by combined with a high value score, we approve that investment. It comes into the portfolio, and then we need to reduce a stock that's in sell a stock that's in the portfolio, and they the selling criteria is what John mentioned. Effectively, it's it's really a combination of eliminating the companies that have the lowest value score
today and or are the oldest vintage insider buys. In other words, if if a stock that's in the portfolio the insider by happened two to three years ago, where there's been a long time period since that inside that triggering insider purchase occurred, we'll look to move that stock out and replace it with newer vintage insider buys.
And sometimes we'll reset the clock. We'll well, we'll that can happen when the value score is still pretty good and insiders continue to buy it. So it might be two years pass and and the stock still has a good value score and they're they're continuing to buy it. We'll treat that in a way as a fresh as a fresh thing, and and we'll give it more time.
So there isn't you'd say, a typical holding period. It just really entirely depended on its you know, valuation and insider behavior.
Well, there's not. I would say that that based on the empirical data. Our our empirical data, it looks like the excess returns UH peak two to three years after the date of the insider purchase. Now, Professor sayan study just had an assumption of a one year holding period, so he didn't go beyond that, but we went we went out three years and and and it just seemed that way. So and it may sort of makes sense if you could get anything like the excess returns in
the studies. Those excess turn returns generally indicate that the the share price the valuation account is probably going up at a much faster rate than the companies at real value. It's unusual to get twenty thirty type an your returns for very long.
It is possible, though, David, because the portfolio tarover is largely a function of the number of new ideas that meet our criteria. So if there was let's say, a big market sell off and a ton of insider buy amongst cheap stocks, it's entirely possible that we could replace really the whole portfolio in a year or less. If there's a bunch of new names that meet our criteria that would come in, and then we'd have to move out the older names and the names with lower value scores.
Right, yeah, yeah.
Do you ever in counter situations where the signals look great, but the investment might just not pan out, you know, where the fundamentals just kind of just don't follow.
Fundamentals do tend to follow the value score. I can think of well leveraged, too much leverage, and events that happened verly soon after the insider purchase that kind of make the data we were looking at stale. Such as a company you buy the stock, you know, in March, and by September the company announces a major, very very large acquisition that requires really leveraging up the existing balance sheet, and they paid a very high price for this company.
They should have used the money or the borrowing power to buy back their own stock much better deal, and they did that. So something like that might say, using sort of zero based budgeting this thing, I think, you know, the value score has gone down pro forma given this wild acquisition. And as you may know, a lot of acquisitions don't work out. There have been academic studies of that, or Warren Buffett often writes about that.
I mean, I think, David, a lot of the names are not going to work out. That's just the truth. Our little methodology here, combining insider buying and quantitative cheapness, is not going to work in every instance. What we're trying to capture is the group result of a large, broadly diversified group of companies. In copies case, it's almost two hundred stocks. In the other portfolio it's one hundred and twenty stocks. What we're looking is for the group result,
a little bit like insurance underwriting. Right, not all clients are going to be profitable. What we expect to happen, though, is the group result the law of large numbers to develop to UH to generate a significant outperformance. But with lots of individual names that don't.
Work, there's skewedness there there. It's humbling and surprising to see see some of the some of the big, big winners. I mean that what we've had, we've had gold miners up through the roof UH, we've had good, excellent results from the South some of the South Korean UH companies that just hit you in the face in terms of how cheap they were. They're not as cheap anymore. But it's stuff we couldn't have. I don't think anyone had
a crystal blonde. Which ones would be the big winners, which ones would have the skewness that makes makes the average good, that.
Actually brings you in the next question. You know that it's the same investment philosophy for both copy and eye copy. But are you seeing like different types of companies if you compare, you know what's in the what's domestic and what's international? Are there, you know, different sectors that seem to be coming up more in one versus the other.
I don't notice that, do you, Jake?
I don't either. No, No, I mean I think we mentioned this earlier. I mean I copy is really just the the non US names within copy, so that there's a lot of overlap. But but no, I don't. I don't think we've noticed any significant differences in the like say the companies or the industries in I copy versus copy.
Okay, and this is my last question. If an investor could take away one lesson from your approach, what would.
It be, follow the money to make money and buy cheap.
What I would say, David, is that look we we we came up with the ticker symbol co O p Y copy right is like upon on. We're copying the insiders, and we just think that adding insider buying to value investing. We're long term believers in value investing and adding this simple common sense qualitative, I guess metric insider buying just makes perfect common sense. And I'll reiterate with John said earlier. If there's a free will buy, insiders only buy their
stock for one reason, they think it's going up. And insiders uniquely have the ability to effectuate change, to catalyze change, to become their own catalyst. And we think that that combination's powerful.
Yeah, we call it in insight information, not insider.
That's pretty good.
And I think they also from us the standpoint of a tax paying investor, and we're all tax paying investors at tweety brown, some more than others. Living if they live in New York City, that it's very attractive being able to essentially avoid most capital gains taxes. We've done one big distribution and kind of some of some of the stocks with large unrealized gains that were no longer
high valuation scores. Evaluation scores that going down because the stocks had gone out, and I think we were able to eliminate about forty five percent or something like that of the total unrealized gain in the in the portfolio. So nice. It was amazing, and it's it's.
Worth reiterating, David, we believe in this strategy, and the partners at tweety Brown have roughly fifty million dollars invested right along aside our client.
Well, it's it's a great place to end. But this is a lot of fun. I want to thank you both for joining Meg Well, thank you for the opportunity. David, you have quite a reputation. You're the guru of active investing. It I appreciate that.
Thank you very much.
We appreciate your Andrew.
Thank you, David. I also want to thank our listeners. If you liked the episode, please share it, subscribe and leave a review. And if you'd like to see more of our research on the Bloomberg terminal, Go to BI fund, Go for fund and active research until our next episode. This is David cole Inn. Sign out.