How to Profit From Insider Buying

Tracking insider buying can boost your returns ... but only if you know what to look for

How to Profit From Insider Buying

Investors have long known that insider buying trends provide insight into the people who know the most about a company’s fortunes. If insiders are willing to stake their personal fortunes on their own company’s stock, the thinking goes, then average investors should do the same.

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The insider buying signal came into the spotlight just two days ago, when General Electric (GE) CEO Jeffrey Immelt announced he was pouring his entire $2.6 million bonus into GE stock. In this case, the markets certainly got the message: GE shares have rallied 3.2% in the past two sessions.

But just how much value does tracking insider buying add over time?

Based on a recent study and an ETF that invests in stocks with heavy insider buying, the answer is “quite a bit” – on both short- and longer-term bases.

A Meaningful Return Advantage

Perhaps the best set of free, publicly available evidence is S&P Capital IQ’s October 2013 piece “Informative Insider Trading – The Hidden Profits in Corporate Insider Filings.” The study shows that insider buying as a whole is a net positive for returns in the week following the announcements, but it’s a particularly effective signal when it comes in three forms: non-recurring purchases, “intensive buying” (i.e., more than one official involved), and a directional change (when a seller becomes a buyer). Purchases by CEOs also tend to provide stronger signals than purchases made by other insiders.

This is good to know, but it assumes investors have the opportunity to monitor Form 4 filings throughout the day and react immediately. For most of us, this isn’t remotely realistic.

Also, investors who pick and choose individual stocks with heavy insider buying might not necessarily be getting the full bang for their buck. There are two reasons for this:

  • First, an executive’s decision to buy doesn’t occur in a vacuum. Insiders know full well that their transactions will be filed, will show up on websites such as insidertrading.org, and in some cases will be reported by the media. For an example, we need look no further than Jeffrey Immelt’s purchase of GE stock this week. In this sense, the knowledge that the purchase is publicly reported — and can have a meaningful impact on price, even for the General Electrics of the world — skews the significance of the act.
  • Second, as laid out in a white paper titled “The Sabrient Insider Sentiment Index,” — authored by Joshua Anderson, Ph.D. for Sabrient Systems — insiders have a tendency to accept an inferior risk-return profile with their own company’s stock for a simple reason: peer pressure. Anderson writes, “…people are also apt to overestimate the value of their special knowledge or to be overly optimistic about their own firm’s chances for and magnitude of success. In a way, there is a risk to insiders in not investing, since if their firm does well and they opted not to buy, then they will feel less well-off than their colleagues who did buy more. It is plausible that insiders might be willing to accept a higher risk for the same level of expected reward in their own stock.”

Guggenheim ETF Adds Another Dimension

So how can investors profit from insider buying?

One way is to consider an ETF that seeks to invest in stocks with heavy insider buying: the Guggenheim Insider Sentiment ETF (NFO).

The methodology behind the construction of the underlying index, the Sabrient Insider Sentiment Index, has two components: favorable insider buying trends and rising earnings estimates. Adding earnings into the equation helps control for the factors noted above by assuring that the fundamentals of the stocks it holds are headed in the right direction.

This strategy has delivered outstanding results over time, performing even better than the advocates of using insider buying as a signal may expect.

Since its inception on Sept. 21, 2006, NFO has produced an average annual total return of 10.71%. The Russell 3000 Index, which Sabrient uses as the benchmark for the strategy, returned 7.49% in the same interval, while the SPDR S&P 500 ETF (SPY) checked in with an average annual return of 7.01%. The difference between NFO and SPY on a $100,000 portfolio in that time period: a whopping $47,770 ($213,480 vs. $165,710).

This demonstrates that insider buying — when accompanied with an approach that takes fundamentals into account — is an important driver not just of short-term performance, but also long-term returns. And the best part about having an ETF for this strategy: Investors have the opportunity to mine this eclectic portfolio for their own individual stock ideas.

The top 10 holdings in the Guggenheim fund are shown below, and the full listing of portfolio holdings can be found here.

Stock Ticker
Forest Laboratories FRX
Green Mountain Coffee Roasters GMCR
Albany Molecular Research AMRI
Trinity Industries TRN
Mallinckrodt PLC
MNK
Logitech International LOGI
Ubiquiti Networks UBNT
Alcoa AA
Silicon Image SIMG
Verifone Systems PAY

As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.


Article printed from InvestorPlace Media, http://investorplace.com/2014/03/profit-insider-buying/.

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