As legendary money manager Peter Lynch once said, "Insiders might sell their shares for any number of reasons, but they buy for only one; they think the price will rise."
On this week's Money Matters, financial commentator Greg Heberlein explains why you should pay attention when executives buy or sell shares in their own companies.
First of all, their are two kinds of insider trading: the legal kind and the illegal kind.
Illegal insider trading is when company insiders secretly buy or sell their stock, or make trades based on information not available to the public. For example, buying shares in your company just before you publicly announce a new development that will boost corporate profits (and raise the stock price) is a crime.
The legal kind of insider trading, which we're focusing on today, is when an executive trades shares in his or her company and the trades are publicly reported to the Securities and Exchange Commission. The trades aren't made based on information that isn't available to the public.
The financial press devotes at least a portion of its time reporting on legal purchases and sales by corporate insiders of their own stock. Tracking those transactions in a timely way has been moderately difficult until lately. A variety of online services now offer nearly instant access to insider buys and sells. One Greg likes to use is www.secform4.com. You can also get the information directly from the Securities and Exchange Commission.
So how do we use this information?
The trades aren't easy to interpret. Insiders may buy because they just joined the company. Officers may wish to pay their tax bills, diversify their holdings, buy a new yacht, pay a divorce settlement, take a big trip, etc.
The best way to use the data is as a whole, bunching buys and sells together for all large companies. Services will tell you if overall buying shows a higher or lower trend. That’s news you can use.
Within a company, transactions by the chief executive and the chief financial officer carry more weight than for others. A few buyers or sellers determine little; a slew of buyers and sellers may tell you something.
Inside trading data is one indicator, not the indicator, of a company’s prospects. Keeping track of what insiders do needs to be supplemented by conventional research into financial results, trends, etc.
There’s another factor. At smaller companies, more officers and directors know how the company is doing, and where it is headed. At a large company, that might not be true. Additionally, so many executives at a large company may be deemed insiders that figuring out why someone is buying or selling becomes even more complicated.
In recent years, Microsoft stock has been flat, almost exactly where it was five years ago. You might suspect some insiders sold four or five years ago to invest in companies with better prospects. Instead, the ratio of sellers to buyers has been consistently about 10 to 1. In big companies, that’s nothing. Starbucks stock is five times higher than it was three years ago, but insiders have sold about 200 times more shares than they bought.
In smaller companies, the link may be clearer.
Here’s an example: because of a severely declining stock price, Seattle’s Cell Therapeutics has had to execute a reverse stock split to raise its share price four times in the past five-plus years. In nearly the same time, insiders – officers and directors – have sold shares 71 times. None has purchased shares.
The bottom line is insider trading should be a part of one’s investment approach, but not the overriding factor.