HOW TO PROFIT FROM INSIDER TRADES

(Cartoonist : Chris Wildt  : Cartoonstock.com)

 

An insider trade can emanate from information, liquidity or manipulation. Hopefully, this post can provide some clues as to how to devise ones own strategy for imitating insider trades profitably.

 

What is insider trading?

 

The SEBI regulations on insider trading talks of ‘connected persons’ who have ‘access to unpublished price sensitive information’. It is impossible to understand what constitutes an insider trade without considering what the regulation say. However, I will not go into the legalese. Suffice to say that, as investors, we are only concerned with the legal disclosures that are routinely made as a part of the compliance requirements. Click here and here  to read what the SEBI provisions say on insider trading. The relevant PIT (Prohibition of insider Trading) disclosures on the NSE website can be found here.

 

Why is tracking insider activity so important?

 

• The most important reason for tracking insider activity is that this is a forward-looking indicator. Most of the tools, like price earnings, earnings per share or book value are based on historical data. Insider activity is not. It does not consider the current market price of the stock, nor its historical information. This makes it unique. Hence, the chances of it being predictive are higher.

• The top management of the company have the most relevant information of all factors which will affect the company in the future. They are running the company. Hence, they are in a far better position than the rest of us to judge the fortunes of the company. When they decide to trade, it obviously means that they have a clue as to the  future outlook.

 

What you should be looking for while tracking insider activity.

 

There are two types of insider trades, one is a purchase and the other is a sale. In the case of a purchase, the insider trade can be said to be profitable, only if the returns obtained over a twelve month period, exceed those that one would have been obtained by investing in an index fund or ETF, tracking the benchmark. In the case of sales it is vice versa. The following is a list of 10 things you must know before you decide to imitate the insiders:

 

1. Are insiders early?

Yes, they are early. In most cases there is no immediate price action. The price tends to react gradually, over time. Genuine insider purchases tend to occur only after a continuous fall in price, when investor sentiment is at its nadir.

2. What to look for in insider buying?

If an insider buys an under performing stock, it is the opportunity of a lifetime. Such an insider, who overcomes the inherent behavioral bias is easy to spot. We just have to look at the trailing stock price. Insider buying has more value in case of beaten down rather than high-flying equities. Insider buying is a strong confirmation that the insider is willing to disagree with the current market sentiment. The insider, effectively, is pretty sure that the company is worth much more than what it’s market price is showing. The fact that an insider has bought, does send a strong signal that the stock has an intrinsic value that is greater than its current market price. The mood of the insiders in the company, and their attitudes towards their stock, does swing according to the stock price. I have often found that it is in direct sync with that of market participants. Needless to say, as the price of a stock is falling, most market participants and company insiders have a very pessimistic outlook of the company, and its prospects. In view of this, when a stock price is battered and an insider buys, it means he has overcome his behavioral bias (fear) and bought. It is easy to write about overcoming behavioral biases. In actual practice these are extremely difficult to overcome. That is just the way all of us are wired. It does require a great deal of conviction to put your money where your mouth is!! Hence, this is a great buying signal.

3. What to look for in insider selling?

What if the insider decides to sell? In such cases the relevance is less than the buy trade. Why?  There can be myriad reasons for insiders to sell a stock. It can be due to profit booking or diversification. It can also be on account of ‘access to unpublished price sensitive information’. Just by reading the insider trading disclosures there is no way we will know. In case of insider buying, in all probability, there is only one reason. That one reason is enough for us to imitate the insider.  Hence, insider selling is less predictive.

4. Which insiders should you be tracking?

There are four types of insiders viz. large shareholders, directors, top management and other company executives. In my opinion, the top management is the one which should be tracked. Not all persons who are mandated to disclose, can be considered to have ‘access to unpublished price sensitive information’. In the case of large shareholders, insider trading disclosures are in the nature of compliance requirements. Their need arises on account of holding the necessary percentage of shares. Hence, the entity has to give the mandated disclosure. However, such insider disclosures may not serve our purposes. Why? For the purpose of basing an investment decision on insider trades, the insider must have ‘access to unpublished price sensitive information’. This may not always be the case with such large shareholders. Hence, we must only look at insider trading disclosures of persons who are known to be privy to such information and not the others. The same is the case with non Whole-time Directors. They are not involved with the day-to-day running of the company’s business. In short, some insiders are better than others!!

