8-3-09

Legal Insider Trading

If you virtually knew for certain that a certain stock would rise and you continually slapped some money down based on that knowledge, you'd make a fortune, right? Sure you would. Particularly if you always cut any losers early on and let the winners ride.

If only, right?

The whole world plays guessing games with endless debates, computer models, chart-watching just to achieve exactly that on what is effectively always a 50/50 bet.

But that's all it is; a big guessing game. And that's because nobody, but nobody, truly knows which way a stock price will go...

...well, almost nobody.

How about the company insiders? If a CEO of a large company knew they were about to report a surprise profit surge, don't you think he also knows that this would cause the stock price of that company to surge and he would bag himself a few hundred thousand shares?

But that's illegal insider trading, surely?!

No.

How would you like access to the same information? Would that be the virtual equivalent of "FREE MONEY"?

If you agree, then the government will give you "FREE MONEY" with something called: "Form 4". Here's how...

Tweedy Browne, LLC, established in 1920, published a watershed report called "What Has Worked in Investing: Studies of Investment Approaches and Characteristics Associated With Exceptional Returns."

In this 56-page report (which you can read for free by visiting their Web site at www.tweedy.com) they outline the five most proven investment strategies of all time. They include:

1)    Buying stocks that are selling for less than their true asset value.

2)    Buying stocks that are cheap relative to earnings.

3)    Buying stocks that suffered a major decline in price.

4)    Buying small-cap stocks with high growth rates.

5)    And buying stocks with a significant pattern of insider buying.  

Imagine if every time you went to buy a stock, you knew exactly what the company's CEO, CFO, board of directors and even its legal team thought about their own company's stock. Maybe the CEO would pull you aside and say, "Listen, next quarter is going to be a big one. We just landed a multi-million contract with a brand new client. When Wall Street finds out about it, our stock will double."

If you had this kind of "insider information" you'd be rich, right? You'd always know what to invest in and when. There is no limit to the money you could make.

The only problem is, you don't have access to a company's top management on a daily basis. And even if you do, they are prohibited by the SEC from doling out such crucial information.

Stinks doesn't it?  It's almost as if Wall Street has it out for you - the "little" investor. There is all this great information floating around - but thanks to all the rules, you can't access it. It's almost as if you are destined to earn mediocre stock returns while the rich get richer. Right?

Not so fast.

While you can't always call up a company's CEO and get the insider scoop on what's in the pipeline, you can get a pretty darn good idea about what he, and every other insider, thinks about their company's prospects. The secret is to see if he and the rest of the "insiders" are using their own money to buy stock in their own company. It's called insider buying.

So what exactly makes someone in a company an "insider?"

A company insider is simply an officer, director or owner of 10% or more of a class of shares in a corporation. It can also be someone with intimate knowledge of a company's inner workings  - usually top management, like a CEO, CFO, COO, lawyer of member of the board.

These are the people who know when sales are likely to rise. They know about a new marketing strategy that could boost the company's bottom line. They know about industry conditions that may be changing for the better. And they know the company's balance sheet like the back of their hands. So when a CEO, CFO, COO or director invests his hard-earned money in his own company, you should pay attention. They know something is going to happen. In fact, they are so sure of their own company's future, they are willing to lay down their own money to buy stock in their company. THESE ARE NOT PEOPLE WHO MAKE A TON OF MONEY TO BEGIN WITH, SO WHEN THEY BUY, IT'S NOT WITH DISCRETIONARY INCOME.

When an insider makes a significant purchase of stock, it's as if he is waving a massive flag over his head, shooting off fireworks and screaming, "This stock is going to rise!"

Remember, a CEO (or any insider) is just an investor like you and I. He has the same universe of investment options you do. So when he uses his cash to buy stock in the company he works for he is saying, "Of all the companies I could invest in to get a high rate of return, this is my single best option". That's exactly why Peter Lynch, the longtime Magellan fund manager, once famously declared there is "no better tip-off to the probable success of a stock" than insider buying. And he is dead right.

Countless studies have shown: If you buy the same stocks the insiders buy with their own money, you will outperform the market. Now the million-dollar question is, by how much?

Between 1958 and 1976 five prominent insider buying studies were published by Rogoff, Glass, Devere, Jaffe and Zweig. They all wanted to show how much money you could make by buying the same stocks the insiders bought - shortly after they laid their money down.

In each study these gentlemen followed two hard and fast rules. First, there had to be more than one insider buying stock in the company - known as "cluster buying". And second, the number of purchases had to significantly exceed the number of sell transactions.   

The reason for these two rules is simple...

You don't want to buy a stock based on one tiny little insider transaction. So if a CEO is making $1 million a year and decides (for what ever reason) to buy $1,000 worth of his company's stock, that is not a sign to sell the farm and invest everything in that company. He can easily afford to lose $1,000 and never think twice about it. But...

