Vintage illustration of a tuxedo-wearing Wall Street fat cat, gambling at a roulette table with the … [+]
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To make gains and be ahead of the masses in the stock market, I frequently say, look in places that others are not looking. Further, smart investing is about looking in the right places. It’s not about being first contrary to popular belief. The rub? You usually have to do a little more work and that doesn’t fit well with most investors these days who are after a quick profit. Monitoring company executives buying and selling their own shares is an absolute must for our firm and clients and an essential ingredient to analyze when approaching an investment. I mean, why wouldn’t you want to buy and sell with the people who actually know what’s going on in their company? Of course you would, but the interpretation and mimicking of their stock transactions can leave you with big losses if you fail to do the analysis and just blindly do what they do. Lets clarify the concept of trading by company executives in their own shares, because it’s not always entirely obvious.
Illegal Insider Trading
Insider trading is the act of trading in the stock of a publicly traded firm by a person who, for any reason, possesses non-public, material knowledge (information) about that stock. Depending on the time the insider makes the trade, insider trading may be either legal or illegal. What exactly is material information? “Material information” has no clear meaning, but it might be broadly interpreted as any information relevant to a company that a stockholder considering buying or selling would deem significant enough to consider before make the trade.
Martha Helen Stewart is an American businesswoman, writer, TV personality and also a convicted felon. She is a media icon who built a business empire throughout the 90’s and 00’s with “Martha Stewart Living” where she was the host of each TV episode presenting insights on things such as cooking, gardening, arts and crafts and decorating. She was extremely successful in the time of high consumerism and had America at her feet, but things went horribly wrong.
Sam Waksal, the CEO of ImClone and a friend of Stewart’s, learned that the FDA had not yet approved the company’s promising experimental cancer medication. Before the news, which was certain to send the price of ImClone stock tumbling, Waksal attempted to sell his shares. As soon as she received word from the Merrill Lynch broker she shared with the Waksal family, Martha Stewart liquidated all of her own shares in ImClone for around $230,000. Both transactions were carried out ahead of the public knowing and it was deemed as insider trading. The U.S. Securities and Exchange Commission (SEC) claims that Stewart avoided a $45,673 loss by selling all 3,928 shares of her ImClone Systems stock on December 27, 2001, after obtaining important, secret information from her Merrill Lynch broker, Peter Bacanovic. Her selling resulted in a 16% decline in the stock value the next day.
Stewart was found guilty in March 2004 of the felonies of obstruction of an agency proceeding, conspiracy to obstruct, and making false statements to federal investigators following a highly publicized six-week jury trial. In July 2004, she was given a five-month sentence to serve in a federal prison.
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Stewart’s case is just one of many high profile illegal insider cases over the years in the US. Others included Michael Milken (the Junk Bond King), Foster Winans of the Wall Street Journal, Jeff Skilling of Enron, and Mathew Martoma and Michael Steinberg of Steven Cohen’s SAC, amongst many others. They are actually not that common, or maybe it’s the case that they are not that commonly uncovered.
NEW YORK – JULY 16: Martha Stewart stands outside Federal Court after her sentencing hearing July … [+]
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Many years ago, I stood in front of a very traditional group of fund managers in northern England. I was going through the way I looked at companies and how I approached an investment. The presentation was going very well and as I flipped to the next slide I announced, “The next area which you should be looking at to make a return on is insider trading.” The room erupted with laughter. In hindsight, I probably could have phrased things a little differently. Insider trading was much more of an issue in the 90’s as the authorities were still coming to grips on how to track it. Investors were confused and weary. It was and still is viewed as a highly criminal activity, and there was I standing in front of a crowd of people with a fiduciary responsibility handling other peoples money telling them to break the law (or so it seemed). Nothing could have been further from the truth with my message.
What I went on to explain is the legal side of insider trading and following the people that matter into their investments by their trading actions. SEC Rule 10b-5 forbids corporate officers, directors, and other insider staff from utilizing proprietary information to gain an advantage (or protect against a disadvantage) while trading in the company’s stock. The “tipping” of proprietary corporate information to outside parties is likewise prohibited under this guideline.
Legal Insider Trading
When corporate insiders such as officers, directors, employees, and significant shareholders purchase and sell stock in their own firms and inform the authorities, this is the legal equivalent. Insiders of corporations are required to notify the SEC when they trade their own securities. There may be a delay before insider data reporting reaches the typical investor. The SEC requires Form 4 filings to be completed when there are ownership changes within two business days after a trade.
