This past week, the House of Representatives voted 417-2 to tighten the ban on insider trading on members of Congress. Given the political climate of 2012, it’s not surprising this bill passed so easily. And there is at least one congressperson — Rep. Spencer Bachus, R-Ala. — who now faces a congressional ethics hearing over alleged insider trading activities.
But investors who learn how to analyze the insider transactions among corporate executives can profit legally from that knowledge. Insider transactions are made public to level the playing field for all investors, and to prevent insiders from cashing in on upcoming major company announcements. Many of the largest financial websites, such as Yahoo Finance, carry this information routinely.
Today, we want to take a look at the basics of insider transactions, and in the process answer these questions:
- Which insider transactions are meaningful and which ones are not?
- Which has more predictive value: insider buying or selling?
- How can investors use insider transactions to time their trades most profitably?
- What is the ratio of insider selling to buying that might predict the next bull or bear market?
Buying and Selling
Insider trading is the trading of a corporation’s stock or other securities by individuals with potential access to non-public information about the company.
Insider buying, rather than insider selling, is a far more reliable indicator of future stock price direction. The reason is simple: Insiders might sell shares of their stock because they need money for a new house, a bigger boat, a fancy wedding or because they are retiring. While an expected drop in the stock price could be a motive at times, it simply is one of many reasons for insiders to sell.
On the other hand, when insiders buy shares of their company stock, it’s generally for one reason only — they have inside knowledge of their company’s prospects that they expect will cause the price of the stock to rise soon.
But having knowledge of insider buying is not sufficient to profit on a regular basis. We also need to separate the significant purchases from the ones that are of minimal importance.
Number of Shares
The number of shares being purchased by insiders is significant, and we must distinguish between automatic purchases, which could be part of a company benefit plan, and real direct market purchases.
If once a month, insider John Smith routinely buys 50 shares of his company stock, we can readily discount the significance of that purchase. Those 50 shares will be bought whether the stock is moving up, down or sideways, as he is simply accumulating shares of stock over time.
But if Smith suddenly buys $200,000 or $300,000 worth of shares, we need to pay closer attention. Furthermore, when several insiders start accumulating large numbers of shares over a relatively short period of time, investors should immediately put that stock on their watch list.
This situation occurred recently at investing firm Jefferies Group (NYSE:JEF). In September 2011, in the midst of a downturn in Jefferies Group stock, four company insiders purchased about 2 million shares each at $12.58 per share. Several weeks later, the same insiders bought another 4.5 million shares at prices between $11.35 and $11.84. Other company insiders also bought smaller yet significant amounts of shares throughout the rest of November as the price hovered above $10.
By the end of November, these transactions started to pay off. The stock took off on a strong uptrend, finally reaching a peak of $16.20 on Jan. 26, 2012. Investors who took notice of the insider buying and purchased shares of their own were treated to a 60% increase in just two months!