Some investors incorporate insider buying into their stock selection strategy under the conclusion that insiders know the company best and wouldn't buy unless the stock was a good value - but this assumption isn't always true. (To learn more about this concept, be sure to read Delving Into Insider Investments.)

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Like all stock selection strategies, insider buying should be examined closely to determine if the standard reports from news services actually represent insider buying, or if something else is involved, which could indicate a false signal.

I recently saw a headline about insider buying at Palm (Nasdaq:PALM), a technology company. After reading further, I was more encouraged as it listed three different entities buying more than 8 million shares each, and all three were directors. This would seem like a bullish sign.

After further research, I discovered what the buying really meant. In December 2008, Palm sold Series C preferred stock to an investor. That preferred stock was convertible to Palm common stock at a price of $3.25, a substantial premium to what Palm was selling for at the time. Palm also secured the right to remarket $49 million of these shares to the public at a later date if it choose to.

The management of Palm was betting that its stock price was depressed due to an overreaction by investors, and it wanted to raise capital on better terms later if this idea was proved true.

Three months later, Palm decided to remarket the shares, approximately 18.5 million of them and compelled the investors to give them up. The company returned what the investors paid for them, and then sold them in a public offering - in addition to another five million shares - at $6. The investors then took the $49 million and bought stock in the offering.

The news headline had three entities buying shares, but it looks like they were all interrelated even though you now know they were not. In this case, the overall result still shows a bullish sign, as the investor could have kept the cash and not reinvested, but you wouldn't be acting on a false assumption.

Identifying False vs. True Signals
Option exercises can also give false signals. An insider at Activision Blizzard (Nasdaq:ATVI) recently exercised options and acquired three blocks of stock totaling 4.3 million shares, and then sold them in the $10 range. It hardly seems like a vote of confidence to buy shares of a $10 stock for $1.

An insider at Salesforce.com (NYSE:CRM) did something similar, acquiring two blocks through an option exercise at prices of $13.73 and $22.64 and then disposing of the shares in the low $30 range.

Of course, some insider buying is true and clean, and the financials have seen much of this lately as the sector attempts to find a bottom. MBIA Insurance (NYSE:MBI) saw several insiders buying stock in the open market recently, with Joseph Brown, the CEO buying 75,000 shares at $3.

Executives at General Electric (NYSE:GE) purchased at total of 130,000 shares recently. Buyers include Jeffery Immelt, the CEO and Michael Neal, the Vice-chairman, who each bought 50,000 shares. A director of the company also bought 30,000 shares.

Insider buying is a useful tool to consider when making a decision on which stock to buy, but it should be looked at carefully lest it give a false positive signal. Investors need to look behind the headlines and conduct their own research before buying on this basis.

To learn about interpreting the other side of the trade, read Insider Selling Isn't Always A Bad Sign.

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