I HAVE INDELIBLE memories of the public reference room at the Securities and Exchange Commission. Thirty years ago, when I was an eager Washington reporter, that was the place to find information about insider trading. The search wasn't pleasant. The neighborhood was dicey, the staff was churlish, and the files were a jumble. When you finally dug out the right Form 4 - the official name for insider filings - it was usually out of date. Regulars, hired to make copies for law firms, "borrowed" all the new material.
Those were the bad old days. Information about insider trading - the legal kind, closely monitored by the SEC - is now a virtual freebie on most financial Web sites, and the timeliness is awesome. Insiders used to have up to 45 days to report transactions, and forms were filed monthly. Last year the deadline was cut to two days. By the end of July, all filings must be electronic. Already it's possible, for a mere $20 a month, to see Form 4s in real time. Insiders often file the day they make a trade.
Unfortunately, I'm not sure this makes for better investing. Yes, insider trading statistics convey valuable information. Academic studies indicate that insiders generally beat the market over time - maybe by five percentage points annually. A handful of newsletters with model portfolios based on insider activity have impressive results. And money managers pay hefty fees to firms that track insider buying and selling.
But analyzing insider behavior is tricky, even for the professionals. The popularity of stock options, hedging and planned-trading programs makes it hard to spot old-fashioned buying and selling. And you get what you pay for: Many of the Insider reports that appear on popular Web sites include lots of irrelevant data and don't convey a clear picture of what corporate officers and directors are doing.
In this column I'll tell you when to pay attention to insiders and when to ignore them. I'll also offer advice on how to penetrate the fog of data. And I'll summarize recent academic research, which contains at least one surprise. Finally, I'll include a table based on stocks recommended by George Muzea, who's been tracking insider behavior since I was cooling my heels at the SEC. His research, popular with hedge funds, costs $30,000 annually.
The biggest problem for individuals is data overkill. Most of today's Form 4 trades are not the classic insider buying and selling that relates to future stock performance. The exercise of options, for example, shows up as both a buy and a sell on Form 4s, but it's a dubious sentiment measure. Regular stock grants can also look like acquisitions on Form 4s. More static.
A new trend that makes it even harder to interpret insider trading statistics is "automatic" trading, a strategy the SEC endorsed three years ago. Insiders get protection from lawsuits if they set up guidelines for buying or selling and leave the execution to someone else, usually a broker. Form 4s include such transactions, but it isn't always disclosed that the sale was scheduled far in advance - and when it is, you need to read footnotes. Hands-off trades now make up roughly 10% of Form 4 transactions, and no one knows if there's a link to stock performance.
It's also important to know which insiders to watch. Form 4s come from several sources - and many don't have a track record worth following. Anyone who owns 10% or more of a company's shares must report trades. But the activity of these so-called beneficial owners has little predictive power. Directors don't have great records either, perhaps because they're often required to own stock and they may be out of touch with day-to-day operations.
The significant action comes from employees - the further up the ladder, the better. At big corporations, 25 or more people can be legal insiders, so look for transactions by CEOs and CFOs. Context is important too: Buying 5,000 shares is a big deal for someone who owns 500. But it's peanuts (maybe even an attempt to send false signals) for someone who owns 5 million. Insiders must disclose their total holdings on every Form 4, and you need these numbers to evaluate a transaction.
Data vendors have turned these numbers into a business. In its institutional products, Thomson Financial, which owns First Call, rates companies based on the activity of "Proven Insiders." Vickers, a unit of Argus Research Group, tracks insider "Prophets." And Muzea calls the most predictive insiders "Studs." But each outfit evaluates performance a different way, and they often disagree. I've seen no independent evaluation of these techniques.
Assuming you know which trades are real and whose trades to watch, what next? Conventional wisdom is that buys mean more than sells, and I agree. Insiders can sell shares to pay tuition or buy a beach house. But they buy only if they think the price is going up. Steven Huddart at Penn State adds a wrinkle, however. He looked at corporations with strings of earnings gains and found a significant pattern of insider selling before "break" quarters (the end of a string of consecutive earnings increases). Previous studies didn't catch this relationship. They focused on trades three to six months before the bad news, while Huddart went back nine months or more.
Economists now realize that insiders think long term. Not necessarily by choice, but because that's the best way to avoid jail - or getting sued. Class-action lawyers watch Form 4s like hawks. Companies also have rules that prohibit insider trading in the weeks before earnings releases. And they impose trading bans prior to other market-moving announcements.
Other recent research suggests insiders have a value bent. They sell when prices have gone up and buy when they're down. There's even the possibility that some of what passes for insiders' superior timing is garden-variety contrarian thinking.
Which brings me to George Muzea. His eight-person firm, Muzea Insider Consulting, is based in Reno, Nev. Muzea made his reputation serving high-end clients, including the seven original partners at George Soros's Quantum Fund. He tracks insider activity at 9,000 companies - the old-fashioned way, with hands-on analysis. No complicated statistics, just buy or sell ratings. And Muzea rarely has opinions on more than 300 stocks. Most of the time he sees nothing significant. He gets excited when he spots buying after prices have moved up; he's nervous about selling after prices have fallen.
To create this month's table, I asked Muzea for the stocks that have popped up on his recommended list since January - just over 200 names. Then I zeroed in on midsize companies, with a market value between $1 billion and $5 billion. That's where Muzea's recent record is particularly good - beating the S&P MidCap 400 by an average of 25 percentage points annually for the past three years.
I narrowed Muzea's 30 midcap picks to eight by applying some of my favorite yardsticks. In addition to insider buying, I wanted companies that looked like bargains in terms of book value, cash flow or earnings multiples and weren't overburdened with debt. Most of my eight finalists also have PEG ratios (which measure P/E against earnings growth) that are below average for the midcap universe. Several have attractive yields, too.
These companies are sufficiently well-known that I won't discuss them individually. But I will recommend two places to track insider trading on your own. I'm impressed with the free company reports at www.vickers-stock.com. Enter a ticker symbol and get 24 months of data, with clear transaction codes. And if you want real-time action, sign up for a free trial at www.insiderscoop.com. A big plus here is that you can see digitized Form 4s, footnotes and all.
Finally, George Muzea has a new book called The Vital Few vs. the Trivial Many (Seven Locks Press, $15.95). Like much advice from successful investors, it's filled with life's lessons. You'll learn about Muzea's high school football career, his time in the Navy and his tennis game. But I also came away with sound, practical ideas - and a great strategy for year-end bargain hunting that you'll read about here soon.
Smeal College of Business, Penn State University, University Park, PA 16802-3603 USA
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