Insider Trading Information

No Magic Bullet, But It Can't Hurt To Look

From the minute the first investors started investing (doubtless in saber tooth tiger-skin futures), they've been obsessed with discovering the one indicator, the one signal - real or imagined - that would unfailingly tell them which way their investment was headed. Not too long ago, stock market investors could be pretty certain that if a company announced higher profits, or a successful new product, or an increased dividend, or a stock split, or a smart acquisition, it would soon translate into a higher share price.

In these stomach-churning times, those old "valuation clues" are fraying. An announcement that would have quickly bumped up a stock price a few years ago can't be counted on to have the same effect today. (Why? Too much money chasing too few good prospects, countless tech companies and their continually- obsolescing products, 24-hour trading, millions of emotional and impulsive individual investors, globalization, money managers motivated by herd instinct, a worldwide shortage of patience and fortitude . . . Take your pick.) Thus the recent heated interest in the stock trading activity of company officers and directors, better known as insider trading.

After all, who would be in a better position than company officers to know what the company, and by extension the stock, is about to do? What could be a better indicator of tomorrow's stock price than what company insiders are doing today? In fact, over the last 18 months, insider trading (primarily selling) has been a fairly accurate three-month-leading indicator of stock price direction, and a respectable indicator of market direction in general. February 2001, for example, saw heavy insider selling, with $29 of stock sold by insiders for every $1 bought. The following months, as we all know, were unpleasant if you were long.

A few insider trading basics

Insider trading data is a reasonable screen to use for following the investments you have and often for choosing a new investment. But since even the best-informed insiders are only human, and occasionally wrong, insider trading should not be considered a "go-to" indicator in and of itself.

An insider is an officer or a director of a company, or an individual or entity owning more than 10 % of any class of a company's shares: In a word, these are people with the greatest knowledge of a company's inner workings and future prospects. The Securities and Exchange Commission (SEC) requires directors, officers, holders of more than 10% of company stock and certain key employees to disclose their stock trades.

Insiders tend to be value investors and early with their transactions, although not necessarily because they want to. Basically, they have to. There are strict SEC rules against insider buying or selling immediately before an announcement that's likely to cause a steep jump or fall; thus, insiders generally buy when they believe the stock is cheap relative to its outlook. Then they hold, confident of both the company's outlook and rising share prices. An insider buy is often an indicator, then, of long-term value.

Incidentally, when you see the designation "beneficial owner," consider it code for a large entity or a partnership. While these owners are often responsible for very large-dollar trades, the trades are not the best indicator of stock direction because they are usually part of a corporate transaction in which the person making the investment decision isn't the person who will suffer if the investment fails.

What to watch for

Probably the first thing to know is that there are any number of reasons for selling a stock - buying a house, sending a child to college, paying medical bills, diversifying a portfolio - but only one reason for buying: Someone thinks the stock price is going to go up. (Still, insider buying is no guarantee that a stock is about to rise.)

When following insider trading, what you especially want to watch for are anomalies, or activity that's out of the ordinary for a particular company, such as a large number of insiders buying or selling at the same time, unusually large purchases or sales, the first substantial insider buying or selling in over six months, or insider buying at a 52-week high. These often signify a fundamental shift in the perception of a company's prospects.

When any of the above happens, it shouldn't necessarily make you immediately follow the insider crowd. It should, however, make you ask questions.

A single sale by a single person (unless it's a significant portion of an insider's known holdings) means little; again, it's clusters of activity that are important. It's usually significant when several insider trade at one time.

One probable danger signal is sudden selling in great quantities (dumping) by numerous insiders when the stock is 75% or more below a recent high, particularly when you see a consistent pattern over several weeks of selling on every upward spike during a downward trend. This almost always means that insiders have lost all confidence in the stock's turning around in the short term. Rather than jumping out a high window when this happens, a sharp investor can jump in and sell the stock short, or buy and sell puts.

In fact, this is among the indicators used by 21st Century Investor. For example, we recently noticed alarming insider selling of Human Genome Sciences (HGSI), as the CEO quietly dumped 1.8 million shares of stock without alerting anyone to his obvious reconsideration of the company's valuation. Coupled with other of our indicators, it strongly suggested a short sale.

Another possible sell signal is one that's closely watched by 21st Century Investor: heavy insider selling with the stock price at a 52-week high. It can be a sign to sell if you own the stock, and to go short if you don't.

Another thing to be alert for is a pattern of selling while good news is coming out of the company. Pumping and dumping is bad for the stock, but possibly a good opportunity to short or buy puts.

Conversely, insider buying as the stock price is falling generally indicates confidence. We have seen none of this during the big tech crash.

The size and value of a transaction are good indications of significance - not only when there's a lot of money involved, but when many shares as a proportion of the insider's known holdings are traded.

The insiders closest to the company's day-to-day operations are the ones to watch: the chairman, president, CEO, CFO, vice presidents and directors. Especially watch the CEO, since his actions are sometimes considered a signal for other officers to follow.

When looking at insider transactions, note that open market transactions are much more significant than options-related trades and other non-open-market transactions. The options that many insiders are given as incentives or bonuses often allow them to make risk-free profits, buying shares from the company at well under market prices and selling them immediately at market price. (Options-related purchases are indicated by the transaction code "Exercised;" often a block of options-related shares will be bought and sold on the same day.)

Other non-open-market transactions could be gifts, awards, or some other type of special trade that doesn't really indicate the insider's sentiment toward the stocks. It means significantly more when insiders invest their own money than when they just reap company savings; and in a D/I (Direct/Indirect) column, transactions of direct holdings are generally more important than transactions of indirect holdings.

Reading between the lines

Insiders must regularly file several different reports with the SEC, the two most important of which, for our purposes, are Form 4 and Form 144. They are filed each time an insider makes a trade or plans to sell unregistered shares, and they give the best insights into probable market activity.

Form 4 is an indication of changes in share ownership and is perhaps the most important insider trading form, as it gives the astute investor dynamic information about the insider's sentiment toward the stock. Of course it lists the insider's name and relationship to the company, the number of shares traded in the reported transaction and the share price - but it also gives the date of the trade and the total holdings of the insider after the transaction, and reports whether the trade was open market, related to the exercise of stock options, or executed for some other special reason.

In addition to being detailed, a Form 4 is relatively timely. The deadline for filing is the 10th of the month following the transaction, so the longest it can take for information to reach the SEC is 41 days. Naturally, there's usually a surge in the number of filings around the 10th of the month.

Form 144 gives the SEC notice of intent to sell a specified number of unregistered shares within the next three months; these are shares that the company can issue directly to insiders as part of a stock bonus, pension, or profit sharing plan or private placement, and that have not been registered with the SEC. Form 144 doesn't commit filers to sell but if they don't, they must amend the form. Typically, the shares on a Form 144 have been sold by the time the SEC releases the news.

Two places to find free, fairly recent insider trading information in digest form are the Yahoo! Finance web site and the SEC's EDGAR web site.

In addition to the spike in February 2001, May saw heavy insider selling too, a ratio of some $33 of stock sold to every $1 bought. This squares with what we've been saying about the market for months: that every rally this year has been a sucker's rally, and that smart money is prepared for yet another slide.