Tips for beating the market tend to come and go quickly, but one has held up extremely well: if executives, directors or others with inside knowledge of a public company are buying or selling shares, investors should consider doing the same thing. Indeed, much research shows that insider trading activity is a valuable barometer of broad shifts in market and sector sentiment. But, before chasing each insider move, outsiders need to consider the factors that dictate the timing of trades and the factors that conceal the motivations.

Reasons to Follow
The argument for shadowing insiders makes a lot of sense. Executives and directors have the most up-to-date information on their companies' prospects. Intimately acquainted with cyclical trends, order flow, supply and production bottlenecks, costs and other key ingredients of business success, these insiders are way ahead of analysts and portfolio managers, not to mention individual investors. Insiders' decisions - legal or not - to trade in their own companies' stocks are certainly worth examining.

Research supports the view that insider information works best in the aggregate. Independent research firm Market Profile Theorem (MPT) showed that insider trading trends signal an up-and-coming shift in market sentiment. To identify trends, MPT analysts employ the Brooks ratio, which divides total insider sales of a company by total insider trades (purchases and sales) and then averages this ratio for 2,500 stocks. If the average Brooks ratio is less than 40%, the market outlook is bullish; above 60% signals a bearish outlook.

University of Michigan finance professor Nejat Seyhun, author of "Investment Intelligence from Insider Trading" (2000), offers a similar story. Stock prices rise more after insiders' net purchases than after net sales. On the whole, insiders do earn profits from their legal trading activities, and their returns are greater than those of the overall market.

The Stories Behind the Signals
Surges in insider trading appear to divine an upcoming switch in the market's direction. But outside investors have to be awfully careful about reading positive messages into every insider buy they see. Investors must also avoid treating individual sales as signals to unload their own holdings. Admittedly, one big insider buy or sell order might offer investors a hint of things to come, but it hardly translates into a sure-fire pointer for outperforming the market.

More companies require newly appointed executives and directors to own shares. As market indicators, these required purchases are irrelevant to outside investors. Other companies encourage ownership by providing stock loans to executives for half the purchase price. These are examples of the company taking steps to align the interests of management and shareholders. While certainly commendable, these transactions do not provide reason for outsiders to buy stock.

Sometimes an insider will announce a stock buy just to get Wall Street's attention, but announcing is not the same as doing. Healtheon founder Jim Clark once proclaimed that he intended to buy as much as $100 million worth of the company stock. Healtheon shares surged the day of the announcement, but Clark didn't buy anywhere near as much as he had suggested. The stock quickly declined, and those who followed his lead got burned.

Although they may buy their company's stock because they expect good things to come, insiders do not sell simply because they think their company shares are about to sink in value. Insiders sell for all kinds of reasons. They might want to diversify their holdings, distribute stock to investors, pay for a divorce or take a well-earned trip.

Another big problem with using insider data on specific companies is that executives sometimes misread company prospects. Some insiders may buy even as share prices collapse. When insiders do correctly assess their companies' share, it can be a matter of luck as much as anything else.

Employee stock options, which compose an ever-larger portion of executives' compensation, can make analysis tricky. Remember this: if the insider is exercising stock options by buying the stock, it is not very meaningful if the options were granted at rock-bottom prices. At the same time, when buying through the exercise of their options, executives do not have to disclose this. Outsiders can really only guess how much "real" buying is taking place.

Tips for Using Insider Data
Investors should consider the following guidelines when analyzing specific insider trading situations:

  1. Some insiders are better than others.
    Directors know less about a company's outlook than executives. Key executives are the CEO and CFO. People running the company know the most about where it is heading.
  2. A lot of trading is better than a little.
    One or two insiders at a big corporation do not make a trend. Three or more provide a better indication that something is happening. Generally speaking, solitary trades are unreliable.
  3. People at small companies know more.
    At small and mid-sized companies, virtually all insiders are privy to company financials. At big corporations, information is more dispersed and typically only the core management team has the big picture.
  4. Stay the course.
    Evidence suggests that insiders tend to act far in advance of expected news. They do this in part to avoid the appearance of illegal insider trading. A study by academics at Pennsylvania State and Michigan State contends that insider activity precedes specific company news by as long as two years before the disclosure of the news.

Here is the upshot: insider tracking is not easy, and it is hardly a guarantee of big returns. A pattern of trades might offer a cue for upcoming market shifts, and it is certainly reassuring to buy or sell a stock knowing that an insider is doing the same thing. Following the lead of insiders, however, will never replace diligent research. For more on how to find insider data and how it can help your investing decisions, see Keeping An Eye On The Activities Of Insiders And Institutions.

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