Should Investors Join Insiders When They Buy?

Should Investors Join Insiders When They Buy?

Although market-beating strategies come and go, one has stood the test of time: if executives, directors, or others with inside information of a public firm are buying or selling shares, investors should consider doing the same. Insider trading behavior is a helpful gauge of broad movements in market and sector sentiment, according to research.

Outsiders must consider the elements that govern the timing of trades as well as the factors that obscure the intentions before chasing any insider move.

Important Points to Remember

  • When corporate insiders start buying stock, it could be a signal for outside investors to follow suit, but it’s important to look at which insiders are doing so.
  • “Insiders might sell their shares for any number of reasons, but they buy them for just one: they anticipate the price will rise,” said Peter Lynch, one of the greatest investors of all time.
  • Insider information is available for free on a number of financial websites.

Insider Trading: Why Should You Care?

The rationale for shadowing insiders is compelling. The most up-to-date information about the prospects of their companies is available to executives and directors. These insiders are far ahead of analysts and portfolio managers, not to mention individual investors, in terms of cyclical trends, order flow, supply and production bottlenecks, costs, and other critical aspects of corporate success. Insiders’ decisions to trade in their own companies’ stocks (whether legal or not) are undoubtedly worth investigating.

Insider information works best in the aggregate, according to research. Insider trade habits, according to independent research firm Market Profile Theorem (MPT), imply an impending shift in market mood. MPT analysts use the Brooks ratio to spot patterns, which divides a company’s total insider sales by total insider trades (purchases and sales) and then averages this ratio across hundreds of stocks. If the average Brooks ratio is less than 40%, the market is bullish; if it is greater than 60%, the market is bearish.

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Nejat Seyhun, a finance professor at the University of Michigan and author of “Investment Intelligence through Insider Trading” (2000), tells a similar experience. Stock prices rise more following net purchases by insiders than after net sells by insiders. Insiders make money from their lawful trading operations in general, and their returns are higher than the whole market.

The Significance of the Signals

Increases in insider trading appear to signal a market reversal on the horizon. Outside investors, on the other hand, must be extremely cautious about interpreting good sentiments into every insider purchase they observe. Individual transactions should not be seen as a signal to sell one’s own holdings. One large insider buy or sell order may provide investors a hint of what’s to come, but it’s hardly a sure-fire indicator for outperforming the market.

More businesses are requiring newly hired executives and directors to buy stock. Outside investors are unconcerned about these mandatory purchases as market indications. Other businesses encourage employees to buy stock by giving them half-price stock loans. This is an example of the corporation taking steps to align management and shareholder interests. While admirable, these transactions do not give a cause for outsiders to invest in the company.

An insider may make an announcement about a stock purchase to attract Wall Street’s attention, but announcing is not the same as acting. Jim Clark, the founder of dot-com startup Healtheon, once stated that he planned to buy up to $100 million worth of the company’s stock. The stock of Healtheon soared on the day of the announcement, but Clark didn’t buy nearly as much as he had predicted. The stock immediately fell in value, and those who followed his advice were left out in the cold. Healtheon later merged with WebMD, and the combined company was eventually purchased by KKR & Co., a private equity firm.

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Insiders do not sell because they believe their company’s stock is about to fall in value, even if they bought it because they expect good things to happen. For a variety of reasons, insiders sell. They may desire to diversify their holdings, sell stock to investors, pay for a divorce, or go on a well-deserved vacation.

Another major issue with collecting insider data on certain companies is that CEOs can make mistakes when it comes to assessing their potential. Even as stock values plummet, some insiders may buy. It can be a question of chance as much as anything else when insiders correctly value their companies’ stock.

Employee stock options, which are becoming a significant part of executive pay, might make analysis difficult. Keep in mind that if an insider is exercising stock options by purchasing the stock, it doesn’t matter if the options were issued at a discount. Executives, on the other hand, are not required to declare this when purchasing through the exercise of their options. Outsiders can only speculate on how much “genuine” buying is going on.

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Tips for Making the Most of Insider Information

When examining specific insider trading scenarios, investors should keep the following guidelines in mind:

1. Some insiders are more knowledgeable than others.

Directors have less knowledge of a company’s future prospects than executives. The CEO and CFO are key executives. The people in charge of the company are the most knowledgeable about its future plans.

2. Doing a lot of trading is preferable to doing a little.

A few insiders in a large corporation do not constitute a trend. Three or more are more likely to indicate that anything is going on. Solitary deals, in general, are unreliable.

3. Small business owners are more knowledgeable.

Almost all insiders in small and mid-sized businesses have access to financial information. In large businesses, information is increasingly fragmented, and the overall picture is often only known by the core management team.

4. Stick to your guns.

Insiders, according to evidence, tend to act much ahead of expected news. They do this in order to hide the fact that they are engaging in unlawful insider trading. According to a study conducted by academics at Penn State and Michigan State, insider action can occur up to two years before specific corporate news is publicly disclosed.

Final Thoughts

The bottom line is that insider monitoring is difficult, and it is far from a surefire way to make a lot of money. A pattern of trades could indicate forthcoming market shifts, and it’s always comforting to purchase or sell a stock knowing that an insider is doing the same. Insider advice, on the other hand, will never be a substitute for thorough research.

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