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Insider Buying: Even If It’s A Lot It Is Probably Nothing

Conventional wisdom says that insider buying is one of the most reliable if not THE most reliable bullish signal an investor can get. It would seem to make sense to follow the action of company insiders. Do they not possess superior information about the firm's prospects? All things being equal, if insiders are acquiring shares then the future is bright, indeed. All an individual investor has to do is follow their lead and the money will roll in.

All of us should consider ourselves fortunate to have such a surefire way to earn excess returns at our fingertips. After all, there is a plethora of websites that report insider transactions free of charge. In addition, hardly a day passes by without an SA contributor leading the cheers with yet another article listing recent insider buys. With this many bulls, I feel like I am in the streets of Pamplona in July.

There is only one niggly problem, though. 99.9% of the insider transactions that you see in the free websites or SA articles have no value whatsoever. That is right. They are not worth one thin dime. In fact, the expected return of the stocks as a group is overwhelmingly negative. I hope that you have not had to find out the hard way that this is true. Before you brand me a heretic, though, allow me to explain my position.

As a first step, let us define an insider. There are three groups: Directors, C-Level Executives and Beneficial Owners (an investor who has acquired at least a 5% stake in the firm). Only one of these three has value.

Directors would appear to be an excellent group to follow. After all, they are the ultimate decision-makers in the company. They should be privy to the all aspects of the company's competitiveness in the marketplace as well as their financial condition. Almost all of them are or have been senior executives in other organizations. Purchases by this astute group should be worth following, right? It may surprise some of you that the answer is no.

One reason is the almost-universal requirement that Directors acquire a stake in the company. Putting "skin in the game" became the mantra during the bear market of the early 2000's when investors took issue with the (lack of) diligence of board members in companies that were worth only 10% of what they were only a year or two earlier. Investors want to see alignment between the interests of Directors and shareholders. Purchases by Directors are almost exclusively window dressing to satisfy this requirement. It is a signal to investors that their "skin in the game" will provide a caffeine-like boost so they will stay awake in meetings and actually contribute to the firm's progress. It is a valid signal to be sure, but it is a signal all the same.

But what about that COB who just bought 1 million shares? This would seem to be a large bullish bet. I have researched this area extensively and, unfortunately, have not found any predictive value on future share price appreciation based on the actions of Directors, regardless of the size of the bet. Others* have reached the same conclusion.

Superficially, this is a controversial statement. Anyone with experience in the markets can think of many examples of companies with healthy share price gains that had Directors owning large positions. Were their positions bullish bets or window dressing? There is no way to tell, especially since there is no statistical difference in the share price behavior of the firms with significant Director buying and those with little or none. In the end, it is just another data point in assessing an investment candidate. It should never be the overriding reason to take a long position.

If you were to compare two lists of companies, one with substantial stakes by board members (100k+ shares) and one with modest stakes (<10k shares) there will be no statistical significance between the share price performance of the two groups. Any difference will be due to other reasons or pure randomness.

Let us move on to Beneficial Owners. This is the "smart money" group comprised of mutual funds, hedge funds, private equity firms, wealthy individuals and professional investors. Surely, this group is the one to hitch a ride on. After all, they are the big time pros. It may surprise you to learn that, again, the answer is no. It seems that this group is wrong just as frequently as the rest of us. There is no statistically significant difference in the share price performance of companies with or without beneficial owners. An ownership stake by this group is just another data point. It should not be the overriding reason to take a long position.

What about the celebrity investors like Carl Icahn, Warren Buffett, Boone Pickens, Kirk Kerkorian or Henry Kravis? All are successful. All have also been wrong many times. If you intend to ride their coattails, you still need to do extensive research before acting. No shortcuts are available. All have success rates below what you may think.

The remaining insider group, C-level Executives, is the only one where a diligent investor can extract value. Not all buying is equal, though, so you will need to parse out the noise and window dressing to identify the truly significant buying behavior.

The explosion of ways an executive can acquire shares has greatly muddled the picture. Stock-based compensation, stock option incentives and stock ownership/grant schemes became commonplace in the great bull market of 1982-2000. What was before an outlay of personal funds and, therefore, a significant commitment is now a routine part of compensation.

Window dressing is the other phenomenon that has greatly muddled the picture. All company executives know how to play the game. They know that there is a global universe of investors tracking insider buying. A lack of buying, especially by the CEO, is conspicuous. The CEO needs to signal his employees, shareholders and stakeholders that he/she is bullish on the company's prospects. It is very common, for example, to see an incoming CEO acquire a large personal stake of shares. This is reason I ignore the CEO's buying and focus on the other C-level executives.

To be more specific, here are a few common sense rules that might help you:

Rule #1: The only insider transactions that matter are "direct open market" purchases. All the others are noise. They have no predictive value whatsoever. Forget 'em.

