The smarter machines and algorithms become, the smarter you must become. To do this, I often say, look where others are not looking. This is smart investing. One of the areas I am big on, and I see frequent mistakes made, is the interpretation of insider trading (company management trading). It’s an area of the market that is neglected and the smarter investors I know always look at what the management is doing with their stock in addition to fundamental analysis. After all, if the management doesn’t have direction, do you think you are going to?
I monitor insider trading more carefully than most and I have an extensive watchlist of stocks under various criteria. I was alerted to a particular purchase of his own stock by an individual from Dollar General (DG). In early October, the Chief Information Officer of the firm made his first purchase ever. The stock had been on a precipitous decline as well as being back at 2022 lows and I was looking for an excuse to buy it. The stock was trading at a PE multiple of 13.1x FY2023E and 12.3x FY2024E. This was almost a 41% discount on the last 3 years of the average PE multiple. After looking at his background and this very unusual first-time buy, coupled with the valuation, I suspected that this was the catalyst I needed. Two weeks later, the firm replaced the CEO and announced a restructuring. I was sitting on an 18% gain. I believe the stock can still go higher. The CIO was a catalyst buyer and knew what was going to happen.
Legal Vs Illegal Insider Trading
The authorities must be notified when corporate insiders, including officers, directors, employees, and significant shareholders, buy or sell stock in their own companies. SEC notification is mandatory for corporate personnel who engage in the trading of their own securities. A delay may occur prior to the dissemination of insider data reports to the average investor. When ownership is transferred, the SEC requires Form 4 filings to be completed within two business days of the trade.
Stock sales tend to generate greater controversy in the context of insiders. An insider who wishes to sell restricted, unregistered, or controlled securities must submit an SEC Form 144. Prior to the sale, an insider must file a paper copy of this form with the SEC. For a maximum of the subsequent three months, Form 144 covers the insider's sales. Both these types of buys and sells, followed up with notification, are defined as ‘legal insider trading.’
Insider trading is the act of trading in the stock of a publicly traded firm by a person who, for some reason, possesses non-public, material knowledge (information) about that stock. Depending on the time the insider makes the trade, insider trading may be either legal or illegal. What exactly is material information? "Material information" has no clear meaning, but it might be broadly interpreted as any information relevant to a company that a stockholder considering buying or selling would deem significant enough to consider before making the trade.
SEC Rule 10b-5 forbids corporate officers, directors, and other insider staff from utilizing proprietary information to gain an advantage (or protect against a disadvantage) while trading in the company's stock. The "tipping" of proprietary corporate information to outside parties is likewise prohibited under this guideline. This is defined as ‘illegal’ insider trading and Martha Stewart served time for this in the past with her ImClone sale.
Interpreting Insider Trades
Assuming you are working on a legal basis, there are essentially three types of insider trades you should first understand and be aware of:
- Due to the 10b5-1 judgment, insiders might plan to buy or sell securities at a specified date or price. Trade begins after the event. These transactions use 10b5-1 plans. Pre-planned events have little impact on share prices.
- Stock options are an absolute red herring for stock direction. Executives receive free stock, usually at a discount, for these “trades”. They get it free and sell it for a profit. It doesn't affect stock direction but does affect incentives. The media often make inaccurate assumptions.
- Buys and sells: When an executive buys shares with his own money, this is one of the strongest signs, although more investigation is needed. According to legendary investor Peter Lynch, "insiders might sell their shares for any number of reasons, but they buy them for only one: they think the price will rise." His point is accurate, but you begin your examination here.
My good long-term friend George Muzea is a great man to know. He has been an expert on insider analysis for decades and I trust him wholeheartedly. He has worked with George Soros and Stanley Druckenmiller.
In his book, The Vital Few vs. Trivial Many, Muzea divides investors into "The Vital Few" (executives and directors) and "The Trivial Many" (the general investing public). He believes insiders' behaviors predict stock performance better than public emotions or actions. I cannot explain it better myself, so here is his view summarized.
- Focus on Collective Insider Activity: Muzea emphasizes analyzing a company's insiders' collective purchasing and selling behavior rather than individual trades. He considers the number and frequency of these transactions more informative than individual transactions.
- Contrarian Approach: Muzea generally opposes insider trading. He's interested in insider buying when the company is underperforming or market sentiment is negative. This is very bullish to him.
- Based on Muzea’ s findings, not all insiders are equal. He prioritizes executive and director transactions over lower-level officers. He thinks executives grasp the company's potential and direction better.
- Context matters: Muzea discusses insider trading's broader context. This comprises market health, sector trends, and the company's key performance indicators. He sees insider trades as part of a wider investment conundrum.
- Timing and Price Points: He studies insider trade timing and price points. Frequent purchasing or selling at falling or increasing prices might be enlightening.
- For insider transaction data, Muzea relies mainly on regulatory filings. He looks for patterns and trends in these filings to predict stock performance.
In summary, George Muzea’ s approach to interpreting insider trades is a comprehensive one, involving a blend of aggregate behavioral analysis, a contrarian mindset, a focus on high-level insiders, and a keen understanding of the broader market context in which these trades occur.
Buys & Sells
Buys and sells are important in insider trading analysis because of timing and context. When insider trading matters:
- When insiders buy during or after a stock dip, it can be an optimistic indicator, especially if the company's stock price has dropped significantly. It may signal that insiders think the stock is undervalued and will rise.
- Cluster Buying: Multiple insiders buying firm stock quickly is a good sign. It implies communal optimism about the company's future.
- Significant Investment: Large purchases show greater confidence than small purchases. More substantial transactions involve investments of greater value or as a percentage of the insider's income.
Top Executive and Director Buys: CEOs, CFOs, and directors are thought to have the most inside knowledge of the company's health and prospects; therefore, their purchases are more credible.
Insider Selling Pattern and Volume
- Individual sales may not be significant due to personal reasons such as portfolio diversification or financing huge purchases. However, repeated insider selling, especially by several insiders, is suspicious.
- Before Bad News or Earnings: Before negative news or earnings reports, insider selling can be a warning indicator. It may indicate that insiders are selling before the stock value drops.
- Compared to past sales, knowing if the insider or company sells like this can provide context. Heavy selling may be risky.
- Sell stock options vs. own shares: Selling stock options is distinct from selling personally held shares. The former may not indicate a firm lack of confidence.
General Thoughts
Legal insider trading is disclosed in US Form 4. These filings include transaction details, which can help interpret the deal. General market conditions can also affect insider transaction interpretation. During a bear market, mass selling may not be as concerning as during a bull market. The company's lifecycle (starter, growth, and maturity) can affect insider transaction normality and perception. Compliance with Trading Plans: U.S. insiders sell under 10b5-1 plans, which can protect them from opportunistic trading based on non-public information.
Insider trading is important because of who, how much, when, and under what market conditions. You can gain a good edge in predicting a company's stock performance by examining these factors. Ensure it is part of your armory.
On the date of publication, Jim Osman had a position in: DG . All information and data in this article is solely for informational purposes. For more information please view the Barchart Disclosure Policy here.
