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12 ways investors can profit via legal insider trading

Insider trading has been top of mind for the past few months with Galleon and Congressional insider trading blanketing the news. While illegal insider trading is being taken to the woodshed, there’s plenty to do with legal insider trading. By following the smart money, investors can follow the cookie crumbs back to the investing profits.

So, here are 12 ways investors can use insider trading data and information to make better, smarter, investment decisions.

1.  generate ideas for investing: Investors come up with investment ideas in many different ways. I use insider trading data to bubble up ideas in companies I would never have heard of otherwise. You can use stock screeners like the best subscription one around, FINVIZ (affiliate link) or free one, J3SG if you roll that way, to look for specific type of buying (say multiple insiders buying stock). From there, dig deeper into the stocks that show up in the screen and do more research. The insider activity functions as idea generator to find interesting investment candidates.

2.  find other stories worth exploring: Sometimes, insider buying is really useful to uncover interesting stories, even when those stores aren’t the ones seeing insider buying. Take, for example, a story I wrote about recently for my Insiderize newsletter subscribers. Two billionaire brothers put a boatload of money ($50M) into $CFX, a company they founded in the 90s. But the real story that makes the investment thesis even more interesting is what they did with another investment of theirs, Danaher Company ($DHR). DHR has performed better than Buffett’s Berkshire Hathaway over the past decade based upon a well-refined model to build an industrial conglomerate completely focused to lean manufacturing and making sound acquisitions. Insider trading is interesting because it gives rise to ideas outside of the stocks being bought or sold.

3.  connect the dots on a stock: Insider trading is frequently a window into something much bigger going on into a company. It’s like a cookie crumb that hungry investors can follow to uncover a lesser-known stock ready to rock. Take for example the small purchase I uncovered recently in $COSI for my Insiderize newsletter subscribers. A new CEO from a larger, better-run company dipped her hand into her pocketbook to buy some of her new company’s stock. That’s a bullish sign, sure. But it’s also a vote of confidence in her new employer and new firm. The insider buy is just a puzzle piece in a larger jigsaw of an investment thesis. Use it to connect the dots. I’m beginning to use BlueTrader (also affiliate link) for more and more of this. Seriously, there isn’t a better platform I’ve found to help with this data. Also, check out MarketBrief.

4.  use insider trading to predict earnings: A lot of investors use insider trading data to cast light on a different part of the investment case. In fact, research shows that insider buying may show that insiders expect future earnings to outperform. I wrote in Tradestreaming (p 167) about Do Insider Trades Reflect Superior Knowledge about Future Cash Flows Realizations: “We find strong evidence that insider traders are associated with the firm’s future earnings performance…consistent with insiders trading on the basis of both security misevaluation and private information about future cash flows”. That would mean if you can identify the insiders trading on this knowledge, an investor essentially can get tipped off to really good future earnings.

5.  follow it as a guide to positive surprises: In Tradestreaming, I wrote about the catalytic insider model developed by George Muzea, author of The Vital Few vs. The Trivial Many. Muzea’s model is predicated on following insider trading for 37 years. He identifies two different classes of insiders trading in their own companies’ stocks. One is the Value Insiders group, buying their firms’ stocks when stock prices drop relative to book value. But the other kind of insider Muzea illuminates is the Catalytic Insider. These corporate managers don’t care about book value — they’re focused on earnings momentum. If they see something interesting on the horizon two quarters out, they’re buying stock. In this light, insider buying becomes a trigger for future positive surprise. Remember, it may not be this quarter or next but the smart money sees something on the horizon and it sometimes pays to be real patient.

6. follow the money flows: When I was a kid, my grandfathers used to take me deep sea fishing. I was so captivated by the use of sonar to track the fish. Instead of waiting for a bite, we fished where the fish were. Investing is no different — we want to invest in things we think will turn out to be profitable in the future. Insiders do, too, putting their money where their mouths are. For a senior manager to plunk some cash down and buy some stock in her company, it’s a bet on the future.  Again, from Do Insider Trades Reflect Superior Knowledge about Future Cash Flows Realizations, “Together, our evidence suggests that insiders are rational, economic agents. They appear to trade on the basis of their superior information about contemporaneous and next period’s earnings innovations.”

