Alpha Buying: 3 Cheap Stocks Insiders Are Buying With Their Own Money

Insider buying is one of the most useful signals available to individual investors, but it is also frequently misunderstood.

An executive buying a few thousand shares does not automatically make a stock attractive.

Corporate officers sometimes purchase stock to satisfy ownership guidelines, create a favorable impression, or demonstrate symbolic confidence after a disappointing quarter.

The signal becomes far more interesting when several insiders invest their own money at roughly the same time.

It becomes even more compelling when the company generates substantial free cash flow and the stock trades at a low multiple of that cash flow.

That combination can identify exactly the type of opportunity Wall Street tends to overlook: a profitable, cash-generating business whose shares have fallen far enough to attract the people who understand the company better than anyone else.

Words Are Cheap.

Purchases Aren’t.

Executives say positive things about their companies every day.

They appear on conference calls, attend investor conferences, and issue polished statements about long-term opportunities.

None of that costs them anything.

Buying shares in the open market is different.

When a chief executive, chief financial officer, director, or operating executive uses personal funds to purchase stock, that person is making a real financial commitment.

The insider may still be wrong, but the decision carries more weight than another optimistic paragraph in an earnings release.

Insiders sell for countless reasons, including taxes, diversification, major purchases, or expiring options.

There is usually only one reason they buy in the open market.

They believe the stock is worth more than the current price.

The strongest signal is rarely one isolated purchase.

It is clustered buying by several executives and directors.

One insider may be overly optimistic.

Several insiders from different parts of the organization buying at the same time are harder to dismiss.

The chief executive sees the strategic picture.

The chief financial officer understands the balance sheet and cash flows.

Directors may bring decades of industry experience.

Operating executives see customer demand and competitive conditions firsthand.

When several of them conclude that the stock is undervalued, investors should pay attention.

Pairing the Signal With Free Cash Flow Insider buying is most useful when paired with valuation discipline.

One of the best valuation tools is free cash flow — the cash remaining after a company pays operating expenses and makes necessary capital investments.

Earnings can be influenced by estimates, depreciation schedules, acquisition accounting, and one-time adjustments.

Free cash flow is harder to manufacture over long periods.

It can be used to repay debt, repurchase shares, pay dividends, acquire competitors, or reinvest in the business.

Free cash flow yield is calculated by dividing annual free cash flow by market value.

It is the inverse of the price-to-free-cash-flow ratio.

A company trading at 10 times free cash flow has a yield of about 10%.

At 6 times free cash flow, the yield is approximately 16.7%.

Those are substantial cash yields when the business has a manageable balance sheet and reasonably stable operations.