Keeping an eye on the insiders

Insider-transaction data can signal optimism or pessimism among company leadership, but investors must use the numbers wisely.

Adam Zoll 25 June, 2013 | 6:00PM

Question: Before buying or selling a stock, I like to know whether company insiders have recently done the same--or the opposite--as I plan to do. How can I check this on Morningstar.ca?

Answer: Under Canadian securities law, company insiders must file reports whenever they trade their company's stock or related securities. Similarly in the United States, the Securities and Exchange Commission (SEC) requires that publicly traded companies disclose the buying and selling of shares by company officers, directors, and anyone owning more than 10% of a share class of the company's stock. These requirements are designed to provide transparency so that individuals who may be privy to inside information about the company's future cannot trade off this knowledge without other shareholders being made aware of it.

Each stock Quicktake on Morningstar.ca includes an Insiders tab with information about company leadership. Within this tab is a section called Insider Activity that reports buying and selling of stock of U.S. companies by their executives and other insiders. (The data is not yet available on Morningstar.ca for Canadian companies but can be found on the SEDI website.)

Transaction information on the Insider Activity page is displayed in aggregate or broken down by transaction type and by key positions for the previous one- or two-year periods. Just put your cursor on any bar on the chart to display the data for that time period. Below the chart is a list of insider transactions for the given time period as well as a summary of holdings for key insiders that includes any changes that have occurred compared with the previous year.

Keeping insider transactions in perspective

Some investors pay close attention to insider transactions (sometimes also called "insider trading," though not to be confused with the illegal practice of using privileged information about a company for financial gain) under the assumption that corporate leaders know best when to buy and sell stock in their firms. An increase in buying among insiders may be taken as a sign of optimism about the company's prospects, while an increase in selling may be interpreted as a sign of pessimism. Yet these interpretations run the risk of being overly simplistic, in particular when it comes to selling shares.

Although one might assume that insiders are selling shares because they expect the stock price to fall, there might be other explanations. For example, an insider may sell a large number of shares to fund the purchase of a new home, to pay for a child's college education, or, perhaps most frequently, to diversify his personal holdings. That's why it's important not to put too much weight behind the news that a lone insider is selling a large block of company stock.

Potentially more useful is information that several company insiders are buying or selling large blocks of shares around the same time. If you notice insider activity at a company leaning heavily to buying or selling in recent weeks, check the transaction history to see who is doing what. Multiple insiders making similar moves would seem to suggest that there is a consensus among those in the know that the company's stock price is headed in a particular direction for whatever reason. Perhaps insiders are selling shares because they see headwinds ahead for their company and its industry. Or perhaps they are buying shares because of a rosy outlook and confidence that the stock's price will climb. There's also the possibility that executives simply think the market is mispricing shares in their company and they hope to take advantage by buying low or selling high.

But does insider activity predict returns?

Academics have studied for decades the question of whether insider trading is predictive of stock performance, and many have concluded that it is. One of the more recent studies, by Manouchehr Tavakoli of the University of St. Andrews (Scotland), David McMillan of the University of Stirling (Scotland) and Phillip McKnight of the University of Wisconsin-Milwaukee, was published in 2011 in the International Review of Economics and Finance and examined insider trades at more than 3,500 U.S. companies during 2000-07. They found that there is a positive correlation between insider transactions--particularly those made by officers and directors (in other words, the decision-makers at a company)--and future stock returns. They also found that buy signals tend to be more predictive than sell signals, and that while trading by directors is predictive at both large and small firms, trading by officers, such as a CFO, tends to be predictive only at smaller firms. Finally, they found that insiders tend to trade around the same time, suggesting that even aggregate trading numbers could be moved by the decision-making of a few key individuals in the organization.

So if executives at a company you like are buying or selling shares, does that mean you should follow suit? Probably not, if you're basing your decision on this fact alone. You can use buy or sell signals from executives to partially infer whether the company's fortunes are headed upward or downward, but they're no substitutes for examining the company's fundamentals as well as its current market valuation. After all, as anyone who keeps up with business news can attest, corporate leaders are very much human and do make mistakes. Letting them run a company for you is one thing; letting them make investment decisions for you is quite another.

About Author

Adam Zoll

Adam Zoll  Adam Zoll is an assistant site editor with Morningstar.com