Why Follow Corporate Insiders?

A corporate “insider” is defined by the SEC as a corporate officer (CEO, CFO, COO, etc.), member of the board of directors, or a large shareholder (who own more than 10% of a company). Each purchase and/or sale must be reported via a Form 4. A Form 4 reports a change in an insider's ownership position to the SEC. It is filed any time an insider makes a purchase, sale, option exercise, etc. in their company's stock.

On August 29th 2002, the SEC made a dramatic change to the laws governing corporate insider transactions. The new law now requires insiders to report transactions involving their own company's stock within two business days. Prior to this, transactions were required to be reported by the 10th day of the month following the transaction. This change in the reporting window has made insider trading information much more relevant to individual investors.

Insider trading usually creates images of corporate greed where people illegally use inside information to profit before the news is made public. It has always been perfectly legal for corporate insiders to buy and sell their own company's stock, as long as they do so without the benefit of non-public information. In addition, knowing that an insider is privy to non-public information, the SEC mandates that an insider must hold the stock that they purchase in the open market for a minimum of 6 months before selling it. If they do in fact sell prior to that 6 month date, they must forfeit the profits to the company.

It makes sense that corporate officers and members of the board of directors have a deeper insight into a company's operations than any outside analyst, financial TV host or money manager could ever hope to attain. Being skilled business people, insiders are some of the best qualified people in the world to evaluate their company's future prospects. They are the smart money.

Although insiders may buy their company's stock because they expect good things to come, insiders do not sell simply because they think their company shares are about to sink in value. Insiders sell for all kinds of reasons. They might want to diversify their holdings, distribute stock to investors, pay for a divorce or take a well-earned trip, or returns are greater than those of the overall market. *

Anyone who buys a stock in the open market does so because they expect the price to rise - no one invests to lose money and insiders are no exception. There are two main reasons why insiders would invest in their own companies… they believe business developments are about to get better, or that their company’s stock price is undervalued.

When looking for companies to invest in, we believe that one should start with those companies that have leadership so confident of future success that they are literally putting their own money where their mouth is. Taking an important step further, why not follow a select group of insiders who have demonstrated success historically of knowing when to purchase their own company’s stock….meaning that the price of the stock they purchased was higher 3, 6 or 12 months later.

University of Michigan finance professor Nejat Seyhun, author of "Investment Intelligence from Insider Trading" (2000), offers a similar story. Stock prices do rise more after insiders' net purchases than after net sales. On the whole, insiders do earn profits from their legal trading activities, and their returns are greater than those of the overall market.**

No insider buys a stock thinking that its price will go down — they do so to make money.

There is only one reason that an insider buys!

Sources:

*Investopedia , Ben McClure.

** Investment Intelligence from Insider Trading , Nejat Seyhun, 2000

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