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South China Morning Post

Look insider for trading tips

March 31, 2002

South China Morning Post


(c) Copyright 2002 South China Morning Post Publishers. All Rights Reserved.

AT ENRON, THE JACKPOTS came easily and quickly: Since 1998, company executives and directors had sold stock worth US$1 billion.

In hindsight, the massive sales by chief executive Kenneth Lay and other insiders should have raised a red flag, brightly painted with the word ``sell", for investors wondering about the company's future.

If only it were so easy. Unfortunately, sales and purchases of company stock by corporate executives and directors do not always telegraph information clearly.

Microsoft founder Bill Gates regularly sells shares of the software company's stock, for example, but investors do not interpret that negatively because the stock has done well in the past after he has sold.

While insider transactions rarely shout ``buy" or ``sell", they do often hint at a company's future prospects.

Many professional investors weigh the data, which must be filed with the United States Securities and Exchange Commission within 10 days from the end of the month in which the transaction occurs, as they pick stocks.

Nejat Seyhun, professor of finance at the University of Michigan, said: ``Usually, it's a good sign if executives are buying and a bad sign if they're selling. But you can't place sure bets. I wouldn't base my entire trading decision on what insiders are doing. I would look at it as a signal among other signals."

Insider trading could be illegal, but usually only if an executive traded with specific advance information that would move the stock price, such as a strong earnings report, Professor Seyhun said. When insiders sell or buy based on general information about a company's long-term prospects, it is generally legal.

Most of the time, insider purchases are a stronger signal than sales. That is because executives and directors have a host of reasons for selling---to make a charitable gift or diversify investments. Insiders have few incentives to buy their company's stock unless they believe it is going places.

John Spears, co-manager of Tweedy, Browne American Value Fund and Tweedy, Browne Global Value Fund, said long-term studies had shown insider purchases, especially at companies whose stock price was low relative to the overall market, generated outsized returns.

When he picks stocks for his funds, he seeks out companies whose shares are cheap relative to earnings or book value. News about insider purchases often tips the balance in favour of buying.

When the Clinton administration's proposals for health-care reform pummelled drug stocks in the early 1990s, for example, Mr Spears noticed that Johnson & Johnson director Thomas Murphy had purchased about US$1 million worth of shares. The company's shares were selling for about 12 times earnings, so he bought.

``It's been a good, long-run winner," Mr Spears said. ~

Context is the key to judging insider sales and purchases. Jeff Auxier, manager of the Auxier Focus Fund, sold Enron shares in part because he did not like the pattern of insider selling. The sales bothered him especially after Enron executives grew increasingly defensive when asked about earnings.

The Houston energy trader, once a darling of the new economy, went bankrupt in December amid allegations of questionable accounting.

Lon Gerber, director of insider research for Thomson Financial, advises investors to consider whether an executive's or director's decision to sell deviates from a normal pattern of selling. If so, it may signal a problem. Similarly, executives and directors selling as a group may hint at trouble.

Group buying, on the other hand, suggests confidence in a company's future. Mr Auxier said insiders tended to be good judges of what their firms were worth, so they bought when they thought the stock was undervalued.

Insiders who sell as a company's stock price plummets, which happened at Enron and Global Crossing---which also filed for bankruptcy recently amid signs of accounting irregularities - should raise investors' eyebrows, Professor Seyhun said.

``Insiders can give you lots of different reasons as to why they're selling, and there's truth to all of those. But what I've found is if insiders are selling as prices are going down, it's a bad sign. If they're selling as prices are going up, that's not as bad," he said.

Penn State business professor Steve Huddart said insider sales followed by a quarter in which a company reported a break in a string of record earnings also boded ill for the stock.

Aggregate insider data also offered clues to the performance of the overall market, Mr Gerber said. Insider sales generally outweigh purchases by 12 to 1. That ratio has reached as high as 20 to 1 in the past two years, suggesting insiders were bearish on the market. But the number began to improve in September.

``It's indicating that the market might represent some decent opportunities now," Mr Gerber said.

Steven Huddart
Smeal College of Business, Penn State University, University Park, PA 16802-3603 USA
(814) 863-0048
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