When that CEO invests $300,000 in his company and the CFO (who makes $750,000) invests another $300,000 and the Treasurer (who makes $500,000) lays down $250,000 - now you should be interested. These guys are putting up real money (money they do NOT want to lose) to invest in their own company.

If you follow these two rules, Rogoff and company proved you can make a lot of money buying the same stocks the insider do. Check out the table below...

During the periods highlighted above, investors who would have bought just after the insiders did would have outperformed the market by an average margin of more than 2-1. So if most people made $10,000 in profits, you could have made $20,000. Not too shabby.

But I know what you are thinking...  

"What about some more recent data? Those studies are from the 1950s, '60s and '70s! Does this insider strategy still work in today's market?"  

The answer is yes.  

Investopedia.com (an online investing resource) published an article on Dec. 3, 2003, titled "Can Insiders Help You Make Better Trades?" The authors proved that in the wake of the Enron and WorldCom debacles -- not to mention the tech collapse of 2000 -- investors who followed insiders in and out of the market would have avoided big losses and set themselves up for nice gains.  

Take a look at the chart below...  

This chart shows you the ratio of insider selling to insider buying between 1997-2003. When the bars are high, the insiders were selling stocks. That's when you should have been getting out of the market. And when the bars are low, the insiders were buying stocks. That's when you wanted to be heavily weighted in stocks. For instance...  

If you bought at points 1, 5 and 12 (when more insider were buying than selling) you would have done very well:   

--   From April 1997-April 1998, the S&P 500 rose 46%

--   From September 1998-September 1999, the S&P 500 rose

--   And from September 2001 to now, the market is up 12%.  

And if you sold when company insiders were selling in bulk (see points 11 and 17), you would have avoided the 100 point sell-off between June and December 2001. But you would have missed out on the profits between October 2003 and April 2004. Hey, you can't always be perfect! But in all seriousness...  

More than not, following the insiders is a great way to make (and avoid losing) money on Wall Street. Here's another perfect example proving my point...

Thanks to Section 16 of the Securities Exchange Act of 1934, insiders are obliged to reveal any trading of company shares by the tenth day of the month after they bought or sold their company stock shares. And they reveal their activity by filling something called a "Form 4" - which everyone, you included, has access to.

On these Form 4s, the insider is required to disclose how much stock he bought, at what price and when he bought it. This is all crucial information.

By scouring the market's Form 4s everyday, you can know exactly what stocks the insiders are bullish on. You can know exactly where the so-called "smart money" is betting the highest returns will be. And as I just showed you, investing in those stocks usually leads to some pretty spectacular gains.

By the way, financial sites like YahooFinance.com, investor.com, all have an "insider transaction" link you can click on to see if insiders in any given company are buying or selling stock. These sites simply download information from the Form 4s and publish it for their readers.

So it sounds simple. Everyone with access to the Internet can be on top of what stocks the insiders are loading up on thanks to these Form 4s and financial Web sites. That's the good news.

The bad news is, it's not as easy as it may seem to know how to decipher through the insider transactions you see on the Form 4s or the financial Web sites.

For starters, there are hundreds (if not thousands) of insider transactions reported in a given day. So it would literally take you ALL day to go through them. And even then, you have to know what to look for. Unfortunately, not all insider activity is useful - even the reported "buys."

Many times an officer or manager in a company receives stock options as part of his compensation package. These options can total in the millions of dollars. And every time a CEO cashes in on an option, he must file with the SEC using a Form 4.

With that in mind, you may pull up a Form 4 and see what looks like a whole lot of insider buying by a CEO or CFO in a company. But in reality he isn't using his own money to buy stock in his company. He is simply using his options he was given by the board of directors to "cash in."

This is not the kind of insider buying you want to look for. You want to buy the stocks that the insiders are using loading up on with their own money - and enough of it that they would feel the pain if they lost out.

Another mistake many novice investors make is they bite at the first hint of insider buying. For instance...

If one insider buys a few shares of stock in their company, the last thing you want to do is blindly buy that stock as well - especially if the insider only put a small amount of money down and several other insiders are selling when he is buying.

Remember the two hard and fast rules Rogoff, Glass, Devere, Jaffe and Zweig used to conduct their studies on insider buying. There had to be at least two or more insiders buying at about the same time. And the number of buy transactions to significantly exceed the number of sell transactions.

So let's recap...

Rule #1: There must be a cluster of buying by the insiders. That means at least two different insiders must be buying at about the same time. AND IT SHOULD NOT JUST BE DIRECTORS.

Rule #2: The total number of buy transactions must significantly out number the total sell transactions.

Rule #3: The insiders must lay down a significant amount of their own money in the stock.

Mark Patricks

 

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