Sales of stock are a little more contentious when it comes to the insiders. When an insider wishes to sell restricted, unregistered, or controlled securities, they must submit a Form 144 to the SEC. Prior to the sale, an insider must file this form on paper with the SEC. A Form 144 covers the insider’s sales for up to the following three months.
So in essence, executives are filing these forms just after they have traded and you as an investor can monitor, track, and decide if you want to follow them. Easy, yeah? Not so fast. The main problem that I frequently see with investors, individuals, and the media is not the monitoring process of the transactions, but the interpretation of them. On the whole, they generally take what they see and fail to dig any deeper. Here at The Edge, we monitor, track, and analyze all the insiders trading activity to try to find specific patterns coupled with our fundamental analysis to work out who are the key insiders that matter and who are not. You might find this odd, but not all insiders are good are buying their own company stock. Remember this.
In my view, you have to firstly figure out what the transaction is about. It essentially could be three things.
- A 10b5-1 Plan: Insiders are able to make trading plans ahead of time if they choose a certain date or price at which to execute a transaction thanks to the 10b5-1 judgment (either a purchase or a sale). The trade is initiated after the event has taken place. The 10b5-1 plans are what are used for these trades. Being pre-planned, they have little significance to future share price moves.
- Stock Options: A complete red herring for future stock direction purposes. These “trades” are essentially free money in the form of stock which have been given to the executives, usually at a discount. They gain it virtually as a free giveaway and sell it at a profit. It really has no implications on stock direction but does have significance when you are analyzing incentives. The media in particular frequently make incorrect assumptions here.
- Buys & Sells: When an executive puts his hand in his pocket and buys stock using his own money, this is one of the most powerful signals you will see, but again, more analysis is needed. One of the greatest investors of all time, Peter Lynch, was noted as saying that “insiders might sell their shares for any number of reasons, but they buy them for only one: they think the price will rise.” He’s correct of course, but this is where you start your analysis.
So you’ve established a framework for monitoring trades, you’ve worked out what to look for, and lastly you need to analyze how significant the purchase really is. Here at The Edge, we rely on many years of data to identify not only the pattern of historical transactions, but the key insiders who are good at buying their own stock. It’s in fact very rare for executives to sell their own shares and the company to come out with bad news, because as we have seen, they end up in jail; so on the whole, I’d generally ignore the sales unless it’s the one exception where the executive is selling into price weakness, which indicates the share (company) is weak and has potentially further to fall. This initially is a huge red flag.
There are a number of other areas where we analyze the purchases of executives and these include the dollar amount bought or sold, the amount in relation to how much they own already, their net worth, and whether historically they have been value buyers (they are buying because they believe their company is cheap) or catalyst buyers ahead of an event. One thing remains: purchases only count if they are in the open market.
My good friend and long-term market professional George Muzea has written an excellent book on the insiders. George has been around over 40 years and has worked with the likes of George Soros and Stanley Druckenmiller and is the world expert on insiders and their behavior. I lean on him for his valuable advice all the time. He’s also a super nice guy. He previously spoke at The Edge Charitable Conference in 2018 and provided excellent insights. He is back this year to present again on November 17 in NYC at The Penn Club. 100% of donations go toward the Alzheimer’s Association of NYC so its a worthy cause and you’ll learn a great deal. Check in for more details.
George explains the biggest mistake he sees with investors is buying with every insider buy that comes along via the Bloomberg terminal or as reported in the media without doing any kind of analysis of the insider’s record or an analysis as to see if it’s value buying or catalytic buying. He clarifies, “80% of all insiders are value buyers. They buy when their stocks drop to or below book value or their perception of intrinsic value. In bear markets you ignore them and wait for the stocks to bottom out and when the stock starts an uptrend and they buy again, then we buy as well. This group of buyers are called catalytic insider buyers as they know good news is coming.”
Insiders are now buying at current levels, but not in enough volume yet. According to George, “In the last two weeks of September, there were 159 buys to 72 sells for a .45 S/B Ratio. To put this into perspective, in the two weeks of March 2020 bottom, there were 2,237 buys versus 176 sales for a Sell/Buy ratio of .08. Cleary, we need to see much more buying by Insiders to support a case for a fundamental bottom. Insiders are still Neutral at this time.”
If George is to be relied upon and history says he is, the market hasn’t bottomed because of the lack of insider buying and and isn’t going higher just yet. I agree with him.
The Edge’s Annual Charitable Conference
George Muzea presents at The Edge’s Annual Chariatble Conference in 2018
Edge Consulting Group
If you would like to know more about how you can benefit from our insider analysis coupled with our fundamental research, or indeed want to know more about the upcoming conference, please email research@edgecgroup.com We will be happy to help.
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