5. When can we safely ignore insiders?

In case the disclosure is part of the ESOP (Employee Stock Option Program). Also, at times the insider trade may be part of the compensation package. This is very relevant in today’s environment. Hence, ignore options and stick to open market purchases. There are plenty of instances where the top management has more value tied up in stock ownership, than in the compensation that they receive. This has to be analysed on a case-to-case basis.

6. How to guard against deceptive insider trades?

There are situations when you cannot trust the insiders. The possibility of an insider making a token purchase to send a buy signal to the market cannot be ruled out. In such instances, insider trades can be deceptive.  When one is looking at the insider activity one has to see if it is a fresh ‘buy’ or whether it is a ‘sell’ of an earlier buy (closing of a previously opened position). The quantity and frequency of insider activity is a good indicator of insider sentiment. It is important to see the buy quantity as a percentage of existing holding. What is the percentage of stock the insiders collectively own (insider ownership as a percentage of total ownership)? Have the insiders purchased at a price higher than the current market price? One has to be wary of insider trading announcements made on media channels. These have an inherent marketing bias.

7. What kind of companies give best results with insider trades?

It is found that the ‘growth’ stocks do not get bought by insiders. The exception is in cases where they get hammered by a one time event. In the case of ‘value’ stocks, insider buying is more predictive. Insider buying is a strong confirmation of value. Companies trading below their intrinsic value tend to suffer from an extreme negative investor sentiment. Also, mimicking of insider trades which occur in smaller companies is more profitable. The reason is that the risk involved is higher. It follows that the higher the risk the higher the reward!

8. Since the insider trade information is widely known is it useful?

I have always said that, in markets when some method or technique becomes widely known, it loses its efficacy. Insider trades are the exception to this rule.  Insiders trades are usually done with a long-term bias, usually one or two years. The insiders, by virtue of their daily involvement with the business, have a very good knowledge of the business cycles, competitor activity and future prospects. Hence these trades are known to have predictive ability. Generally insiders tend to trade on an ongoing basis, over a period of a month or two. In most cases you will find that the market tends to ignore such trades. Why? The reason is that we are too concerned with global cues, individual biases and daily news trends.

9. Is the quantity and periodicity of the insider trade important?

There may, in certain cases, be insider ‘buys’ and insider ‘sales’. In such cases, the net aggregate of such an activity, in terms of the number of shares, must be considered, to decide whether it is an insider ‘buy’ or an insider ‘sale’. Also the periodicity of insider activity is important. Moreover, insider trades have less relevance to the direction of the broader market. They are stock specific and must be used accordingly.

10. Are insiders just lucky or are they good at predicting stock price changes?

It is difficult to assign a percentage as to the ratio of success achieved by imitating insiders. There have been many cases where insider activity has proved to be stupid. The fact that an insider has bought or sold, does not add any fundamental value to the shareholders. However it is a good indicator where there is a blatant mispricing of securities. The insiders tend to notice such anomalies before most of us.

 

Conclusion

 

The costs of obtaining, analyzing, and trading on legally available insider information is relatively small, compared to potential profits. There is a definite opportunity for stock picking by tracking insider trades. Insider trading, if analyzed correctly, can provide good investment ideas. We are, after all, looking for predictive power in our investment model. Since there are so many insider trading disclosures made on a daily basis, it is difficult to separate the wheat from the chaff. It is advisable to incorporate insider trading disclosures as an additional tool while taking investment decisions. Is it safe to blindly imitate the insiders? No, please don’t try it. In markets what seems safe, is infinitely dangerous.