There’s an old investing adage that tells us that there are many, many reasons for CEOs and other corporate insiders to sell their shares.
But there’s really only one reason to buy: They see a chance to make money.
I’m going to tell you who the CEO was in just a minute – and I’ll also share details of the move that he made. Because once I disclose whether he bought or sold, you’re going to want to make the very same move…
A Reason to Deal
When you read about the lives of a Silicon Valley CEO, you wouldn’t think that they have to deal with any of the same challenges that face Main Street Americans.
But that’s not necessarily true.
You see, even Silicon Valley CEOs sometimes face personal financial challenges.
Those challenges might consist of buying a new home or putting a child through college. Or they might involve a hefty tax bill, an expensive divorce or even the need to do some estate planning.
Those might be different from the challenges that you and I face, but they’re challenges nonetheless.
And one straightforward way to solve those issues is to sell some of their own company’s stock.
And that brings me back to the stock-market adage that I used to begin today’s discussion with you.
The fact of the matter is that there are any number of valid reasons why a Silicon Valley CEO might want to sell some of his or her company holdings.
And a stock sale doesn’t necessarily mean that they see bad news ahead.
But when you get right down do it, there’s really only one good reason for insiders to be buying shares of their company – they believe better times are ahead and that the stock is destined to rally.
In fact, spotting insider buying is a good way to consistently beat the market. Basically, this is about as bullish an indicator of a company’s future as you can find.
I believe that’s particularly true when you come across an insider whose buying shares in his or her own company at a time when the stock has been beaten down, or when their particular sector is deeply out of favor.
And insider buying on a beaten-down stock in an out-of-favor sector is just what we have.
For me, that’s cause for excitement – especially since the CEO in question is a highly regarded executive who I’ve known and dealt with for several years.
And the story gets even better: You see, research shows that insider buying is a great leading indicator of a surging stock price.
Let me show you.
A Hot “Buy” Signal
In my three decades of tech-investing experience, I’ve found that when insiders put their own money on the table, it’s only a matter of time before hedge funds and other market pros jump on board.
Solid research backs me up.
In fact, several major studies have shown that insider buying is a much better predicator of a stock’s future performance than is an endorsement from some Wall Street analyst.
Take the case of professors Carr Bettis, Don Vickrey and Donn W. Vickrey. Their study 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.
Of course, sometimes patience is required. But if you take a longer view, your chances of making big money off insider buying are excellent.
A landmark study by University of Houston Prof. R. Richardson Pettit and P.C. Venkatesh of the Office of the Comptroller of the U.S. Currency came to that very same conclusion.
Richardson and Venkatesh found that insiders tend to increase their net purchases up to 24 months before a stock makes a big move.
And the small-cap, high-tech defense firm I’m going to tell you about today just reported insider buying by its highly regarded CEO, a guy I have known and dealt with for several years.
The company: Kratos Defense & Security Solutions Inc. (NasdaqGS: KTOS), a broadly diversified provider of products and services that the U.S. Pentagon just can’t do without.
A Broad Offering
The San Diego-based Kratos is involved with such things as complex gear for satellite communications, drones, electronic warfare, surveillance systems, jammers that blind the enemy’s radar and ballistic-missile defenses.
Being indispensable explains why Kratos CEO Eric DeMarco believes he can greatly improve earnings – even in the face of a challenging environment for U.S. defense firms.
DeMarco recently bought 10,000 shares of his own stock at $7.17 a share, investing $71,700 in Kratos’ stock.
And that was only his latest purchase.
Back in December, DeMarco bought 31,273 shares of his company’s stock at an average price of $6.40, spending about $200,150 to do so. Following that buy, he directly owned 326,468 shares of Kratos stock with an approximate value of $2.1 million.
Repeat purchases make for a compelling case.
But what’s even more remarkable is that DeMarco thinks so much of his firm’s financial prospects that he’s willing to average up, investing more even as the stock price rises.
In other words, he’s very confident that he has Kratos on the right track, even though the stock is off 22% from its 52-week closing high of $9.07 a share, set back on Sept. 11.
Because I’ve talked with DeMarco directly on several occasions over the last few years, I believe I can offer some valid insights into what’s driving his investments.
Kratos proves a key point about investing in small-cap defense firms. If you want a “snapshot” of its future cash flow and earnings, you need to take a look at its pipeline of potential new awards.
With a market cap of just $405 million, Kratos is looking at upcoming sales of roughly $1.1 billion in defense and security-related contracts. Of those, roughly $543 million are already funded.
It also has a bid and proposal pipeline of roughly $4.6 billion, and DeMarco expects to meet the industry average and convert about 30% of those into actual sales over the next few years.
DeMarco isn’t currently planning any new acquisitions. And that’s a good thing because it means he can focus on improving the firm’s financials in a lean defense budget environment.
About four years ago, Kratos embarked on a major buying binge, snapping up other firms it needed to fill out its franchise.
Folding these into Kratos’ operations steadily added to the firm’s pipeline of funded contracts. It was like knocking on more and more Pentagon doors and finding a pile of cash behind each one.
But this type of fast growth does have its downside. All that M&A activity cast a pall on the firm’s reported bottom line.
The company had to write down a laundry list of expenses related to the buyouts. We’re talking about transaction costs like lawyers, investment bankers’ fees and other items that have nothing to do with how well run the company really is.
In short, DeMarco has greatly improved the firm’s operations. Last year, Kratos had operating income of $32 million. That compares with an operating loss of $50 million the year before.
To be sure, Kratos reported net losses last year. But even that shows a substantial improvement. In 2012, the company had reported losses of $2.44 a share. But for 2013, the figure fell to 65 cents.
I believe DeMarco’s focus on improving margins will be a big benefit to his shareholders.
Last year, Kratos had sales of roughly $950 million. That marked a decline of less than 2% from 2012. But it’s an increase of 190%from 2009 sales of $334.5 million.
Thus, Kratos is in the midst of a corporate turnaround and ranks as a “special situation.”
Indeed, when DeMarco joined the company back in 2003, it was a struggling supplier of Web infrastructure services. It was a “dot-bomb” victim that had zerodefense sales.
Today, roughly 70% of sales stem from U.S. defense. The rest comes from overseas defense as well as a new area for the firm – critical infrastructure security.
That last category covers digital-security systems for facilities like rail stations, pipelines and skyscrapers. Things that terrorists might like to attack so they could wreak havoc on the U.S.
So, while the company faces some challenges, if offers investors a lot of potential upside.
Over the past three years Kratos has grown sales at an annual rate of 35%. If DeMarco can get earnings growth to just two-thirds that rate, we’re talking profit growth of more than 22% a year.
At that rate, the stock could double in a little over three years.
No wonder DeMarco is investing his own money in this “special situation” profit play.
Kratos is the kind of small-cap play that belongs in the high-risk portion of your portfolio.
But for patient investors who can stomach the volatility that comes with turnaround like this one, it can add dramatically to your wealth.
Have a great weekend.
[Editor’s Note: Michael wants to hear your ideas, thoughts, comments and suggestions. Please share them below.]