Better Late Than Early

Talk about going from bad to worse. To optimistic insiders who bought shares of their own banking companies over the last 12 months, the stocks must have felt like falling knives. Indeed, the entire financial system seems to be falling apart so completely that “falling knives” might be too polite a description. (How about this description: the end of times?)

Throughout the phases of the banking sector's year-plus period of destroying shareholder value, executives and directors have shown bullishness in a much larger number of banks than they have in the past.

Reviewing the performance of the 17 insider-bought bank stocks presented in the October 2007 issue of Registered Rep. (see table on p. 84) shows the group off an average of 28 percent a year later. Only four banks on the list showed positive returns. That may be a better success ratio than a random sample of financial institutions over the past year, but it is not nearly the hit rate I'm used to getting when I use insider buying to jumpstart my investing process.

Of course, this is hardly a shocker. Most of the banks on that list failed miserably to meet the earnings-per-share (EPS) expectations set for them over the last year — even though their fiscal years were over half completed at the time. Even those banks that did manage to meet earnings expectations last year succumbed to reality soon after. Fiscal 2008 EPS estimates for all but one bank on last year's list have fallen off a cliff.

Early Can Hurt

Having followed the insider transactions filed with the SEC for nearly two decades, I'm used to insiders being early. But when does “early” equate to just plain “wrong”? Being more of an investor than a trader, I'm prepared to wait for fundamentals and technicals to confirm a bullish insider signal before removing an insider-inspired potential investment from my watch list. But my patience is not endless. It goes without saying that neither important metric has materialized in bank stocks, which made the strong, sectorwide bullish signal from buying by financial execs a hard one to bet heavily on.

It's worth pointing out, however, that sometimes insider bets take some time to pan out. Back in the late 1990s, it took energy insiders a solid two-year lag to see their heavy bets bear fruit. From January 1997 to December 1998, one measure of the spot price for crude oil fell from $23.84 a barrel to $9.16. Shares of energy E&P firms understandably fell likewise, as the incentive to pump the commodity out of the ground went south as well.

Insiders at these firms started indicating value in their falling shares in the first quarter of 1997, when oil broke through $19 a barrel. But the fall in both crude prices and the sector's shares was just beginning. By mid-1998, energy insiders were looking pretty clueless indeed to have bet so early on the sector they supposedly knew better than most.

But by mid-1999, oil prices had doubled from the nadir hit six months earlier. By mid-2000, oil had trended above $28. And even those insiders “clueless” enough to have bought their firms' shares in early 1997 were sitting on major profits.

Fast forward to the present. The financial crisis affecting bank stocks is “only” a year-and-a-half old. Taking the early energy insider tale to heart, financial insiders may yet be proven right to have shown faith in their institutions.

Possible. But even this believer in insider buying signals isn't prepared to give enough credit to financial executives yet to follow them en masse into bank stocks. After all, the news out of financial institutions worsens by the moment.

As constructive as government intervention may eventually prove to be, it's clear to me (and, apparently, the rest of the world) that we are still in the discovery phase of this global financial catastrophe. The amount of bad assets that any bailout-born government entity will try to digest from ailing banks isn't known. Neither is the price it will pay for them.

If the recent past is prologue, the size of the problem has likely been underestimated by our comrades in government — not to mention the bankers themselves. The estimates keep rising: AIG (NYSE: AIG) said in mid-September that it needed $40 billion from the government but, just weeks later, it decided it needed $85 billion. That sum wasn't enough either; in mid-October, the Treasury Department added another $37.2 billion.

While the energy execs' insider buying eventually proved prescient, this time it is clear that many of the insider buyers at banks were actually clueless.

Take Wachovia. Just over two months before its stock went on life support, Robert Steel, the new CEO and supposed savior of the troubled firm, bought over $16 million worth of shares for as much as $17.02 each. Mr. Steel is an ex-vice chairman of Goldman Sachs who left his position as an under secretary in the Treasury to take the post. There was every reason for investors to feel that Wachovia would be a survivor given Mr. Steel's show of confidence, and his apparent ability to assess — and fix — Wachovia's problems. Adding to the bullish insider signal, two more board directors bought $11.3 million worth of Wachovia's shares for between $11 and $12.25 on September 15.

Just two weeks later, Wachovia officially failed.

While many of the heavily insider-bought banks — if not most on my list — will undoubtedly survive and eventually thrive in the new reality that develops after the current financial implosion, the risk that more insiders in the sector will turn out to be wrong instead of merely early is much greater than when energy insiders were overly premature with their bets.

Even if you do your homework and properly identify the banks that will survive the crisis, how long will you have to wait until that bank stock actually starts generating a return sufficient to compensate for the added risk you're taking by acting now?

A larger question is just how useful any thoughtful analysis of a bank's health will end up being. Earnings estimates made by professionals following the industry a year ago turned out to have been wildly optimistic. Now, these same professionals are indicating by their estimates that this year will be the earnings nadir for the beaten-down sector. Fool me once…?

Supposedly important capital ratios are likewise useless if the experience of last year's sample of insider-bought banks is taken to heart. Every bank on that list boasted audited results showing Tier 1 capital of at least 8.6 percent of assets. But that did not foreshadow safety. Even Midwest Banc Holdings (Nasdaq: MBHI), with a Tier 1 ratio of 11.8 percent last year, had its estimates lowered dramatically for 2008. Its shares have lost 86 percent of their value over the past year to boot.

Current Tier 1 ratios for last year's sample are still impressive, but will that finally mean something in the coming year? At this point, your guess is probably as good as anyone's.

Jonathan Moreland is editor of InsiderInsights.com, an investment newsletter specializing in insider trading.

TOO OPTIMISTIC?

These stocks were featured in the October 2007 issue of Registered Rep. and recommended by InsiderInsights.com based on bullish insider purchases during the summer of 2007.