7.  go contrarian to analyst calls: Investment analysts frequently get stock picking wrong. These smart people can’t win — the business is tough. It doesn’t particularly reward bold predictions and most of the time, analysts are reactive, raising and dropping predictions after the fact. In fact, Hsieh, Ng and Wang looked at the connection between analyst ratings and insider trading. They found that insiders are more likely to buy shares when their stock is out of favor with Wall Street analysts. In other words: insider trading has predictive power for future stock returns only when analyst recommendations have changed. Makes sense if insiders are looking for value — they’ll buy when the stock is out of favor.

8.  remove some hands from the cookie jar: Professor H Nejat Seyhun uses what I call the Informational Model of Insider Trading in his landmark book on the subject of insider trading, Investment Intelligence from Insider Trading. He categorizes insiders into 4 groups according to their access to valuable information. C-level executives obviously have the best view of the information that drives their companies and large, outside stock holders (like mutual funds or hedge funds) have access to the least valuable info. That’s not to say that large funds with seats on boards don’t know anything. “While most trading by outside directors or large shareholders are uninformative, it is still quite possible that large transactions (over 10k shares) are informative” (Seyhun, 72). But an additional role these large investors may play is by limiting corporate profiteering by making sure other insiders keep their hands out of the corporate cookie jar. In Markarian and Bricker’s Institutional Investors and Insider Trading Profitability: ”The results provide preliminary evidence suggesting an incremental negative relationships between proxies for institutional monitoring and insider trading profitability.”

9.  examine other ways insiders get rich: Insider trading is transparent (the activity, not necessarily the motivation for). But corporate insiders may use other tools to enrich themselves that make it harder for the rest of us to mimic. In fact, one of these activities, places them directly across the table from other shareholders. There’s evidence that insiders use share buybacks to exploit their access to insider information and make profits at the expense of public shareholders. In Insider Signaling and Insider Trading with Repurchase Tender Offers, Jesse Fried found that managers may initiate share buybacks if they believe they can purchase stock below its fair value through a buyback or sell it if it’s market price is bloated. That’s a real transfer of value from investors’ portfolios to the corporate coffers/management.

10.  piggybacking government insider trading: Of course, recent evidence that government officials regularly exploit insider information (even if it’s not exactly insider trading) isn’t necessarily surprising. But congressmen and women seem to regularly make money off of their positions. Members of Congress routinely receive access to confidential information and act upon it. Though the passage of the STOCK Act may result in curbing of this behavior, my guess is that it won’t really. Following politicians to see what they’re investing in is a great signal to where legislation is headed in the future. This could have broader impact than just on the stocks in a Congressman’s portfolio. Follow the money.

11. use insider trading as part of a larger strategy: It’s probably not a good idea to buy stocks based just on the fact that they’re experiencing strong insider buying. Better, use insider activity as just one (but important) input into the investing calculus. This screen places buying side-by-side other valuation information. The Sabrient Insider Index used in the Guggenheim Insider Sentiment ETF uses insider trading and analyst rankings to determine which stocks it includes. So, use insider trading as an initial screen and then do more work on the names that come up. Or, once you’ve found a stock that tickles your investing fancy, drill down to see what kind of insider activity is going on. Like a good poker player, it may be the best tell you can get as to where future prices are headed. BlueTrader bubbles up daily signals to try and identify those insider trades that according to its algorithm, are bullish signals.

12.  insider buying, market movements and ETFs: Maybe buying and selling insider stocks isn’t quite your thing. As mentioned previously, there is an ETF ($NFO) that follows insider trading activity. It’s the only security of its kind that I know of. But insider trading can also be used to take the temperature of the market as a whole. While previous research didn’t necessarily find a connection between insider buying and market gains, recent papers have found a tighter correlation. “Given that insider trades are driven by superior information aggregate insider trading  should therefore be construed as a leading indicator of market wide activities. Furthermore, such trading by insiders will drive prices towards fundamental values,“ wrote researchers.

I’m always surprised that more investors aren’t incorporating insider trading strategies into their investing. Like creating your own hedge fund by piggybacking other hedge funds moves, people can essentially outsource their research and let the smart money sniff out the opportunities.

Who’s smarter than those insiders buying their own companies’ stocks?

About Tradestreaming

Tradestreaming is a community of investors learning directly from experts. I’m Zack Miller, investor, entrepreneur, and founder of Tradestreaming.com and I literally wrote the book on how to invest in the age of Facebook and Twitter. Tradestreaming is the resource I’ve created to help me become a better investor.  I believe it will help you … Continue Reading