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This “Insider” Is Buying – And You Should, Too

12 | By Michael A. Robinson

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 was thinking about this bit of stock-market wisdom just the other day after noting that a tech-sector CEO who I know made a move with his own company’s shares.

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.]

12 Responses to This “Insider” Is Buying – And You Should, Too

  1. Anthony Cacciottolo says:

    I seem to have seen this article some weeks ago. Besides This particular Firm was mentioned in an article along with two others (if I remember correctly) a month or so ago.The question remains: should one invest or not? And what about a stop for security? I am making these questions because I am somewhat new to this market and would like some firm directions. A reply to these queries would be greatly appreciated.
    Thanks for the advice and a very happy Easter.

    • Maerciii says:

      The company has several big contracts.,one of their customers is the air force ..DeMarco is brilliant..I am going for 500 shares

  2. Roobert .V says:

    Luuvv your recamendations an drill down – keep em comeing tnks Mr M.
    i call it ” the X – factor “

  3. Edward H. Rudberg says:

    Dear Michael,

    I like small-cap stocks when their general market is in an upward trend. In fact, I favor them when they are in favor.

    I can see good probabilities in KTOS as a possible money maker. However, why shouldn’t I wait for the current volatile market to decide whether it will have a fairly deep correction or not, before entering KTOS into my portfolio? The market seems ripe this year (long bull market) to decide that question.

    Why shouldn’t I put my money to work in KTOS at a time very favorable to small-caps in general? This way I can have the same money in cash or working for me in a positive way (maybe buying ETFs that go up in a down market, if that’s where we’re headed) instead? Yes, it’s a timing thing but it could keep me safer and ready with saved money, when KTOS does start its major run upward, instead of holding it at this time.

    This may be a special-case stock but my preference would be to wait and hold onto stocks that do better in volatile markets or just use my strategy explained above (more defensive).

    Remember that Mr. DeMarco has a considerable bet (probably a good one) in his company but unless he’s worth a lot of money more, than his stake in KTOS, it could be a very dangerous bet for him.

    Even though it’s probably a good strategy to follow the leaders when they are buying, I think that we onlooking smaller traders, also need to realize the market climate and our own wallets, before doing so.

    Sincerely,
    Ed

  4. mick says:

    Thanks for your tips on ktos. Is ktos a good bet to develop drones outside of the military and security market? I’m thinking agriculture. How would you play drones for that market? Thanks Michael.

  5. snakevp56 says:

    From my perspective as a former defense service provider exec, Kratos sounds interesting but would want to see its success rate in USG contract bids (number bid, number won by size) and know who he has on staff with detailed experience in the military contracts he is pursuing. 70% of sales can be one contract in USG business.

  6. Wesley Leeds says:

    Hey Michael,

    I just want to take a moment to give you a hearty “Thank-you” for offering your newsletters and instructionals on what you have found to be good in the Bitcoin venue and for such a good limited-time offer price!
    Having written that, I have to tell you that I haven’t ever invested in my entire life! I should have done it years ago, and I might be doing the same kind of thing you’re doing; however, I had no one much that ever inspired me to do so! My brother came closest; however, he earns lots of money—and quite frankly–I don’t! In any case, you have inspired me to get a start at the age of 36. I already had a brokerage account linked and waiting for investments, but I haven’t used it. For the last year and a quarter I have been paying student loans, when the sinking realization hit me—while looking at the recent activity of Bitcoin and what it did back in December—that I missed fantasy being “reality” when I found out about Bitcoin last year and never researched actually investing in it!! I work nights and easily could have been stowing away some of my extra money (though it is definitely limited) in Bitcoin several months before December (I think that’s when I first heard of Bitcoin). I missed that opportunity. I can’t go back. But I can change the future somewhat! There are some things out of my control, like when our economy will implode—but hey, I could have been out of debt months ago had I invested in Bitcoin like I could have and should have and would have! Not only that, but I’d already have paid that mountain of lawyers’ fees and remaining $8,500 of student debt I owed and could not evade with bankruptcy (declared that last year after my wife divorced me–which seems to be the trend these days, even when you never had an affair—and stole me blind, legally–while the “mafia” corrupted her with power and continues to do). Well, you’ve likely had your own experience with that! Anyways, my point is that I could have already been debt free and sitting on another $15,000 or more, judging by how I operate with buying and selling (based on my recommendations for my brother as he was buying and selling stock on the margin many years ago; I told him to sell while he had a $9,000 profit in hand, but no—he got greedy and held onto it. That one took him about five years of investing or more to recover!! But you know, that experience has taught me that I have a lot of good “horse sense” when it comes to knowing when to get in and get out of the market!! I’m going to use that gift, Michael; and I’m determined that I’m going to start with practically nothing and get out of debt—as long as economy should last!!

  7. Rakesh Lakhotia says:

    KTOS: Though you have incorporated safeguards in your write -up, better bargains are available. I would not buy KTOS:

    (I) Low market capitalization
    (II) Low price of the stock.
    (III) Many funds do not buy a stock if the price is less than USD5 or in the vicinity.

    One can only hope that the company is bought by a large player. Stock price will then shoot up in double digits on announcement.

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