Rule #2: Focus on the open market buys by C-level executives that are a multiple of their base salary. Exclude the CEO regardless of the size of the stake acquired. Personally, I focus on the CFO. This is person is usually the hard-nosed numbers-oriented curmudgeon of the executive team. If they are loading up, then I take note. For example, if a CFO makes $200k in base compensation and buys $500k of shares on the open market with their own money, then this company deserves a closer look. This is extraordinary.

Rule #3: If you have identified extraordinary insider buying then look at the firm's most recent 10-K under "Related Party Transactions" to insure that the company did not loan money to the executive(s) to fund their stock purchase. Most of the time this applies only to the CEO, but on occasion will include others. In all cases, this is a material financial arrangement that requires disclosure. If the insider borrowed money to buy their stake, then it does not qualify for consideration. Move on.

Rule #4: All of your normal criteria for scrutinizing an investment should still be satisfied before considering action. If you have been diligent enough to uncover a truly extraordinary situation, the presence of insider buying still remains a single data point in your assessment of the investment. Consider the presence of extraordinary insider buying as a bonus. The stock should be one that you would buy without any insider buying whatsoever.

Rule #5: Wait for a good low risk entry point. Let us assume that you have satisfied the first four rules and have a truly extraordinary situation that looks like a sure 5-bagger. After the backslapping and high five's you might be inclined to mortgage the house and dive in. Not so fast. It is a rare case, indeed, where there is not ample time to establish a stake. What you do not want to do is deploy your money and be under water immediately. A paper loss is still a loss so you do not want to be down 10%, 20% or more in the weeks or months you hold the position.

A superb example of what situation to avoid is where you see executives buying shares in a struggling company. This is an act of desperation. They are hoping that some suckers will come to the rescue and buy shares. It never works. If the company is not a suitable investment without any insider buying, then avoid it. The odds are overwhelming that you will lose money.

Rule #6: Establish a clear exit point. Let us assume that you have satisfied the above five rules and you have established a large position at a low-risk entry point. Hello, 5-bagger. I would not fly to Tahiti just yet, though. Preservation of capital is job #1 so if the price drops more than 5% from your entry then sell it immediately and wait for a better opportunity to re-enter. It will come. This simple sell rule will save you a lot of money. You can be wrong 80% of the time and still catch that plane to paradise.

Anyone using insider buying as an investment criterion should take extreme care to avoid making a spurious connection with share price appreciation and buying by insiders. Unfortunately, our minds are hard-wired to perceive connections and patterns where there are none. If you are patient and diligent enough to wait for something truly extraordinary then your chances of success will be much higher.

Research has shown that the drivers of equity prices are:

General Market: 40%

Industry: 37%

Sector: 12%

Company: 11%

You can see that 89% of a stock's price performance is due to broad market forces, not company-specific events. If you want to make money with a long position then you need to be aligned with the broad emphasis of the market.

You have probably noticed, though, that much of insider buying occurs in industries that are currently out of the market's favor. Research has also shown that the most frequent reason that insiders buy shares is that they perceive that they are undervalued. They are a bargain. Maybe they are a bargain for a valid reason. You should consider only those instances where C-level insiders (sans CEO) perceive a COLOSSAL bargain. Their level of commitment to this perceived bargain should be reflected in the size of their open market purchases. Ignore everything else. In many cases, you are swimming against the tide anyway. Even without insider buying, the chances of success of a long position in a market that is in a correction and/or a stock that is a member of an out-of-favor industry group is very small. If you find a case of extraordinary insider buying, then you still need to do a world-class analysis of the company and its industry. Ideally, it should be clear why insiders are accumulating stock. If you are not sure and still take a position, then you are gambling, not investing.

How often does extraordinary insider buying occur? Let us assume that there are 10,000 NYSE and NASDAQ stocks worthy of consideration (you should not question why I exclude the AMEX). The number of instances each year is probably less than five. It is that rare. It is like everything else associated with investing. It takes a tremendous amount of hard work to discover the gold nuggets.

Still not convinced? I have two suggestions for you:

1. Track the stocks listed by SA contributors. Set up a spreadsheet. List the symbol, date published, closing price that day and the closing value of an appropriate benchmark, e.g. Dow, NASDAQ, Russell 2000. Record the closing prices every 3 months for a year. Compare the performance of the stocks to their benchmark to determine the alpha. This should provide clear proof of how these stocks really perform (hint: they disappoint).

2. Make a list of the top 25 price gainers for the past several years for the NASDAQ. Research the degree of insider buying prior to and concurrent with each stock's big move. You know what you will find? There will be little or no net buying. The insider activity will be heavily biased toward SELLING.

Unfortunately, there are no shortcuts. The value of insider buying is one of the most abused notions out there yet I continue to see article after article listing worthless transactions. I urge you to do your homework before committing your hard-earned money to a false hope. The market is rarely what it seems.

Recommended reading:

· H. Nejat Seyhun (2000). Investment Intelligence From Insider Trading. The MIT Press.

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