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What's Good for the Prince: Insider Trading

What's Good for the Prince: Insider Trading Wouldn't you love to be a fly on the wall in some of the biggest boardrooms in the country? Wouldn't you love to be able to play ?10-questions? with Bill Gates? Well, getting inside information will never be this easy for investors. However, the next best thing is a strategy traders are implementing in their everyday investing called the Signaling Approach and it applies to insider trading. The theory is surrounded by the simple idea that insiders have information not available to the market. Moves made by corporate insiders can signal information to investors and change the price of the stock. The thinking goes that if a high level executive such as the CEO is selling, he is probably doing so for a reason, so you should get out. The reverse applies to insiders buying their companies stock. It is not a coincidence that corporate executives and board members seem to frequently buy and sell at the right times. After all, the Chief Executive and Chief Financial Officers of the world have access to all the company information most investors will never see. But, this doesn't mean we are left in the dark. Insider trading data is available for those who want to use it.

Let's step back and start from the beginning. What is insider trading and who are these insiders? Insider trading is a term that conjures up visions of unlawful backroom dealings to trade shares based on information not available to the average Joe. We have all heard of cases of illegal trading by corporate heads. However, tens of thousands of shares are bought and sold weekly by insiders and the vast majority of this activity is perfectly legal, as long as proper guidelines are followed. The SEC considers typical insiders to be company directors, officials or any individual with a stake of 10% or more in the company. Insiders are required to report their buy and sell transactions within two business days of the date the transaction occurred. Prior to Sarbanes-Oxley (2002), it was ten days. For example, if an insider sold 5,000 shares on Tuesday, July 7th, he would have to report this change by Thursday, July 9th. Changes in insider holdings are sent to the SEC electronically.

There are two types of insider trading: legal and illegal. Illegal insider trading is the buying or selling of a security by insiders who possess material information about the company that has yet to be disseminated to the public. Per SEC (Securities & Exchange Commission) guidelines, this type of act puts corporate insiders in breach of their fiduciary duty. The jist of what the SEC wants is an even playing field. Thus, it wouldn't really be fair for insiders to be able to trade on information no one else had available to them. A common misconception is that only directors and upper management can be convicted of insider trading. However, this is not the case. Anybody who has material and non-public information can commit such an act. This means that nearly anybody, including Martha Stewart's stock broker, family, friends and employees, can be considered an insider. A simple example of illegal insider trading would be a CEO selling stock after discovering that his company will be losing a big contract with IBM next month.

The next type of insider trading is the legal variety. Insiders don't always have their hands tied and their trading is restricted/illegal only at certain times and under certain conditions. One of the key distinctions comes as to whether or not the information traded upon is material. Insider trading is legal once the material information has been made public. Hypothetically, at this time, the insider has no direct advantage over other investors. However, this doesn't tend to be the case. Insiders understand more than just the strict numbers of their company (i.e. earnings, revenues, profit margins). They understand the trends of their business and that's why following insider positioning for you and I is so important. For example, if insiders are buying shares in their own companies, they usually know something that normal investors do not. They might buy because they see great potential, a merger, acquisition or simply because they think their stock is undervalued. Peter Lynch once stated that, ?insiders will sell their stock for a number of reasons but they only buy for one; they think it's going up?. This is important because most high level executives have the majority of their wealth tied up in their company stock. Thus, if they want to buy a new beach house or invest in another company, they have to sell stock. However, insiders don't buy stock in their company for any reason other than they believe in the long-term potential. Understand, insiders are prevented from trading their company stock within a six-month period. Therefore, they only buy stock when they feel the company will perform well over the long-haul.

Let me make one caveat before we move forward to our historical research. Employee stock options, which compose an ever-larger portion of executives compensation, can make analysis a bit more difficult. Remember, if the insider is exercising stock options by buying the stock, it is not typically considered a meaningful purchase as, in many cases, the options were granted at rock-bottom prices. Thus, for insiders to simply convert ?no lose? shares into profit isn't a truly significant event. In comparison, an insider taking money out of his personal checking account to buy stock in his own company at the market price is a significant event and what the signaling approach is truly based on.

Now that we have defined what insider trading is, let's take a look at its relevance and how we can use it in our everyday trading. Nejat Seyhun, a renowned professor in the field of insider trading (University of Michigan) found that when executives bought shares in their own companies, their stock tended to outperform the total market by 8.9% over the next 12 months. On the flip side, he found that when they sold shares, the stock underperformed the market by 5.4%. As a side note, if you?re interested in his research, he wrote a book on the subject called Investment Intelligence from Insider Trading. Essentially, what Nejat's research tells us is that insider trading is significant and if you know how to interpret the data, it can add alpha (out performance) to your returns.

In closing, let me say that insider trading is not new. For years, people have been using the signaling approach by basing their investment decisions on the actions of insiders. There is little doubt that as a complementary indicator, insider trading can be an effective tool when used in conjunction with other technical indicators. Blueprints for beating the market tend to come and go quickly, but one has held up extremely well: if executives and directors of a public company are buying or selling shares, investors should take note.

Resources:
With the click of a mouse, anyone can find the latest insider trade data for just about any public company. Here are a couple of sites that track insider-trading and provide the data at no cost:
  • Yahoo! ? If you look up any stock quote on Yahoo Finance, you will see a link for "Insiders" on the quote page. Yahoo seems to have one of the most current data feeds.
  • Edgar Database ? It's not an easy site to navigate. However, this is where data is first sent. To find these filings on the SEC website, you must search for the "central index key" (CIK) for the company. The CIK is used on the SEC's computer systems to identify corporations and individual people who have filed disclosure with the SEC. Once you have the CIK, you can search for individual filings at: www.sec.gov. Generally speaking, we would recommend using one of our two other sources. However, if you?re a glutton for punishment, EDGAR could be for you.

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