Investing Guide at Deep Blue Group Publications LLC Tokyo: Winning An Insiders' Game In Stocks

Buy stocks that are getting scarce–their price is likely to go up. That quirky strategy is behind AdvisorShares TrimTabs Float Shrink (TTFS), an exchange-traded fund that invests in companies creating a share scarcity of sorts by buying in their own stock. In the philosophy of Charles Biderman, founder and chairman of TrimTabs Investment Research, prices on Wall Street are a function not so much of earnings as of supply and demand.

That philosophy would be somewhat jarring to a student of corporate finance. Indeed, a classic theorem says that, in the absence of real-world frictions, a corporation neither helps nor hurts its shareholders when it buys and sells shares, borrows money or pays a dividend.

As for shares going up because they are in short supply, the finance professor might well ask Biderman: How could there be a scarcity of something that can be manufactured with a mouse click? Corporations can issue more shares whenever they feel like it.

They can, but they don’t. If a company like Apple AAPL +0.04% or 3M MMM +0.08% is buying its own shares in the open market, Biderman says, it’s more likely than not that the insiders expect good things from the business. TrimTabs owns both of those stocks.

If Twitter TWTR +1.74% or Alibaba is selling shares in a public offering, that could be because the smart money considers the pricing rich. Biderman doesn’t want to own stocks like those.

However quirky Biderman’s theory looks on paper, it works passably well in practice. The fund is up 96% since it opened its doors in October 2011; over the same period the S&P 500′s cumulative return is 81%.

Delving deeper into his theory about what makes Wall Street tick, Biderman describes assets–commodities or stocks–as chips in a casino. “In every market the house has an edge over the players, or the market wouldn’t exist,” he says. Commodity producers, corporate managers and Wall Street underwriters have to be compensated, or they wouldn’t bother to be in business.

What saves us, he goes on, is the fact that in a rising economy there is enough money to make the insiders happy and still leave at least a little something for ordinary investors. And ordinary investors can improve their odds by watching what the insiders are doing.

If there’s a bit of cynicism in Biderman, it could be blamed on the fact that the 67-year-old started his career as a journalist (assistant to Alan Abelson, the longtime editor of Barron’s). He got a degree at -Harvard Business School, became a Wall Street analyst and started TrimTabs, a Sausalito, Calif. boutique research firm for institutions, in 1990.

Biderman branched into money management late in life. He was just reaching Medicare age when the Float Shrink fund started taking in money. It now has $138 million.

There is no shortage of corporations doing buybacks. Standard & Poor’s researcher Howard Silver-blatt calculates that share repurchases have overtaken dividends as the principal means by which big companies disburse profits. Shareholders should be pleased. The switch to buybacks lowers their taxable income.

So corporate executives who authorize share repurchases are devoted to maximizing the aftertax wealth of shareholders? A cynic would have an alternative explanation. Buybacks also boost the value of executive stock options, to which executives are especially devoted.

Let’s pursue the cynic’s line of thinking. In a world where any corporation might rationally replace its quarterly dividend with a buyback program but only some do, what do buybacks tell us? Perhaps that the insiders at those companies see better prospects ahead. “It’s not illegal for a company [as opposed to the managers] to buy back shares on insider information or to sell on inside information if things are getting worse,” Biderman says.

You can’t put too much faith in raw share reductions, since corporate treasurers’ timing is imperfect. Buyback volume was high in 2007, when shares were expensive, then shrank in the depths of the recession, when shares were cheap.

So Biderman looks for further evidence that the share repurchases are a sign of strength. To get in his portfolio a company has to be generating more cash from operations than it is consuming in capital expenditures, and it can’t be increasing its ratio of debt to equity. That distinguishes his fund from PowerShares Buyback Achievers (PKW).

There’s another refinement. The TrimTabs analysis looks not at shares outstanding but at the “float,” the count of available shares not held by insiders. If the company is buying in shares but managers are lightening up their own holdings just as fast, then Biderman doesn’t want to own it.

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