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This week's Editorial Guidepost:

Last week we introduced the Contrarian Investor’s first rule:

That is, if the 52-week high for a stock is $20, its price must have fallen to $10 or below before it would be considered as a buy. This “down-by-half” rule helps define a contrarian stock.

Contrarian investors (those who are contrary) avoid going along with the crowd. They try to stay away from the fever of short-term news events, frequently finding themselves all alone in their opinions. But the intent of their strategy is to buy and to sell a stock ahead of the crowd, hopefully putting the odds in their favor. That sounds like an attractive approach. Who wouldn’t want to put the odds in their favor? But wanting to and actually doing it are not the same. The sad truth finds the majority of investors caught up in a “herd mentality,” reacting to media hype being tossed to and fro. Contrarian thinking provides a blueprint, a strategy to follow that takes advantage of investor emotion, acting on rather than reacting to.

To capture this advantage, contrarian investors need to know what most investors are thinking and doing. The first contrarian rule introduced last week, the 50% price drop, is one way to measure market sentiment. This means there is a strong bias in the market against that stock. A stock that sees a price drop like this doesn’t have much support. The “down-by-half” rule is an objective measure of negative market opinion. It infers what investor’s mindset is on a stock. By itself this rule is not enough to single out good stock buys. Other contrarian rules are needed to help scratch the poor investment opportunities. But the “down-by-half rule” is the primary contrarian play.

Other rules for the contrarian are termed confirming indicators. That is, they confirm the decision to go with stocks that are down 50% in price. The confirming indicators are used as follows:

A stock satisfies the Contrarian Buy Rules if it is:

Let’s deal with the first confirming indicator, Insider Buying (2a). Insiders are corporate officers who are close to “inside” information about a company. If a company executive knows the quarterly earnings will be below expectations he might sell stocks before the price reacts to the report. Likewise, if the executives in the company know of a new product development that will double revenue, they might buy at what will be a relatively low price ahead of the announcement. Insiders, with privileged information, represent what is called “smart money” for obvious reasons. The contrarian aligns himself with the smart money using this confirming indicator.

This number one buying rule with the key confirming indicator hits both side of the fence. The 50% down is a negative feature, driving most investors away. The insider buying confirming indicator is a positive feature, broadcasting the direction of smart money. The 50% down means the price is attractive, the insider buying suggests this price will rise.

Insider trading is a matter of public record because the SEC requires that company officers file timely reports that detail their buying or selling of company stock. This also includes outside investors who hold more than 5% of the company’s shares.

Questions:

1. How much buying is significant? Research shows the average insider trade was $59,000 during the period studied. To set a level that is truly significant, the contrarian uses twice that value, or $120,000 as a break point.
2. Over what period should the buying be measured? An insider is more likely to buy or sell in smaller increments spread over time rather than one large trade that could affect the price. Thus, an additional criteria would be that the $120,000 trade be a total value over the past six months.

In any case, the larger the trade and the more insiders taking action, the stronger the buy signal.

We will deal with the fundamentals confirming indicator as well as contrarian sell signals in later guideposts. Let’s close with an easy way to access insider buying information on the net.

1. On the Pro-fundity Home Page, scroll down and click on Tools & Links
2. Click on Investorama, taking you to the Stock PowerSearch window.
3. For this example, enter the ticker DLTK, and click on GO.
4. This will take you to the large Stock PowerSearch screen featuring Deltek Systems Inc. with many options to select.
5. Scroll down and click on Yahoo! Company Profile.
6. This will take you to a screen highlighting features of DLTK. Click on Insiders.
7. This shows inside trades made on this stock showing the value of each trade.
8. For a great explanation of the Insider information shown, scroll to the bottom of the window and click on Questions or Comments.
9. Click on Insider Trades FAQ.
10. To look at another ticker, back out of Yahoo with the Back Arrow to Stock PowerSearch and enter the new ticker, press GO.
11. Other selections on the Stock PowerSearch for Insider information include Quicken.com and I/B/E/I Earnings Report.
12. You may not be able to find insider information on all tickers.

Next week we ill consider the Fundamentals Confirming Indicators to see under what other conditions the contrarian will buy a stock.

Bibliography:
"The New Contrarian Investment Strategy," David Dreman, Random House, 1982
"Contrarian Investing," Anthony M. Gallea & William Patalon III, New York Institute of Finance, 1998

Stay tuned.

It is our intent to help our subscribers understand market strategies well enough to make informed decisions and understand the risks.

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