TheStockAdvisor Advice

Insider Buying and Selling

Many research firms track insider buying and selling, and claim it is a strong indicator of where the market is headed. And Wall Street warms to insiders who like buying their own stock, viewing it as a sign that management sees good things on the horizon.

But investors who believe they can profit by mimicking insider buying sprees have had little opportunity to do so. The latest statistics show that insider buying is the exception, not the rule, with corporate insiders across the United States currently steering clear of their own stock.

Insider buying fell to $149 million in March, down from $168 million in February. Experts say this lack of buying is a strong bearish indicator.

Tracking of insiders' behavior proved an excellent predictor of last year's stock market correction because insiders, key corporate managers or executives who own 10 percent of a company, are in the best position to know how their stock will fare.

In February 2000, insider selling, a negative barometer, was at its greatest level ever, at $10.8 billion. Just a few weeks later, the technology-stock meltdown began, with the Nasdaq composite index falling 33 percent from mid-March to mid-May. Insider selling also picked up in August 2000, before the Nasdaq slid 20 percent in the following two months.

Experts were surprised insider buying slowed in February and March of 2001, surmising that company executives would have snapped up their own stock, available at deflated prices.

Still, there is one sign the broader stock market may have bottomed out, even though insider buying continues to fall. The blistering pace at which insiders were dumping their stock throughout 2000 has slowed to a trickle this year, with selling declining from $4.4 billion in February to $2.2 billion in March.

While indicators such as these are easier to chart for the wider market, it is much harder to use insiders' behavior to predict how individual stocks will perform.

There is evidence to prove that investors who acquire stock based on insider buying records earn higher returns than those who do not. Nevertheless, investors who profit the most are those who closely review the insider buying transactions.

Always checks to see who is doing the buying, noting that the higher the rank of the insider, the better the indicator. For example, chief executives are in a better position to judge a company's prospects, knowing more about upcoming projects and long-term goals than, say, directors.

But insiders do have to trade in accordance with Securities and Exchange Commission rules, which state that executives can not buy or sell shares based on proprietary or "inside" information. Still, experts say insiders are rational investors who buy and sell based on the financial condition of a company and its likely prospects.

Analysts recommend that investors follow the success rate of insiders. For example, Wilfred Corrigan, chief executive of LSI Logic, a circuit and storage network firm based in Milpitas, Calif., has a 100 percent hit rate: He has bought LSI stock 11 times and it has gone up 11 times over the following six months.

But investors should not be fooled by insider buying-which may be merely a PR stunt. If an insider buy is well publicized, in a news release for example, it is likely to be done for the company's image. Also, if an insider buys, say, 100,000 shares, but owns 10 million, it is not terribly significant since that number comprises a small percentage of the holder's overall portfolio.

Insider buying trends are easier to read for small- to mid-size companies, which tend to offer insiders fewer, less profitable, option incentives. Those at larger corporations are often awarded an abundance of valuable stock options, which provide handsome gains on a small percentage rise. Therefore, for insiders at large corporations there is less incentive for buying. With smaller companies, insiders are typically not awarded as many options and are forced to go into the open market if they want to share in any future appreciation. On the flip side, insider sales are not always an accurate measure that bad times are to come.

With the motive behind executive selling more of a blur, investors need to tread carefully before jumping ship. For instance, company executives may sell to diversify their portfolio, or to pay for a house or a divorce. Many executives are paid in part by stock options, and exercise them to get cash.

The insiders who are selling are aware that everyone [Wall Street] is watching them and are hesitant about selling before bad news arises. While insider sales should be looked at, they are only a small piece of a lot of information. But much can be gained by reviewing insider selling, if the data is carefully reviewed.

Investors need to be on the lookout for behind-the-scenes moves as well. In some cases, insiders are able to protect the value of their holdings by entering into option contracts with banks, experts said. A chief executive could buy a put option from a bank, which would protect the value of their holdings if they dropped below a certain price.

Therefore, if they were pessimistic about the future, they could legally buy puts, according to the SEC. However, if they bought puts with the knowledge of bad news to come they would be breaching insider trading laws.

There are few insiders who have reported their option transactions to the SEC, many insiders fail to report them and therefore they do not get picked up on the selling radar screen. This is a violation of SEC rules.

Insiders have to be careful when buying options; the first thing the SEC does when it believes illegal insider trading took place is to look at whether the trader had owned options.

It appears it is beneficial to track insider trading, but, as with anything else, it is not the key to financial success. It is just another tool a smart investor can use.

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