Grading the investment skills of company “insiders” – Can they beat the market trading in their own company’s stock? And can YOU profit from mirroring their trades? 0 comments

Feb 9, 2011 1:48 AM | about stocks: CLMT

Can company insiders beat the market by trading in their own company’s stock? And if so, can everyday investors beat the market by mirroring the trades made by insiders? As I’ll explain below, I believe that the answer to both of these questions is a resounding yes. But in order to explain why insiders can beat the market, we need to dive (briefly) into a bit of modern portfolio theory.

As you probably know, very few investors are able to consistently beat the market over a long period of time. Modern portfolio theory posits that, because the market is so good at processing all publicly available information (i.e. efficient), it is virtually impossible to consistently earn a higher rate of return except under the following three circumstances:

1. Blind luck. The idea that if 1 million people each flip a quarter 10 times, the odds are that at least a couple of the poeple (out of a group of millions) will get heads each time.

2. Taking more risk. Another tenet of modern portfolio theory states that the return an investor achieves is tied to the amount of risk that investor takes. In other words, it is the idea that without risk there is no reward. Hence, it is consistent with modern portfolio theory to believe that you can outperform the market but, to do so, you must take on significantly higher risks than you would if you held the market portfolio made up of all of the stocks that are publicly traded.

3. Trading on non-public information. Even the strongest supporters of the efficient market hypothesis — think Eugene Fama and Kenneth French, for you modern portfolio theory geeks out there — will likely state that you can beat the market if you have material non-public information that no one else has and you use that information when making your investment decisions. Trading on material non-public information in the manner I just described is illegal and is commonly known as insider trading.

But what about company insiders, such as the CEO or a member of the board of directors, who are always in possession of information about their own company that is not known to the investing community? An outright ban on trading by insiders would seem unfair, especially since such a large portion of these individuals’ compensation is tied to, or payable in, the company’s stock. Are insiders forbidden from buying or selling their own company’s stock in the open market? The answer is no. The laws are complex, but essentially as long as the insiders are not in possession of specific, non-material information about the company, the insiders can buy and sell in the open market almost just like you and me. I say almost because there are strings attached to their trades.

The first restriction on insiders’ trading activity is that they cannot trade while in possession of material non-public information. For instance, if an executive knew what his company had earned in the previous quarter but the number had not yet been announced to the public, then he would be in possession of material non-public information. So, too, would he be in possession of material non-public information if, for instance, he knew that his company was going to be involved in a merger or make a large acquisition but such information had not yet been publicly disclosed. Under either of these circumstances, an insider is forbidden by the insider trading laws from buying or selling shares of his company’s stock. Usually company insiders trade only in the three or four weeks immediately following a quarterly earnings release, as it is less likely that they are in possession of material non-public information at that time.

The second restriction is that insiders must report all transactions they make, including buying or selling shares of their company’s stock in the open market, to the SEC within two business days of each transaction. As you can imagine, these reports (called Form 4s) provide a treasure trove of information about what the insider thinks about the value of his company’s stock. What’s more, these reports allow regular investors just like you and me to mirror the trades made by company insiders. If the CEO of a company you’re thinking about buying makes a large purchase on the open market, then you will know about that purchase within two business days (and often on the same day the trade happened).

The third restriction is that insiders are subject to a six-month holding period. If they violate the holding period, then they can be sued and all of the profit from their trade can be taken away from them by a court (called short-swing liability). For instance, if a CEO buys shares of his company’s stock on the open market on January 1st, then he is legally forbidden from selling those shares at a profit until July 1st (six months later). The matching also works the other way, meaning an insider cannot sell shares at a higher price and then buy them back less than six months later at a lower price. Assume the CEO sells shares in the open market on July 1st and then, by August 1st, the company’s stock price goes down and is lower than it was on July 1st. As much as the CEO might want to buy shares at the lower August 1st price, he is legally restrained from doing so. This is because six months have not passed and so he would be subject to the short-swing liability referenced above.

While these restrictions work against company insiders, they can work in favor of investors. In particular, when company insiders buy stock on the open market (which the public quickly finds out about due to the reporting requirements), they are sending a very strong signal to the market that they believe their company’s stock is undervalued. When everyone is working from the same information, one person’s opinion that a stock is undervalued likely doesn’t carry much weight. But remember, company insiders know things about the company — in particular, a general sense for the future prospects of the company — that no one else knows. When an insider uses his own money to purchase shares in his company, he is doing so for only one reason — to make money. Recall that by purchasing shares of his own company’s stock, the insider is taking quite a risk; due to the short-swing liability rules, he is effectively locking his money up for at least the next six months. The insider could have chosen to invest in any other stock and been able to withdraw his money at any time, but instead he chose to lock his money up for six months in his own company’s stock. Why would a smart, high-achieving corporate executive make that choice unless he thought he would earn a superior return on his investment?

So what does the data say about whether company insiders can beat the market by investing in their own company’s stock? Many papers have been written about this very topic, and the answer is. yes, they can. What does this mean for you? It means that, by following the lead of company insiders, you can beat the market as well.

A significant portion of my own investmenting strategy is driven by tracking and analyzing the open market purchases and sales made by insiders of publicly traded MLPs, as I believe that valuable information can be gleaned from such transactions. In fact, Ive created an extensive database on these types of transactions and now have a system in place to identify the most promising insider transactions. As I’ve discovered through studying my own data, some types of insider buys convey better information than others. For instance, the aggregate amount invested, the number of insiders making open market purchase in close proximity to one another, the identities of the insiders making the purchases (e.g. 10% owners who are deemed by the law to be insiders typically don’t have access to the type of non-public information that executive officers and directors do, and so their purchases are not necessarily good indicators of value), and even the past performance of the insider’s previous trades are all factors that can be analyzed to spot the insider buys that are most likely to result in a whopping return to anyone who mirrors the trades.

In future posts, I intend to share some of the information that I’ve unearthed regarding how to spot the best buying opportunities in the MLP sector by analyzing insider trades. For now, though, I will start with one of my simple strategies: I look for situations in which at least three insiders (including at least one non-employee director and at least one non-director executive officer) have purchased shares in the open market in substantial quantities (which I define as an investment of at least $50,000) shortly after a large drop in the price of the common units. Obviously, these situations don’t arise often, but when they do I always pounce.

For instance, in May of 2010, Calumet Specialty Products Partners (NASDAQ: CLMT ) reported disappointing earnings and the price of the common units fell off a cliff.

Sources: CLMT press release, Yahoo! Finance historical stock price charts, SEC filings

As is illustrated in the chart, the sequence of events was as follows:

• On May 5, 2010, CLMT reported a loss for the quarter, which fell short of the market’s expectations. The stock immediately plummeted.
• Beginning on May 7, 2010, one of the executive officers of CLMT stepped in and purchased approximately $250,000 of common units in the open market.
• Over the next couple of weeks, two non-employee directors of CLMT made purchases on at least seven more days. Combined, they purchased approximately $380,000 worth of common units, and each invested more than $50,000 individually.
• The purchase price for the common units purchased by these three insiders ranged from about $16.35 to $18.50.
• At any time during this period, regular investors could have mirrored these trades by buying in the open market at the same prices as the insiders. (Lucky for me, I bought in at $17.50, which turned out to be a fantastic investment!)
• Less than nine months later, the insiders — as well as anyone who had the guts to step up and mirror the insiders’ trades — are now sitting on an average total return of approximately 42%. They’ve also seen CLMT increase its distribution — twice — during this time.

In future posts, I will share some of my other strategies relating to insider buying. I truly believe that investors can achieve superior returns most, but not all, of the time by following the lead of insiders.

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