Insider Play example: NRZ (rethinking the changes in assumptions when new events occur)

This is a very interesting example. There was recent insider buying between $5-$6. Since then, the price dropped to $3.30. Do we buy? Answer: HOLD YOUR HORSES. There might have been a change in the situation even in those two weeks. Find out the change in situation, and ask yourself whether those insiders anticipated it or not.

To help explain the nuances of the trade, here's my thinking process.

First caveat when using insider buys ... this is a prerequisite for further inspection, not a guarantee that it makes money. You still have to understand the business model, and have a thesis why the stock should be worth more. The insider buy should corroborate your thesis.

The situation:

The insiders, especially the CFO, bought good amounts of stock. The CFO is the one that should be the closest to understanding their debt structures, and the net asset values of the company. He bought 18 Mar 2020. Only 2 weeks earlier. The key question to always ask, did anything change since he made his calculation to buy stock? The answer is maybe, and so we have to look into the nuances of the situation.

First thought:

What was the situation then?

By this time, COVID fears were already starting to rise, and there was talk of retrenchment etc. So, I'm sure he baked this into his calculation. However, since 2 weeks later, there were some new news.

Trump said that the COVID was going to take longer than expected, he postponed people going back to work until after Easter, when initially he said it was hopefully by Easter. Next, and maybe more importantly, there were reports that U.S. regulators are holding off on helping mortgage servicing firms that could be hit with a surge of missed payments from borrowers affected by the coronavirus crisis.

Now, M-REITS make money by interest payments from the mortgages they hold minus the bank borrowing interest. So, depending on how leveraged they are, if the interest payments stop coming in, they may have to sell off assets to cover the liquidity.

So, the question is, did the CFO project that the US might have only 1 quarter of weakness? Maybe we will have 2-3 quarters of weakness. And next, how much assets will they have to sell (at discounted prices) to service immediate debt? Also, will they be able to refinance expiring debt?

So the first question to ask is: at the time of Insider Buying, was there anything new that happened to change the situation?

In this case, maybe.

The question is whether this news was baked into the CFO's analysis 2 weeks ago.

Answer: it's hard to tell. That's why the price is at $3.30.

However, in the new present regime, KBW thinks, "For NRZ, Hagen and George expect the REIT to continue to sell assets to de-risk its portfolio. "We assume that ultimately book value could fall around 60%, which suggests book value of around $7.00,"

So, this is the thesis. Did the CFO know that damage to their portfolio when this is all over would fall to $7? So if, then this stock could be worth $7. But how do we know?

HOW TO PROCEED:

Since something possibly new occurred, I would wait for at least 2 things before taking action.

1) If this was already factored in by the insiders, you should see MORE insider buying at this level. If insiders bought at $5, then would buy more at $3.

2) Since we aren't sure exactly how low this can get, we could wait until the daily MACD cuts upward as a trigger signal. It's important here because as I mentioned, the broader market is weak.

Decision Trees:

So, if I see MORE insider buying at this level, and the MACD crosses up that would be a strong signal for a short term buy. Remember that in this COVID crisis, 2 weeks can change what analysts or CFOs think. This would be a confirmation that they have factored the new news into their calculations, and although they know the value of their stock should be lower, it might be at $7ish dollars or so.

If I see the MACD crossing, but no extra insider buying, then it's a simple trading buy. This means we only know that they thought the company was worth more than $5 2 weeks ago, but not sure what they think now that mortgage bailouts are delayed. We should have no illusions that this company could be significantly more impaired, but its still possible to gain 10+% just on the retracement alone, before reality sets in.

Risk Management:

NRZ are companies with liquidity and refinance issues but have a lot of assets. The risk and reward are both great. Companies like DELL or XOM aren't having such liquidity issues, and people can still buy computers and oil even when working from home. However, for mortgage REITS, the risk and rewards are greatly magnified.

The shorter the COVID19 lockdown, and the availability of Trump's QE on morgage payers will greatly save a lot of asset destruction.

The longer the COVID, the greater the liquidity issues, and problems to refinance.

This company is the type that can literally make you 100% gains, or 40% more losses.

Conclusions:

If this were me, this is a very interesting speculative gamble, and I would not commit significant amounts of your portfolio.

I definitely would love to see if there is more insider buying with the new news and the new lower prices.

If I see more insider buying with a MACD cut, I would commit maybe 5% of my total portfolio at max.

A person could go in before the MACD cuts upward, but to do that means you have to be an expert in the M-REIT industry and know how this might turn out, or that you know what the CFO was thinking 2 weeks ago and that he expected all this.

But, I will also cut my position if the daily MACD cuts back downward, indicating that it might be much worse than expected.

Diversify

Because this is a +100% or -40% loss type of stock, if you play this, you have to find a couple of others. Some will work out, some might not, but the hope is that the ones that work out will cover the losses of the others.

Remember if you are bottom fishing on non blue chip stocks that are trading near bankruptcy, you have to buy a few. Those that survive will get you 100-200%, and some might drop -50% or go to zero.

Broad Markets

Even when looking at individual stocks, it is still good to have a feel of what the broader market is doing. As the saying goes, a rising tide lifts all boats, but it's the same the other way round.

This quarter is going to be choppy because of the potential for volatile news - unemployment vs QE kicking in, hospitals overrun vs private companies helping to make ventilators or vaccine development.

So, this means that we have to be more risk adverse than usual. If you aren't sure about a company's survival, it means many other people probably do as well, and you might as well pass since there will be other opportunities.

Cautious Investors

For the more cautious investor, I would pass on companies that have legit liquidity threats. There will be companies out there over time that will be low in price, have insider buying, and have better balance sheets and cash flow management.

Hope this helps!

Disclaimer:

This post is for education purposes only. The content reflects the opinions of the writer and is not an encouragement to trade. Before investing in any stocks, consult your own professional financial advisor.