Insider Activity: One of the Very Best Investing Signals You Can Get Here’s How To Use It

by Alexander Green, Chairman, Investment U
Monday, April 2, 2007: Issue #657

Hardly a week goes by that I don’t receive a message from a reader with a fill-in-the-blank complaint. “How could you possibly be recommending shares of [blank] today when the insiders are selling in droves?”

In truth, the majority of insider activity is actually insiders selling in droves at the majority of publicly traded companies. And ordinarily, this is nothing to be alarmed about.

Bill Gates has been a regular seller of Microsoft for decades. So has Larry Ellison at Oracle. Yet if you had held these stocks for the past 20 years, you would have done okay. In fact, you would have earned many, many times your original investment.

There are plenty of legitimate reasons an insider might sell that have nothing to do with the business prospects of his company. He might be diversifying his portfolio. He might be paying for an expensive private school or buying a second home. Maybe he’s getting a divorce and is required to sell half his shares.

Delving Deeper Into Insider Activity

And then there’s the biggest reason of all

Much executive compensation today comes in the form of option grants. But you can’t capitalize on the difference between your exercise price and the current market price until you sell your shares.

For all these reasons, there are typically about 15 shares sold by insiders for every share bought. Investors unaware of this fact often find themselves in a panic when they realize how much insider selling is going on at the companies they own.Usually, their fears are unfounded.

How To Recognize When Insider Selling Is A Red Flag

However, sometimes there are good reasons for concern. Particularly if the insiders are selling heavily into a declining share price.

As negative indicators go, this one is a bell-ringer. It sends the message loud and clear that the people who run the company want out – and they aren’t being terribly particular about the price.

The insiders at Enron, for example, sold 1.1 billion shares in the 12 months leading up to the company’s bankruptcy filing. A jury clearly believed that Ken Lay and his pals knew what they were doing.

Aside from misunderstanding the nature of insider selling, many investors misinterpret the monthly insider buy/sell ratio, published in the financial press and on websites like Thomson Financial.

For instance, many investors jump to the conclusion that the market is about to tank whenever insider selling spikes. Likewise, if insiders are buying more than average, they believe it means the market is about to rally.

That’s not necessarily so.

Timing the Market Doesn’t Work

While top executives know a great deal about the companies they run, they don’t know any more than you do about what the broad market is going to do. And while heavy insider buying is occasionally an indication of a market bottom, widespread insider selling is rarely a sign of a market top.

Here’s just one recent example. The U.S. market tanked last October. The following month, the insider sell/buy ratio hit 33.5, more than twice the average. But – once again – this was not a good market timing signal, as the Dow tacked on nearly 800 points between the first of November and mid-February.

The sad truth is market timing generally doesn’t work. (The rare exception is when investor sentiment hits extreme levels of pessimism or euphoria.) And insiders, it turns out, can’t time the market much better than you can. Furthermore, there are legitimate reasons an insider might sell that have nothing to do with his company’s business prospects.

But turn the equation around. Why would lots of insiders buy significant amounts of their own company’s stock, with their own money, at current market prices?

The answer, of course, is that based on their experience and knowledge – which generally includes plenty of material, non-public information – they believe the shares are selling for a lot less than what they’re worth.

The bottom line is this. Broad measures of insider activity are relatively meaningless. Insider selling at specific companies is a mixed bag. But heavy insider buying at individual companies is a highly significant indicator.

In fact, it’s one of the very best buy signals you can get. So do yourself a favor and use it.

Good Investing,

Alex

Today’s Investment U Crib Sheet

The March tally for insider activity is in Insider buys totaled $758 million last month. Meanwhile, sellers unloaded $9.9 billion worth of shares. That’s a sell-to-buy ratio of 13.1. Last week, the software/services industry topped the sellers’ list, in terms of dollar value – 46 insiders in the sector sold more than $253 million of company stock. Pharmaceuticals were the heaviest buyers, at $11.4 million.

Despite housing sector concerns, the CEO of Brookfield Homes (NYSE: BHS) continued his insider’s shopping spree On March 27th, Ian Cockwell bought $2.2 million in shares of the homebuilder on the open market. According to Barron’s, it’s the 15th open-market purchase he’s made since January 2003.

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