Insider stock transactions – the buying and selling of stock by corporate “insiders” – won’t tell you where the overall stock market is headed. But the analysis of this type of legal insider trading can be a handy indicator when it comes to making buy and sell decisions on individual stocks.

In fact, by watching insider transactions, investors can actually gain an edge in certain situations, an academic researcher and leading expert on insider transactions said in an interview with Barron’s earlier this month.

“What we found is that in small companies, insider trading is more predictive. When insiders trade more, those transactions are more predictive,” said the researcher, H. Nejat Seyhun, a professor of business administration and finance at the University of Michigan's Ross School of Business. “And large trades by top executives tend to be more predictive. Maybe in smaller firms, it is easy for top executives to understand everything about the company. There is also a lot of volatility in smaller firms, so whatever information they have has large return implications. They take advantage of this by trading.”

If your primary source of information is the sensation-driven popular media, you probably have at least three distinct impressions about insider stock trading:

• It usually involves unscrupulous executives or their shady financial associates reaping large and illicit profits by buying shares in a company based on information the general public isn’t yet privy to – information that will send the stock price soaring once it’s announced.
• It’s nearly always illegal.
• It’s always unfair to the average investor.

The reality is that all three of those impressions – while they may reflect today’s headlines – are largely incorrect. Insider transactions by beneficial owners, board members, executives, managers and the like – occur on a daily basis, with most transactions based on public information or personal financial considerations. And it’s perfectly legal, so long as trades above a certain size or value are reported to the U.S. Securities and Exchange Commission (SEC). Section 403(a) of the Sarbanes-Oxley Act of 2002 requires the reporting of insider stock trades within two business days, and the SEC issues an updated list of these filings each Friday. Companies must also file a so-called “Form 4” report by the 10th day of each month listing all insider trades for the prior month.

What’s more, it can actually be highly advantageous to average investors who monitor insider trades as a guide to what’s going on with specific companies, industry groups or the market as a whole. Indeed, there’s a standalone industry of advisory services that base the bulk of their recommendations on the actions of corporate insiders, as reported to the SEC.
The general premise underlying the analysis of legal insider trading is fairly basic:

• When a lot of corporate insiders are buying shares in their company, it typically means they see improving business conditions ahead. Thus, it’s a bullish indictor for the individual stock – and possibly for the industry the company is in.
• When a large number of corporate insiders are selling shares in their company, it usually indicates that rough times are ahead. Thus, it’s a bearish indicator for the individual stock – and maybe for its industry.
• When insiders for a large number of different companies are buying stock, it’s bullish for the market as a whole – and, when a lot of insiders at different companies are selling, it’s bearish for the overall market. Because of this, the “ratio of insider buys to insider sells” is a closely watched indicator for many analysts and market advisors.

The Lowdown on Insider Buying

However, as is usually the case with broad theories, the actual analysis of insider trading isn’t quite that simple. For starters, most analysts place far more emphasis on insider buying than they do on insider selling. As mutual fund legend Peter Lynch explained it: “There are many reasons why insiders sell, but only one reason insiders buy” – that “one reason” being, of course, that they think the business fortunes of their company are going to improve in the weeks or months ahead, sending the stock price higher. 

Actually, there is one other reason for insider buying: When new board members or corporate officers are named, they’re often required to purchase a large block of stock in the company as an act of faith – even if future expectations reveal nothing but gloom. Many companies will actually even loan new directors the money needed to make such good-faith purchases.

That’s a major reason you should never place too much bullish emphasis on reports of just one or two insider buys of a single company’s stock.
Timing can also be an issue in interpreting insider buying. Although it is definitely bullish, the fact that six or seven insiders buy a company’s stock doesn’t mean the price is going to jump next week, or even next month. In actuality, corporate officers or executives tend to buy as far in advance of expected good news as possible, if only to avoid even the appearance of illegal insider trading.

Insider Selling Can be Tricky

Unlike insider buying, stock sales by insiders can have a number of catalysts – some bullish and others bearish. And many of the catalysts triggering the sales have little or nothing to do with a company’s anticipated fortunes or the future direction of its stock price.

For starters (the Obama administration’s proposed limits on executive pay notwithstanding), the top officers of most major corporations receive a large portion of their compensation in the form of stock. If they later sell some of those shares, the reason can be very simple: Maybe they need the cash for ordinary expenses, or want it to fund a new car, vacation or other purchase. Perhaps they want to “diversify” their investment holdings. Tax bills, divorces or a child’s entry into college are also frequent triggers for “routine” insider sales.

As such, a one-time stock sale by a single insider – particularly if the transaction involves less than 10% of his or her total holdings – usually shouldn’t be a cause for concern about the company. On the other hand, if the weekly SEC reports show several top executives selling large blocks of stock at the same time, you’d probably do well to conduct at least a quick review of the company’s fundamentals in a search for signs of trouble to come.

It’s also a good idea to check the news if you see multiple sales or large-block liquidations by a single executive or one or two board members. Such sales could be prompted by the insider’s retirement or firing, or by the election of new board members.

