It’s widely considered that insider purchases, management buying stock in their own companies, is a strong bullish signal. Insiders have an unparalleled view on the company’s current trading and fortunes, so they are in the best position to profit from a well-timed, and legal trade.

 

Stocks following insider buying outperformed the market by 4.5%

There is plenty of data that supports this conclusion. According to Catalyst, research by H. Nejat Seyhun published in, Investment Intelligence from Insider Trading, The MIT Press, 1998, between 1975 to 1994, stocks following insider buying outperformed the market by 4.5%, while stocks following insider selling underperformed the market by 2.7%. These results are based on an exhaustive data set, capturing information on insider trading in all publicly traded firms over two decades, around one million transactions!

Nejat Seyhun concludes that on the whole, insiders do earn profits from their legal trading activities and their returns are greater than those of the overall market. However, investors should not necessarily follow insider deals without doing their own research. Investopedia’s description of insider dealing which really sums up the whole argument.

“…Surges in insider trading appear to divine an upcoming switch in the market’s direction. But outside investors have to be awfully careful about reading positive messages into every insider buy they see. Investors must also avoid treating individual sales as signals to unload their own holdings…”

Moreover:

“…Research supports the view that insider information works best in the aggregate. Independent research firm Market Profile Theorem (MPT) showed that insider trading trends signal an up-and-coming shift in market sentiment…”

Insider buying poorly timed

The key criticism of following insider buying is that while insiders may know their businesses well, they are not sophisticated investors, as a result, their purchases can be poorly timed. This is compounded by the fact that executives usually view their company through rose colored glasses.

British newspaper, The Times only this week reported on a study from Banc De Binary, an options specialist, supporting the above statement. The study analyzed the performance of ten FTSE 100 companies with the highest boardroom shareholdings and the ten lowest boardroom share holdings. The results showed that companies with a high management shareholding underperformed those with a low management shareholding over the past year.

However, a similar study, conducted over a longer five year period showed that the boards with the largest shareholdings presided over a better long-term share performance, confirming the Investment Intelligence study.

Successful insider buying: NFO outperformed

To capitalize on successful insider trades, the Claymore/Sabrient Insider ETF (NYSEARCA:NFO), which tracks the Sabrient Insider Sentiment Index (INDEXNYSEGIS:SBRIN) —an index of 100 stocks and ADRs with favorable insider buying trends was established. Over the past ten years the fund has both outperformed the DJIA and S&P 500 by around 50%, excluding fees and dividends.

Then again, over the past five years the NFO fund has only outperformed the S&P 500 (INDEXSP:.INX) by a total of 13.6%, (S&P 500 return – 97.81% | NFO return – 111.4%). When NFO is compared to the S&P 500 total return index, the fund’s outperformance drops to zero, the index returned 111% over the period.

Further, over the period from the end of 2007 (pre-crisis peak) to the beginning of 2009, (depths of market crash) the NFO fund underperformed the S&P 500 and DJIA by 3% and 7% respectively. In seems that insiders paid too much for their stock just before the crash and suffered for it. [Note: this is not including those companies that went under during the crisis, following insider buying in those cases would have been a bad move — there is an element of survivorship bias here.]

So in conclusion, there’s no doubt that following insider buying trends can produce outperformance. That said, evidence indicates that this is only the case over the long-term and in conjunction with other research. It seems as if insider buying is more of a confirmation signal than anything else.

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