Corporate insiders are the company's top officers, directors, and large shareholders who own 10% or more of the company. These insiders know the firm's prospects better than any analyst or money manager could. They know whether inventory is being depleted or is building up. They know what new products are coming out and how their competitors are reacting. They know everything we wish we knew. Although we might not believe what these insiders say about their firms, we should take notice of their actions. Specifically, insiders must report to the Securities and Exchange Commission the buying and selling of their shares of firm.
Indeed, it is a common belief that insiders have better knowledge of the firm and frequently use that knowledge to better time their trading. It is also commonly believed that an investor can mimic the trades of insiders and also earn high returns. Indeed, a cottage industry has developed to follow insider trades. Every week, The Wall Street Journal highlights insider trades in its "Insider Trading Spotlight" column. This information is also printed in the weekly Barron's, the institutional investor service Insider Trading Monitor, and a newsletter targeted to individual investors called Insiders' Chronicle.
Early academic studies of insider trades show that they do predict future returns. These studies find that when the news of an insider trade is released, the stock price has a small but quick reaction, much like the price pressure effect described in the section "Dartboard." But unlike the pros' picks in the "Dartboard" column, the stock price continues to move long after the insider trade. That is, insider purchases precede increases in the stock price in the short term and the long term. The media also subscribes to this view. Reporters commonly base articles on the buying or selling behavior of executives and the following stock price movements. For example, Michael Dell of Dell Computers thought the stock price of Dell was an excellent value, so he bought 215,000 shares and profited from the 45% increase in price that occurred over the next seven weeks.18
However, beware that making money using insider trade information is not as easy as it looks. Hulbert Financial Digest tracks the performance of a newsletter that makes stock recommendations based on the insider trades. An investor trading on the advice during 1985 to 1997 would have earned an average annual rate of return of 16.0% after transaction costs. The S&P 500 Index earned 18.4% per year during the same period.
If insiders have better information and make better trades, why is it so hard to profit from the reports of their trades? Several important factors complicate the process. First, there is at least one insider trade in over half of the stocks in any given year.19 That is a lot of choices! Second, the sales of insiders do not predict poor stock performance. Indeed, most of the sales by corporate managers are done to change part of their compensation (stock and stock options) into cash. The sales are for consumption, not market timing. Lastly, the high performance of stocks after insider purchases is limited to small-growth companies. Knowing that insiders purchased stock in General Electric or General Motors is not as important a signal because investors know a lot about those firms. Knowledge of smaller firms is not as good. Therefore, the insider trades of those firms are stronger signals of future performance. However, small stocks also have higher transaction costs (due to larger bid-ask spreads). This means that much of the profit is lost to trading costs. Contrary to popular belief, these conclusions don't change even if investors look for three insiders trading in their stock instead of just one.