Back to the Basics: Insider Trading
Is It Legal?
Insider trading can be influential and controversial because it walks on a very thin line between legal and illegal. That line gets even hazier when you take into account all of the information the insider could have and that the public does not have.
Insider buying and selling is deemed illegal when an insider uses non-public information to base their decision to buy or sell on. This material non-public information can be obtained from the insider’s day-to-day workings at the office. This is what happened to homemaking mogul Martha Stewart in 2002. Stewart was told that she should sell all 3,928 shares she held in ImClone Systems because the company was about to implode. She did. Then she was fined $30,000 and she spent a daunting five months in federal prison. What made Martha’s move illegal was that she was privileged information that was not made readily available to the general public.
In order to prevent misinformation to the public, the U.S. requires that any corporate officer, director or significant shareholder (10% or more of the firm’s equity securities) report any trade to the Securities and Exchange Commission (SEC) within two business days. It should also be noted that the Canadian Stock Market has different rules; insiders in Canada are not required to report their insider trades to the SEC for an entire week.
Despite the controversy, insider trading is (for the most part) a legal action that corporate officers partake in. In fact, some investors and analysts regard insider trading very highly because they believe that those who have the most stakes in the company have the best insight into the company. Insider buying or selling can foreshadow factors such as the retirement of the CEO who is selling their shares or that of a new corporate leader buying into the shares which demonstrates a commitment and hope for a positive future for and with the company.
Why Do Insiders Matter?
No one says it better than Peter Lynch when he says, “Insiders might sell their shares for any number of reasons, but they buy them for only one: They think the price will rise.”
Insiders have proven to be smart investors of their own companies. In a research study on insider trading activities, GuruFocus found that insiders are primarily value investors and contrarians. This meaning that they tend to sell more when the market buys and buy more when the market sells.
Insiders know their companies. Without having any material evidence, a CEO might simply be optimistic about the direction in which their company is moving and decide to invest more into it. On the other hand, there might be a switch in policy or some other factor that a corporate officer might not like it and decide to drop some of their stock.
One thing you should watch out for when looking at insider trades is insider sells. Just because an insider sells a large amount of their shares, it doesn’t mean that the business is crashing. It could mean that the exec is diversifying their holdings, low on cash or even taking a vacation.
Does It Work?
University of Michigan professor, Nejat Seyhun, conducted a massive research project on insider trading. He found that when executives bought shares in their own companies, the stock tended to outperform the total market by an average of 8.9% over the next 12 months.
Seyhun also found that when the executives sold their shares, the stock underperformed by approximately 5.4%. For more information on Seyhun’s research, check out his book, "Investment Intelligence from Insider Trading."
So what we’ve learned is that following insider trading can be a beneficial tool to help you to make informed decisions when picking which stocks to invest in, but it cannot be the only thing you look at. When a company’s executives are confident enough to invest their own money into their stock then you should be too. But when those executives drop stocks there is no need to freak out immediately because there are infinite reasons why they could be cutting back on some of their shares. Do your research, look at the trends and look at the insiders, and then you can make an informed decision!
For more information on who is making insider transactions check out the GuruFocus Insider Trade Page.