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San Diego Union-Tribune
The Inside Scoop
In the proper context, purchases and sales of stocks by executives and directors may hint at a company's prospects
KNIGHT RIDDER NEWS SERVICE
03/31/2002 The San Diego Union-Tribune 1,2,3 H-3 (Copyright 2002)
At Enron Corp., the jackpots came easily and quickly: Since 1998, company executives and directors sold stock worth $1 billion.
In hindsight, the massive sales of Enron stock by CEO 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 don't always telegraph information clearly.
Microsoft Corp. founder Bill Gates regularly sells shares of the software company's stock, for example, but investors don't 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 Securities and Exchange Commission within 10 days from the end of the month in which the transaction occurs. The information is available free on the Yahoo Web site. (Click on "finance," type in the company stock ticker, and click on "insider.")
"Usually, it's a good sign if executives are buying and a bad sign if they're selling," said H. Nejat Seyhun, professor of finance at the University of Michigan. "But you can't place sure bets. It's soft information. 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 can be illegal, but usually only if an executive trades with specific advance information that will move the stock price, such as a strong earnings report, or a merger announcement, 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's because executives and directors have a host of reasons for selling -- to make a charitable gift, to diversify investments or to pay for a child's college education. Insiders have few incentives to buy their company's stock unless they believe it is going places.
Long-term studies have shown that insider purchases, especially at companies whose stock price is cheap relative to the overall market, generate outsized returns, said John D. Spears, co-manager of two Tweedy, Browne mutual funds: American Value and Global Value Fund.
When he picks stocks for his funds, he seeks out companies whose shares are inexpensive relative to earnings or book value. News about insider purchases often tips the balance in favor of buying.
When the Clinton administration's proposals for health-care reform pummeled drug stocks in the early 1990s, for example, Spears noticed that Johnson & Johnson director Thomas Murphy had purchased about $1 million worth of shares. The company's shares were selling for about 12 times earnings, so Spears bought.
"It's been a good, long-run winner," 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 didn't 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, collapsed in bankruptcy 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, can suggest confidence in a company's future. Auxier said insiders tend to be good judges of what their companies are worth, so they buy when they think the stock is undervalued. About 18 months ago, executives at Cinergy Corp. began buying large stakes. The shares have risen from about $20 when they purchased them to about $35 this past week.
Insiders who sell as a company's stock price plummets -- which happened at both Enron and Global Crossing Ltd., which also filed for bankruptcy amid signs of accounting irregularities -- should raise investors' eyebrows, said Seyhun.
"Insiders can give you lots of different reasons as to why they're selling, and there's truth to all of those," Seyhun said, "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."
Insider sales followed by a quarter in which a company reports a break in a string of record earnings also bode ill for the stock, said Penn State business professor Steve Huddart.
Aggregate insider data also offer clues to the performance of the overall stock market, Gerber said. Insider sales generally outweigh purchases by a ratio of 12 to 1. That ratio got as high as 20 to 1 in 2000 and 2001, suggesting insiders were very bearish on the market. But the number began improving in September.
"It's indicating that the market might represent some decent opportunities right now," Gerber said.
1 DRAWING; Credit: James McFarlane / Knight Ridder/Tribune
Smeal College of Business, Penn State University, University Park, PA 16802-3603 USA
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