Mention insider trading" to a friend at a cocktail party, and he or she is likely to look around to be sure no one is listening in. The phrase conjures up visions of hot tips, fast moves, and wary eyes on the regulators of the Securities and Exchange Commission.
The fact is, most insider trading is neither illegal nor secretive. Precisely to prevent abuses of privileged information, the SEC requires all corporate insiders -- company officers and directors, and those owning 10% or more of a corporation's stock -- to report all their trades in their company's securities. These reports become part of the public record, and they are printed up in due course by the SEC -- usually six to eight weeks after the reports are filed.
In the meantime, of course, there are a lot of us outsiders who would like to know what those insiders are doing, for it is hard to escape the presumption that they know something we don't. And that is where a handful of information-gathering companies come in. They scoop up the insiders' reports to the SEC and the stock exchanges as soon as they are filed. Then they analyze and publish them, usually in newsletter form. Their customers thus get a jump on the rest of the investing public, and theoretically can use this "inside information" as part of their investing strategy.
That, anyway, is the theory. For an inside look at how the process works -- and at one (admittedly biased) view of how well it works -- INC. staff writer Lisa R. Sheeran talked with Richard A. Horowitz, editor of The Insiders Edge. Published in Dallas, Tex., Horowitz's newsletter tracks inside trades of every stock listed on the New York and American stock exchanges, and every month provides both summary and analysis of the latest buying and selling.
INC.: First thing first. Why should we outside traders care what inside traders are doing?
HOROWITZ: Most presumptions about the stock market have been proved wrong. One presumption that has been proved right is that insiders know more about the future fortunes of their companies than the rest of us know. Literally scores of studies back up this assertion; they show, in essence, that you will make more money by paying attention to what insiders do than you will if you don't pay attention. While we can't know what insiders know about their companies, we can track their footprints and do what they do.
INC.: Should we pay equal attention to both buying and selling among insiders? How do we know that an insider hasn't sold shares of his company's stock for a down payment on a house, for instance?
HOROWITZ: Insider buying patterns do have a better predictive record than insider selling patterns. Why? Insiders have many opportunities to buy their own stock at below-market prices through stock-option plans. When they go out into the open market and pay full price for their own stock, that typically represents a strong conviction on their part that the price of the stock is going to go up. If you were to call a company's officer and ask, "Why are you buying that stock?" the answer you would probably get, if the insider was willing to talk to you, would be that he or she has great confidence in the company's prospects. That would be an honest answer.
If you ask why he or she is selling the stock, you would get a much more vivid answer -- "I have two kids whose teeth need fixing," or "I just got divorced and need money for the settlement." Rarely would insiders tell you they sold the stock because they have a bearish outlook on the company. Some of our subscribers, both individual and institutional investors, will not as a rule purchase a stock that is being sold by insiders. Still, that means they sometimes forgo profitable opportunities.
INC.: Insider buying and selling must go on all the time. What clues tell us when inside trading is significant?
HOROWITZ: The Insiders Edge Highlights Report -- the service we offer individual investors -- focuses on two different parameters. The first is the exact number of shares that were sold at a price, month by month, for a period running as far back as 36 months. That tells you at a glance whether insiders have traded only 500 shares, which might not be significant, or 5,000 shares, which is significant. The second is the frequency of trades, without respect to the size of the transaction. It is best to use a combination of these two indicators, but statistically, it is more important how presistent those insider transactions are than how large they are. We like to see insiders committing, over time, in excess of $100,000 of their own hard-earned money. We also like to see a significant number of transactions within six months to a year. When insiders are committing more than $100,000 and there's a clean slate of insider selling, you've got something eye-catching that ought to be pursued.
INC.: How do stocks traded by insiders fare against the market in general -- the S&P 500, for instance?
HOROWITZ: From April of 1983 to April of '84, the S&P 500 was up 4.1% and the 25 Insiders Edge top-ranked insider buys were up 25.4%. Stocks that were sold by insiders during the same period were down 5.7%, which means that the insider sell portfolio underperformed the market average by 9.8%. Together, the percentage difference between the insider portfolios and the S&P 500 is more than 30%.
INC.: How does the investor know when it is a wise decision to buy or sell insidetraded stocks?
HOROWITZ: You can get a good idea of timing considerations by looking at the stocks that are at the top of the Insiders Edge tables. If you are holding stocks that are being sold heavily by insiders, look those stocks over very carefully, or go to the person who recommended them and ask, "Did you know insiders are liquidating this stock heavily? Why do you think they are doing that? And maybe you, Mr. Investment Adviser, want to go back and talk to the company about why these guys are selling this stock?" Proceeds from the sale might then be invested in stocks that show strong insider-buying patterns.
This way you are lining up with insider-based probabilities, illustrate some insider trading patterns from your tables?
HOROWITZ: Sure. Carter Hawley Hale was about $12 when insiders started buying it in a significant way. Two years later it reached as high as $32. Chicago-Milwaukee was $43 after insiders started buying it, and two years later it's $151. Conwood Corp., on the New York Stock Exchange, moved from $12 to $30 in about the same period. Most of these trends, incidentally, began several months before the last bull market turned strong.
INC.: Two years is a while to wait for results.
HOROWITZ: I have never found a strategy that increased net worth dramatically that didn't require patience. Some strategies seem attractive and magical from the outset, but when the strategies are analyzed statistically, we find that the only people who really get rich on those fast-turnover strategies are the brokers.
One reason patience is required is that insiders are early by nature -- they don't want to be too close to the event. In a weak market they'll sit with a bushel basket and accumulate stock that no one else wants at $4 a share. Typically, those stocks won't move until either a significant corporate event occurs -- a turnaround situation or a buyout -- or the stock market becomes very strong.
