Eight months ago I bought American Eagle Outfitters (AEOS) because I felt the market overreacted to an earnings guidance and I noticed the Chairman had purchased $21 million of shares.  Last week I sold my entire position because my first reason for buying the stock no longer holds true: the price has risen back to where it was when it first dropped.  Also, many insiders (but not the Chairman) have been unloading shares lately and that always makes me uneasy.  My average gain on two sets of shares was 50%.

Going forward, do I think AEOS is a great company?  Absolutely.  They recently announced a 50% dividend increase and are opening new concept shops.  Sales are great, earnings are great, and the cash keeps flowing in.  The chain could keep growing and growing and thus the stock could keep shooting up and up.  Since they are small, American Eagle is also an excellent acquisition target.  Prospects look good as a whole.

But I did not buy the stock because I liked the business and wanted to be a long-term investor.  I bought the stock because I was exploiting an obvious overreaction in the market.  Furthermore, from the Chairman’s insider buying, I knew the price was good value.  At current multiples, I believe the price is fair, or maybe a little undervalued, depending on the outcome of their growth initiatives.  Time will tell.

However, there are plenty of cheaper retailers out there.  Pacific Sunwear (PSUN) looks more undervalued, also has recent insider buying, and is repurchasing shares.  Or better yet, I am personally considering Wal-Mart Stores Inc (WMT).  That is because I firmly believe the US Dollar will collapse and the economy will go into a major recession.  If that happens, people won’t necessarily buy from Gap Inc (GPS) or AEOS, but for sure they will continue to shop for necessities at the cheapest store around: Wal-Mart.

Let me close with some lessons learned from AEOS.  There were two of them.  First, I realized the power of buying great companies at bargain prices (a.k.a Magic Formula).  Because AEOS is such a cash-cow, I was able to stomach a one-day 8% decline, and had no problems buying more when the stock was down 10%.  Second, the insider buying gave me great confidence in knowing what price I should pay.  Insider buying is like a confirmation of value, and sometimes even acts as a catalyst or price support for the stock.  Never purchase a stock without knowing what the insiders are doing first!  In summary, I learned a lot from this deal and will keep trying to find more just like it.