Friday, June 24, 2016

The Impacts of Legal Insider Trading & Its Correlation with Stock Performance


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


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