Are insider sales and purchases effective in predicting the future price movements of a stock?
Peter Lynch, arguably the best fund manager ever, managed the Fidelity Magellan Fund from 1977 to 1990, during which time the fund's assets grew from $20 million to $14 billion, achieving a CAGR of 29.2% and beating the S & P 500 index benchmark in 11 of those 13 years. In his books, he shared that he made use of insider trading as one of his strategies to buy stocks. I read his books and have adopted this tenet with alacrity in some of the stocks that I purchased, e.g. 800 Super (my blog posted on May 29, 2016), Singapore Land (before its privatisation), Innovalues, Ellipsiz, Best World (my blog on April 23, 2016 ) and all have produced wonderful profits for me.
Peter Lynch made his point straight: If the boss buys his own company stock, the only reason is he sees potential in his company and he thinks the stock price will go up. But if he sells the stock, it is not necessary that the company is not doing well.
Insider trading happens in different kinds of companies, big or small, and can be at any time. The information is, through my trading experience, more crucial in smaller companies than large companies. All stock exchanges will impose strict regulations, restrictions and penalties if the substantial shareholders do not disclose their trades within a certain timeframe after the transactions have been concluded. The information will be disclosed quite timely for all market players and we have to make use of it to our advantage.
We need to classify the insiders into different levels. The top insiders -- people like CEOs, CFOs, Directors, Chairmen of the board – are generally able to trade more profitably than other insiders. It is quite easy to come to that conclusion as they are privy to the company’s developments. The investment funds, even though they are substantial shareholders, either will not have the big picture or they will receive the information at a later stage.
The market timers and asset allocators will
be encouraged by evidence that insider trading data can predict future stock
returns. But my years of experience and knowledge told me that not all insider
trading information is equally predictive. I would like to share with you the
nuances between the various insider trades to increase your odds of picking the
right stocks at the right time:
1. Insiders typically have undiversified portfolios as their
holdings are huge. They also generally get stock as compensation. Being rich
and risk-averse, they will want to diversify their portfolios. So, to buy more
shares in the same company runs counter to the principle of diversification and
the only reason that insiders would buy more has to be the positive development
of the company they are privy to. They can sell to diversify, for liquidity
reasons, or for other reasons. Sales are still informative but less informative
than purchases.
2. Insider trading in small companies is more predictive. It
is generally easier for top executives of smaller companies to understand
everything about the company.
3. When insiders trade frequently and have large trades,
those transactions are more predictive.
4. Try to wait for some time, say 3 months or so, to see if
you can get the stock at a price cheaper than the insider’s. This is not to
suggest that the insider is wrong in his prediction of the company’s future
growth. Most of the time, the technical analysis do not support the price moving
upward when the insider bought the stock. If the price has gone higher before
you get in, so be it. There is always another opportunity.
5. If the price of the stock moves up and an insider is
buying it, it is very predictive.
6. If the price of the stock moves up and an insider is
selling it, it does not imply that the company is in trouble. The scenario can
be: The insider knows the company is doing well and there will be a good
earnings announcement, but he needs to sell some shares to raise money. There
will usually be a restrictive period for insiders to buy or sell within a month
before the quarterly result announcement. So the insider postpones the sale
until after the stock has priced in the good news. The insider has no intention
to exploit future stock-price declines. It is timed to take advantage of the
good news and in that sense the insider’s sale is not that informative.
7. Even with insider trading, buying into strength and
selling into weakness tends to be more informative. We have to worry if the
insider sale takes place when prices are falling.
8. You still need good diversification even when you buy
stocks after insider purchases.
In a nutshell, investors willing to 'mimic'
large trades by top executives of smaller companies will make money and the effectiveness
of the purchases is nuanced by the above summary that I have made.
Superphang
http://superphang.blogspot.sg