The 7 Lessons Of Insider Transactions

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Includes: GNC, JPM
by: Integer Investments

Summary

Insiders often buy or sell shares in their companies.

These events are considered by many as indicative of future performance.

However, academic evidence shows mixed results stemming from insider trading strategies.

Here we propose seven lessons that can be learned from academic evidence.

From now on we will start exploring insider transactions and will issue a weekly newsletter.

This article will summarize our current understanding of trading strategies and signals based on insider transactions. It will be an introduction to a regular weekly newsletter where we will review insider transactions and select the most interesting companies to invest in, based on these transactions. We will select these investment ideas based on insider activity. But first, let's start with some basic concepts.

Insiders are executives that hold insider information. For example, CEOs and CFOs are considered insiders. They are allowed to purchase stocks of their companies, but only if they don't do so with an unfair advantage, namely using private information. However, there is a thin line between private and public information. For example, executives cannot do transactions based on an M&A proposal. On the other hand, they receive information about everyday business progress, and this is not considered private. However, this type of information can be extremely valuable. For example, if the company experiences a surge in demand for its products, the CEO can trade on this. Therefore, it is not surprising that when insiders buy shares, the market usually reacts positively. A recent example that we followed is represented by GNC. A few weeks ago, we wrote about the company insider trades and likelihood of being acquired by KKR.

GNC has had strong insider activity. Over the last few months, numerous executives have bought company shares. In 2017 alone, two directors, the CIO and the CEO bought shares worth more than $6M (the CEO bought $5M worth of shares). Unsurprisingly, when the CEO disclosed his position, on the 21st of February, GNC stock climbed more than 10% on the news, from about $7.6 to $8.6 per share. At Integer Investments, we started a position on the news as well (as disclosed we exited our position at $9.7 after the earnings, now the stock is back to $8.12). Therefore, we decided to start exploring the academic evidence on the topic, and to start a regular update on the main insider transactions.

Macro-trends

We have found a very interesting relationship between macro trends in insider trading and overall market direction. The graph below, taken from www.openinsider.com, shows that insiders generally sell (red) many more shares than they buy (blue). However, when this trend is reverted, it is usually a strong buy signal.

For example, from the above chart, we can see strong spikes in the periods of:

- November 2008
- March 2009
- August 2011
- August 2015

Looking back at market performance, we can see that in October 2008 the S&P 500 stood at approximately 800, 15% from the absolute bottom of the crisis, and almost 50% from the top achieved a year earlier (S&P at 1560). Therefore, this signal was already pretty accurate. But it became even more accurate with the second wave of purchases in March 2009. This has been the absolute bottom of the stock market. If someone was to buy shares at this level, results would be handsome (S&P tripled in the following eight years).

Further, in August 2011 the market corrected due to uncertainties in Europe. The S&P 500 fell from approximately 1350 achieved in July to 1120 in August. Again, buying shares at this level would have proven very profitable. Shares doubled over the next five years. Finally, insiders bought back substantial amounts of shares during the correction of August 2015. S&P 500 prices declined from 2120 in July 2015, to 1920 in August, approximately 10%. However, they then climbed to new highs within a few months. Within a year, values reached almost 2200, for a climb of 15%. The chart below shows, with red circles, the periods where insiders bought significant amounts of shares. It can be easily noted how insightful these transactions have been.

(source: Google Finance)

Micro-trends

These trends can also be found at the company level. We already talked about GNC. Another example that comes to my mind is J.P. Morgan (NYSE:JPM). Back in January 2016, the CEO Jamie Dimon bought a massive 500,000 shares, worth $26M. The stock chart below shows that JPM shares did not really move much from 2014 to 2016. However, since Dimon bought his shares, the stock price started climbing. He bought the shares at an average price of $53, 60% below the current market price of $84, not a bad return (plus 3.6% of dividends).

(source: Google Finance, JPM stock performance)

Academic evidence

Since I am an academic myself (at Auckland Business School), I always review the academic literature to find out what is the academic evidence. I will try to extrapolate a few lessons on insider trading strategies.

By reviewing the book from University of Michigan finance professor Nejat Seyhun, author of "Investment Intelligence from Insider Trading" (2000) we can learn that following every insider transaction is not feasible. Further, the author shows that even specific newsletters might be poor performers. Professor Seyhun shows that from 1980 to 1992, the insider-trading newsletter Market Logic gained 339%, compared with the Wilshire 5000 gain of 432%. The underperformance was also coupled with greater volatility.

Lesson #1: Following every insider transaction is not feasible, nor profitable.

Seyhun also provides us with a second lesson. The author explains that "while most trading by outside directors or large shareholders are uninformative, it is still quite possible that large transactions (over 10k shares) are informative". Therefore, if insiders buy just a few shares, this might not provide a strong enough signal. Further, we believe that it is important to evaluate the significance of this signal from a general perspective. For example, if a CEO owns 10M shares, and buys 50k additional shares, he might not send a strong signal and maybe he is just trying to push up the price of his holdings.

Lesson #2: Only relatively large insider trading provides an informative signal.

Seyhun published additional articles in 1988, 1992, and 1998. In these papers, he shows that aggregate insider trading significantly predicts market movements. Hence, multiple insiders buying shares send a better signal than a single insider.

Lesson #3: Aggregate insider trading is more informative than individual insider trading.

Another insightful paper is represented by Lakonishok and Lee (2001), "Are insider trades informative?". Examining insider trading activities of all companies traded on the NYSE, AMEX, and Nasdaq during the 1975-1995 period the authors reach interesting conclusions. In general, very little market movement is observed when insiders trade and when they report their trades to the SEC. The authors do not observe any major short-term (3 months or less) stock price changes around the time of insider trading or around the reporting dates. This is very surprising given the attention that insiders' activities receive. However, they find that insiders' trades are informative for longer investment horizons, suggesting that the market under-reacts to this information. In details, they show that insiders' activities predict long-term stock returns. Firms with extensive insider purchases during the prior six months outperform companies with extensive insider sales by 7.8% over the next 12 months.

Lesson #4: Insider transactions generally do not predict short-term movements, but rather long-term stock price changes.

Insiders also seem to be able to predict cross-sectional stock returns. The result, however, is driven by insiders' ability to predict returns in smaller firms. In addition, informativeness of insiders' activities is coming from purchases, while insider selling appears to have no predictive ability.

Lesson #5: Insider transactions are more effective in predicting returns for small companies.

Insiders, in aggregate, are contrarian investors. However, they predict market movements better than simple contrarian strategies. This can be seen from the graphs presented above. Periods with significant insider transactions followed market corrections.

Lesson #6: Insiders are generally contrarian investors.

Another interesting paper co-authored by Bettis, Vickrey, and Vickrey (1997) shows that outsider investors can earn significant abnormal returns by mimicking insider traders. The authors show that insider buys are more predictive signals than sells. Hence, a long-short strategy might not work, but a long-only one can boost portfolio returns.

Lesson #7: Insider sales do not offer a strong trading signal.

Therefore, today we have summarized the current evidence on investing signals generated by insider transaction activity. These 7 lessons will be the base for a regular newsletter. We will follow these seven rules to present our readers with the most compelling insider transactions. The goal of this newsletter will be to present the most significant transactions in a timely manner. We will aim to present this newsletter on a weekly basis. We will communicate buy-sell signals as well as track performance of our recommendations. We would be glad also if readers point us toward significant transactions that we might oversee.

As always, thank you for reading. If you wish to follow our future articles about insider trading, just click the "Follow" button next to our name at the top or below. If you would like us to cover a company, please let us know in the comments. For information about Integer Investments, visit our profile. Thank you for reading.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.