7 'Insider' Indictors to Note Before Buying Value Stocks 

Aviation is safer today than it has ever been.

Modern commercial aviation boasts an accident rate of approximately 1 fatal accident per 16 million flights, far lower than historic numbers.

Do you know why has flying become so safe?

There are two black boxes on an aircraft. One records mechanical information (e.g. fuel levels). The other records sound in the cockpit (including the pilots' conversations).

During accident investigations, these black boxes provide holistic, unbiased information to reveal what happened, so corrective measures can be taken to prevent future accidents.

Pilots are typically rewarded (not penalised) for reporting mistakes. Accidents are investigated in depth and insights are shared throughout the industry to facilitate learning and improvement.

This is summarised as an open loop system in the book Black Box Thinking where failures are seen as a building block for success.

In the investing parlance, information sharing about what is happening 'inside' the cockpit or 'insider activity' has helped make flights safer.

Unfortunately, such insider indicators are often ignored in the world of investing and therefore stock price crashes are commonplace.

Take the case of IndusInd Bank. In a recent interview to CNBC, the CEO attempted to explain the bank's lapse of corporate governance in reporting discrepancies in derivative transactions.

He said...

• I continue to believe the bank is fundamentally very strong. Yes, we've had our hiccups and the hiccups have not left us. The treasury thing has been a big blow personally to me also, but I think it's a matter of time that the bank will come up, and I don't think there are any hidden skeletons in the cupboard, and we are not hiding any losses, or we are not hiding anything from the investors.
  
  There is an absolute transparency in the system, and if I can come and disclose the number before I knew the final number, I think it tantamounts that we want to be transparent to our investors, and to the media at large, and I don't think there is a view that we want to hide anything in the market.

The problem is that the CEO's speculation of more skeletons in the cupboard was not without reason.

In December 2024, the RBI had levied a monetary penalty of Rs 2.7 m against IndusInd Bank for non-adherence with deposit interest rate guidelines. The RBI was of the view that the bank had opened savings accounts for ineligible parties, and in doing so, had violated guidelines.

Further, RBI had restricted the reappointment of Sumant Kathpalia as managing director and CEO for a term of only one year. This was against the three-year tenure proposed by IndusInd Bank's board. The regulator cited dissatisfaction with the bank's risk appraisal process for the early change in management.

To top these, there had been significant insider selling of shares amongst the top management of the bank in 2023 and 2024.

Such information is disclosed to the exchanges.

Of course, one could argue that such warning signs are more visible only in hindsight.

But it is important that investors be wary of specific insider indicators that could alert them of corporate governance lapses.

Here are seven indicators of insider activity that should not be ignored:

1. Use of Derivatives and risky financial instruments

   Ever since the financial crisis of 2008, derivative instruments have been regarded as 'financial weapons of mass destruction'. Hence entities that go overboard in trying to profit from such instruments are bound to have their risk management policies questioned.

2. Role of Auditors

   The role of auditors truly came under the spotlight when a big 4 audit firm (PwC) was found guilty of shadowing the massive corporate governance lapse at Satyam Computers in 2008.

   The story repeated itself in 2018. While auditors were to play a crucial role in pointing red flags, they chose to turn a blind eye to some frauds. And when matters get worse, typically, the auditors resigned.

   32 auditors had resigned between January and May 2018. The number may seem miniscule given the quantum of listed stocks. However, what was alarming was the rationale of the resignations, which weren't in the normal course of audit contracts.

   Auditor resignations have especially been a warning signal for smallcaps.


3. Lack of Transparency

   The greed of fast growth often leads managements to diversify into unrelated business, leverage balance sheets, undertake huge capex or buyout businesses at steep valuations. Such misallocation of capital can be a drain on shareholder returns.

   However, management tends to deny such misallocation of capital instead of being transparent in sharing the possibility of lower returns with minority shareholders. Expensive acquisitions, foray into unrelated businesses etc need to be questioned for transparency on behalf of the management.

4. Quality of Assets

   The absence of an external auditor doing a concurrent audit on IndusInd Bank's marked-to-market (MTM) derivative losses has put the spotlight on a process gap that might not be limited to the private lender alone.

   In IndusInd's case, although the treasury transactions faced internal scrutiny, there was no external examination of the trading transactions. External scrutiny could have exposed the bank's treasury to questions on its hedging positions.

   Such regular audits can also point to vulnerability of the banks' asset quality and give warning signals before the loans become unrecoverable loans (called non performing assets, NPAs).

   Given how vulnerable the banks' return ratios (Return on equity) are to the rise in NPA and depletion of networth, not keeping check on the slippage of asset quality and treasury book is as good as the management's disregard for shareholder interests.

   
5. Solvency

   In a banking entity's loan portfolio, NPAs impact operating performance, which in turn disturbs the profitability, liquidity and solvency of a bank. A bank that sees a sharp deterioration in solvency (calculated by the capital adequacy ratio, CAR) could even witness an embargo on deposit collection, lending and cash withdrawal in extreme cases.

6. Promoter pledging

   Share pledging is not an illegal activity, but you need to keep your eye out for companies with questionable managements.

   This is because over leveraged firms with high percentage of pledged shares could very well turn out to be poor investments. If the company fails to repay and the lender decides to sell the pledged shares in the open market, then the promoters will be left with only a minority stake in the company. risking losing control over the company. Here's the list of stocks with high promoter pledging in India.

7. Contingent liabilities

   As the name suggests, these liabilities turn real only when the event they are contingent upon does so. They are not a part of a balance sheet in the normal course of things.

   However, they must be taken note of if they account for a large part of the company's net worth. For if they turn real, they could land the company in serious trouble by wiping out a huge chunk of its net worth.

   By themselves, these parameters may not yield much information about the quality of financial reporting of a business. But combine them and you could be well onto something.

To conclude, the insider activities may not be the exact sign of weakness in a stock. For often insider selling of shares could also be out of the promoter's need for liquidity. However, the indicators are certainly a checklist that investors could consider evaluating before buying value stocks.

For instance, while most investors are wondering if 'IndusInd Bank is now an attractive value buy', the question left to be answered is whether the bank's networth is now stable. Without adequate assessment of its books and regulatory scrutiny judging the bank as a deep value stock would be a mistake.

More importantly, entities that fail to uphold corporate governance often tend to lose premium valuation multiples for a prolonged period.

So do not rush in buying value stocks without running this checklist.