Insider Stock Trading: Due Diligence For “Insider” Profits
by Mark Skousen, Chairman, Investment U
Monday, May 15, 2006: Issue # 535
There are at least a dozen newsletters and trading services promising unlimited profits by following the buying and selling habits of company insiders. But does this insider stock trading technique work? Some have a great track record, but lately it’s becoming more difficult to figure out how significant a purchase or sale is, especially with small-cap and penny stocks.
Remember one of our cardinal rules of investing: “Investment fads stop working when they become too popular.” Remember the Dogs of the Dow strategy? This contrarian technique required you to find the 10 Dow stocks with the highest dividend and buy them for a year. According to Michael O’Higgins, the inventor of this technique, in his book Beating the Dow (1991), you can handily beat the market. His technique worked well in the 1990s, but fell apart recently as major brokerage firms started using it as a “sure fire” way to make money.
Today, let’s take a closer look at the “insider trading” strategy…
Insider Stock Trading Rule # 1: Beware Of Company Officials Playing Games
Following insider transactions may be following the same pattern. Executives of small-cap companies have caught on to this phenomenon… and are starting to buy stock in an effort to boost their stock’s performance, even though there may be no improvement in the company’s fundamentals. One company recently even went so far as to issue a press release announcing insider buying!
The key to profiting from insider trading is to recognize the motivation of the company officer engaging in insider transactions. The questions you should ask are:
- Is he attempting to artificially pump the stock?
- Is he required to buy stock on a regular basis?
- Or is it purely a voluntary purchase because the official knows that the company is going to report better-than-expected earnings? Sometimes it’s hard to tell.
And Insider Selling May Also Be Misleading…A CEO may set up an “automatic” or “planned” sale arrangement with his company as a way to diversify his portfolio. Many company officers receive an excessive amount of stock options, and this is a way of diversifying without running afoul of SEC regulations.
Don’t dismiss planned sales automatically as “noise.” Regular sales of blocks of stocks can put a drag on a good company for years. For example, one of the largest tech companies in the world has a profit margin of 31%, earnings growth of 16%, and is selling for only 18 times trailing earnings. Yet, the stock has floundered for the past five years, selling between $23 and $28 a share. It never moves much one way or another. Investors keep holding on, thinking the stock will eventually break on the upside, but they wait in vain.
The reason? The company president keeps selling huge blocks of stock throughout the year to finance his charitable foundation. In February alone, he sold 40 million shares worth $1 billion! No wonder the stock isn’t going anywhere.
The name of the company is Microsoft (Nasdaq: MSFT), the president is Bill Gates, and the charity is the Bill and Melinda Gates Foundation. The Gates Foundation, one of the world’s largest ($30 billion), has a monstrous hunger and is being fed at the expense of Microsoft’s shareholders.
Conclusions on Insider Stock Trading
In sum, using insider stock transactions may still work to pick undervalued stocks, but don’t rely exclusively on this information. There is no easy formula for finding winning stocks. You must do your homework, and know what motivates company buying or selling.
Good investing, AEIOU,