News reports can also explain other large sales that are unrelated to the actual operations of the company.

For example, the accompanying chart (“Insights on Insiders”) – which lists the 10 companies with the most insider sales for the 30 days ended Nov. 6 – shows software giant Microsoft Corp. (Nasdaq: MSFT) at No. 2. But the sales don’t indicate problems with the company.

Rather, the charitable foundation supported by Microsoft founder William H. “Bill” Gates III and his wife, Melinda, announced more than $250 million in donations and grants in October and the bulk of the Microsoft stock sales were made by Gates to fund those gifts.

[Similarly, though it didn’t make the Top 10 list, Warren Buffett’s Berkshire Hathaway Inc. (NYSE: BRK.A, BRK.B) stock also reported a number of insider sales linked to the Gates Foundation, which is a major Berkshire shareholder.]

If routine insider activity or news events can’t explain a surge in insider selling, the reason probably lies with a problem in the company’s operations or outlook – but the true cause may be difficult, or even impossible, to discern. Still, research shows it’s well worth noting. Seyhun, the University of Michigan researcher and recognized expert on insider trading (his book, “Investment Intelligence from Insider Trading” is recognized as the standard on the subject), did a comprehensive study that quantified the value of the information to investors:

• When executives bought shares in their own companies, the stocks outperformed the overall market by 8.9% over the following 12 months.
• When executives sold shares in their companies, the stocks underperformed the total market by 5.4% during the ensuing year.  

Broad Market Calls Less Reliable

Seyhun says that his analyses of insider trading shows that investors can benefit by tracking the trades made by corporate insiders and using that information in making their buy-and-sell decisions on individual stocks. However, the results are far less reliable when investors attempt to use the insider-trading information to predict the movements of the broader market.

Information on what insiders are doing “is statistically very, very significant” when used to predict the future prices of individual stocks, Seyhun said in the Barron’s interview. “It shows up in different time periods. It shows up in different kinds of firms. It's more important in smaller firms than large firms, but it is a very strong statistical relationship. And this is all during an era when there are lots of restrictions and penalties and sanctions on insider trading with material nonpublic information.”

For example, in early May of this year, The Wall Street Journal reported that, in the wake of the rally from its mid-March bottom, insider selling had spiked to its highest level since September 2008, with 1.2 insiders selling for even one who was buying. The article indicated this was very bearish and suggested individual investors might want to follow the insiders’ lead and sell, as well.

So what happened? As we now know, with the exception of a modest dip in July, the overall market has rallied steadily ever since, with the Dow Jones Industrial Average hitting a new yearly high earlier this month. In retrospect, it appears the insiders were merely taking profits from the March-April run-up to offset losses suffered in the 2008 meltdown.

This points out the necessity of taking a longer-term perspective when using insider trading as a broad-market indicator. For example, a number of analysts expressed concern in September when it was reported the insider “sell-to-buy ratio” had reached 60-to-1.

However, while that seemed alarming in the moment, that alarm turned out to be more alarmist when further analysis showed the net insider selling in July and August was just over 30% of the net insider buying in the first six months of 2009. A check of the recent price history of the companies being sold also showed the inside sellers were likely taking healthy profits rather than bailing out of a bad situation.

Insider selling may be a more valuable tool when it comes to industry analysis. For example, back in August 2008, Bloomberg News reported that insider sales by officers and directors of leading oil refiners, including Valero Energy Corp. (NYSE: VLO) and XTO Energy Inc. (NYSE: XTO), had risen to record levels in July – despite a spike that sent the prices of crude oil and retail gasoline to all-time highs. By the end of the year, both oil and gasoline prices had plunged by 30% or more – and the stocks of major refining companies had done even worse (Valero went from $38 to $14 in just two months).

Places to Start Your Research

The bottom line is that the analysis of insider selling can be an important tool in determining potential trouble for both individual stocks and the broader market – but you can’t take it at face value. Always look a little deeper to make sure what you’re seeing really means what you think it does.

If you want to review recent insider trades relative to the stocks you hold or are considering buying, here are a couple of sites that offer free insider-trading reports:

• Yahoo! Finance: Call up the quote for any stock and click on “insiders” listed under “ownership” in the left column for a list of the latest trades.
• SEC EDGAR Database: This is the official site for SEC reports and the first place insider trades show up, but it’s not pretty to look at and somewhat difficult to navigate. First you have to find the “Central Index Key” (CIK) for the company you’re interested in, then use that to search for individual filings at this site.

News and Related Story Links:

• SEC.gov:
  Official Web Site.
• Money Morning Special Report:
  International Investing: Why U.S. Investors are “Boxed Out” of Big Global Profits.
• Wikipedia:
  Form 4.
• Forbes.com:
  Peter Lynch.
• Barron’s: Q&A:
  The Inside Skinny on Insider Trading.
• H. Nejat Seyhun:
  Faculty Profile.
• Amazon.com:
  “Investment Intelligence from Insider Trading.”
• ZeroHedge.com:
  Insider Selling/Buying Ratio Doubles to 61.8x.

 

Tags: Business/Finance, Insider, Stock, Stock Market