This is the often repeated mantra: If insiders are buying the stock, it is a positive indicator. After all, who better to know the current business environment and the future prospects of the company than the insiders.
This argument makes perfect sense. Insiders may sell a stock for many reason – maybe they needs money to send junior to college, or perhaps they have had an eye on that new yacht and just can’t wait any longer. However, if they are spending their own hard earned money to buy the stock of their own company, it can mean only one thing: they believe that the stock will be higher in the future (according to Peter Lynch). The only possible reason for this belief is that the business is improving.
At least in their view.
Heck, there are even funds that invest based on insider buying trends. For example, Guggenheim Insider Sentiment ETF (NFO – awesome ticker by the way) tracks the Sabrient Insider Sentiment Index (NYSE Arca: SBRIN). The index itself tracks 100 stocks and ADRs with favorable insider buying trends based on their public filings. Catalyst Capital Advisors has two mutual funds that track the insider sentiment, CIACX and CIAAX (see here), that take long position in stocks experiencing clusters of insider purchases and a counteracting short position in stocks experiencing clusters of insider sells. According to Catalyst, research by H. Nejat Seyhun published in Investment Intelligence from Insider Trading, The MIT Press, 1998, between 1975 to 1994, stocks following insider buying outperformed the market by 4.5% while stocks following insider selling underperformed the market by 2.7%. Presumably, the fund by its strategy of long/short is targeting a 7.2% outperformance over the market.
Although 2013 YTD is not long term enough, it should be noted that CIAAX fund is up 3.36% while S&P 500 is up 17.69% in the same period in 2013. CIACX performance is similar (it is basically the same fund, just a different class of shares). NFO has done better returning 14.84% YTD, which is understandable as it does not suffer from the excessive fees that Catalyst charges.
Research Versus Practice
If you agglomerate all stocks exhibiting pronounced insider purchase trends, your portfolio will probably do better than the market. There is no doubt that insiders, as a collective, have an edge over most individual investors. However, building this diversified portfolio based on insider purchases is not feasible. Sure, mutual funds can try, but the fact is that they can only go by the SEC Form 4 that insiders file after they have transacted in their shares. There is a time delay, and this gap can make all the difference.
But here is another reason. Going through all the insider purchase and sells SEC reports is intensive work, given that there are tens of 1000s of stocks and ADRs that trade in the US markets. Invariably, this is an expensive proposition and what you gain in out performance is offset by the expense (fees). Sure, as these types of products proliferate, this information will become cheaper and these funds will be more affordable. The problem is, cheaper information makes the insider trading data “market” that much more efficient so the potential rewards will shrink.
There is no free lunch.
Insider Purchases are Not as Relevant for Individual Investors Buying Individual Stocks
When Peter Lynch ran the Magellan Fund, he could take advantage of the insider purchase premium. The fund was large and invested in 100s of stocks at any given time. He could also call upon Fidelity’s extensive research capabilities. Individual investors do not have such scale. For you and me, when we see hefty insider purchases in any given stock, we need to ask many questions before we can take this as a positive. Blind assumption works when you scale across 100s of stocks. When you are dealing with one or few stocks at a time, many of the factors that cancel out in a large portfolio become more relevant.
Here are a few reasons why insider purchases may not be something to get excited about:
- Insiders are business people, not investors – Insiders may be a good judge of future business potential, but they are not sophisticated investors. They might buy the stock when the stock is over valued. In fact, most insiders tend to believe that the market consistently undervalues their company stock (rose colored glasses). They are not objective.
- Insiders may not be good judges of the future business potential – There is a reason many industries go through boom and bust cycles. Management keeps investing in growth believing that good times will last and when the supply far outstrips the demand, they are left with over capacity and huge debts. On the opposite end of the cycle, management cuts down its R&D, inventory and employees to such a large extent in order to cut costs, that when the demand starts picking up, they do not have the capacity to ramp up quickly. Too much optimism at the peak and too much pessimism at the bottom also reflects in their stock purchase/sale history. If you follow their transactions, you will lose.
- Insiders may have ulterior motives – This is hard to prove but in many instances insider buying just does not make sense. Unless you realize that insider purchases (and sales) are a signaling mechanism. For example, if the management is pleading for additional loans and making rosy projections for the future, a good way to build credibility is to commit some skin in the game – which often means the CEO and certain top executives will end up buying stock in the open market. Presumably, the rewards of getting additional funding far outweigh the cost of a few extra shares. Again, hard to prove, but it pays to be a skeptic when you try to understand why management does certain things it does, specially when you are putting your hard earned capital on the line.
This is not to say that insider transactions have no validity as a signal. They certainly do, but as individual investors building a portfolio that is necessarily not as well diversified as the market, we need to ask a few more questions. Between all the dogmas and rules of thumbs propagated by the street and the financial media, we forget the most important thing: Insiders are humans just like you and me and are driven by human desires and failings.
Ultimately what really matters is the business and the valuation. Insider transactions are secondary data points.
Case in point: Molycorp (MCP) is a rare earths miner that is about 25% owned by insiders. In fact in the last 6 months insiders bought 15 million shares with no sale transactions. Institutions however had a net 225 thousand shares in sales. Insiders have been purchasing the stock for many months now. However, the rare earths prices have not cooperated with the management (like all other commodities) and it does not help that the business is overly dependent on what the Chinese government does, as China dominates the rare earths production. As the insiders keep buying, the stock continues to decline and is down 38% in the last 52 weeks. In the recent quarter, the company reported 53% HIGHER losses than was estimated buy the analysts (based on the earlier company projections). If insider purchases gave you the confidence to go all in on the MCP stock, you just lost big.