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Insiders vs. Outsiders: Why Raj Rajaratnam is no Martha Stewart

|Includes: Martha Stewart Living Omnimedia, Inc. (MSO)

Martha Stewart was a billionaire in 2001.  She floated her own media firm, Martha Stewart Living Omnimedia, on the New York Stock Exchange in 1999 and witnessed her stock price double just on the first day it began trading.  Her T.V. shows combined with magazines and a home furnishing line were just hitting their stride.  She was the queen and dominated the smart, simple and fresh themes that she presented in her suggestions for lifestyle, cooking, and organization.

Unfortunately, calamity stuck and Stewart went from champ to chump literally over night.  According to the U.S. Securities and Exchange Commission, in late 2001, Stewart, upon receiving a tip from her broker from Merrill Lynch, Peter Bacanovic, decided to sell her holdings in biotech firm, ImClone.  An assistant to Mr. Bacanovic, forever known as Martha Stewart’s broker, told Ms. Stewart that ImClone’s CEO, Sam Waksal, was selling all his shares in advance of a report from the Food and Drug Administration that would severely impact ImClone’s stock.  She sold, avoiding a loss of $45, 673.

In 2003, Stewart was indicted on a variety of charges including securities fraud and obstruction of justice.  She was ultimately found guilty of conspiracy, obstruction of an agency proceeding and making false statements to federal investigators.  She was sentenced in July 2004 to serve a five month term in a federal correctional facility after which she was released to home confinement for another five months and required to wear an ankle bracelet.

In similar fashion, we’ve just uncovered the largest case of insider trading in the post-Madoff world.  The Galleon Group, run by famed hedge fund trader, Raj Rajaratnam, knocked out 25% yearly returns like butter.  From inception in 1992 until this year, Galleon returned almost 3000% cumulatively. Rajaratnam, a billionaire himself, built his empire on what seemed to be an intimate knowledge of the technology industry.  This deep knowledge of the sector allowed Galleon to gain an edge on the market as it seemed to know where tech stocks were headed.  As Galleon grew assets and its fame, investors put almost $3 billion into the fund to be steered by Rajaratnam.

Rajaratnam’s industry expertise made him the envy of his peers.  His contacts were unrivaled and the research that Galleon’s analyst did on the industry shamed investment bank analysts.  Galleon clients were provided with the top industry analysis — a veritable treatise — on a quarterly basis that mapped out how Raj and his team saw stocks moving.  While he dabbled in other industries, Galleon’s success was predicated on the firm’s vertical expertise in high tech, including semiconductor, computer hardware, and Internet stocks.

It turns out that Galleon’s ability to achieve outsized returns wasn’t completely fair.  According to one regulator, it appears that Galleon was extremely adept at making money off of insider information: “Deliberate and systematic use of inside information to inform his trading decisions was for all practical purposes [Galleon founder Raj Rajaratnam’s business model.” Apparently, the SEC had uncovered an intricate web of accomplices and industry contacts that fed Galleon valuable, secret information for years.  For Galleon, it meant easy money.  By soliciting high-level executives to become investors in Galleon, Rajaratnam created a mobile insider army which had access to secret data at all levels of global organizations.

Former WSJ publisher Gordon Crovitz has an interesting piece on the WSJ today arguing that unlike what befell Stewart, Galleon’s methods shouldn’t be outlawed.  Whereas Stewart received inside information transforming her to insider status, Crovitz makes a distinction regarding the investment analyst’s role:

Instead, the Galleon case is about what might be called “outsider trading”—trading by people who gathered information from insiders about company performance or operations, not trading by the insiders themselves.

He argues that efficient markets require information free information transfer between parties and any regulatory effort to crimp analysts’ work would result in more instances of mispricings, not less.  As Milton Friedman once quipped, “you should want more insider trading, not less. You want to give the people most likely to have knowledge about deficiencies of the company an incentive to make the public aware of that.”

Regardless of the differences between the Stewart and Galleon cases, investors should recognize that they themselves have the tools and power to track the moves of corporate insiders.  Insiders have been shown to make market-beating profits by trading legally in their own stocks.

University of Michigan’s Seyhoun has written the definitive book on the matter, Investment Intelligence from Insider Trading (that’s an Amazon link where I get paid a nominal fee if you decide to purchase via this link).  In this book, Seyhoun systematically studies how well different sets of insiders trade and devises strategies to profit by piggybacking on their moves.  I recommend the book and understand how powerful this could be for individual investors.  He credits corporate management’s ability to beat the market due to an informational advantage executives have over the rest of us: even if they aren’t trading on inside information, company employees do have a damn good view of their businesses and industry.

It turns out (read the book) that multiple insiders at small cap firms trading in large share counts profit the most.  Premium sites like GuruFocus and InsiderScore make it very easy for investor to launch a totally legal insider trading strategy.  Like AlphaClone assists us in tracking guru hedge fund investors and their every moves, sites like these enable us to identify and track the best insiders to profit alongside them.

Stewart and Galleon may be two prominent cases where powerful insiders abused their access to valuable information.  As individual investors, we don’t really need insider access — we can profit by tracking and mimicking their moves.