The Inside Track On Insider Buying

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by: George Putnam

Summary

For nearly a century, the SEC has sought to protect individual investors from trading by people who know secrets about companies.

If these people could freely trade on critical private “inside information,” investors might view the stock market as unfair.

However, this tight restriction could be unfair to officers and directors of public companies.

As long as corporate “insiders” buy and sell within specific rules, are not taking advantage of material, non-public information and properly report these trades to the SEC, it is perfectly legal.

We feel that insider buying can be a useful investing signal.

Steve Cohen, the high profile hedge fund manager, narrowly escaped a prison sentence for trading on insider information. Yet cable billionaire John Malone’s recent insider buying of $16 million of Liberty Global (NASDAQ:LILAK) (NASDAQ:LILA) shares, where he is Chairman of the Board and clearly knows a lot of non-public information, is perfectly legal and may be a valuable signal to investors. Can both be possible at the same time?

The not-so-simple answer: yes, and no. It depends on who is involved and what they are doing.

For nearly a century, the United States Securities and Exchange Commission (SEC) has sought to protect individual investors from trading by people who know secrets about companies. If these people could freely trade on critical private “inside information,” perhaps that a company was about to be acquired at a huge premium, or that an earnings report was going to be a disaster, investors might view the stock market as unfair. This would not only damage the public’s confidence in the market but also impair its capital-raising function.

What qualifies as “inside” information? The widely-used definition is “material, non-public information” - that is, something that could likely have a meaningful impact on the stock price or that a reasonable investor would consider important when making an investment decision. And, it needs to be information that isn’t generally known by the investing public. If you overhear a barista at Starbucks (NASDAQ:SBUX) talk about how well the new iced coconut milk macchiato is selling there, that’s not material as Starbucks has 26,000 stores and sells hundreds of different drinks. However, if you somehow learn that total company revenues across the entire chain will be up 12% next quarter, that’s material.

Just knowing the information is not illegal - it is what you do with the information that matters. If you trade on “inside information,” or in some cases merely pass along that information to others who then trade on it, that is illegal. Hedge fund managers and anyone else who trade on or are involved in passing along this kind of information should be prepared to spend some time in a court room on “insider trading” charges.[*]

However, this tight restriction could be unfair to officers and directors of public companies. They might rightfully want to buy and sell stock in their company, yet are also in a position to know a lot about their company that isn’t public. The SEC has carved out some protections for this group, whose trades are often referred to as “insider buying.”

As long as these corporate “insiders” buy and sell within specific rules, are not taking advantage of material, non-public information, and properly report these trades to the SEC, it is perfectly legal. John Malone, of Liberty Global, followed these rules so his trades were legal.

For investors, these reported “insider” trades can indicate that those with the best knowledge of a company believe it will do better in the future. Long before anything newsworthy happens, or before an upturn appears in a company’s financials, an insider may see positive changes and purchase the company’s stock. This can be a sign that “outsiders” should consider buying it, too. Numerous academic studies support this idea and we agree that insider buying can be a useful investing signal.

Insiders who buy their company’s stock aren’t always right, however. It’s possible for insiders to be too close to a company and miss some broad, negative signals. Or, someone can be so loyal to their company that it clouds their thinking. There have been a number of cases where an insider buys into their company only to see the stock slide downwards.

Perhaps the most valuable insider buying signal is when a healthy company’s stock is temporarily out of favor and a savvy, highly credible CEO makes a large public purchase. In a famous example, Jamie Dimon, CEO of JPMorgan (NYSE:JPM), bought $26.6 million of his company’s stock in February 2016 at $53.18 per share, at a time when most investors were selling heavily. By year-end, the shares traded at $86, for a 62% gain worth over $16 million that everyone would like to take to the bank.

[*] This note is intended as a general overview of insider trading regulations for investors, and is not intended as legal advice. Insider trading case law and regulations are complicated and can change, sometimes abruptly. Please consult a qualified attorney or compliance officer if you need more specific guidance or advice.

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. I have no business relationship with any company whose stock is mentioned in this article.

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