Street Courner

by Robert McLister, BBA2

"If you're not inside, you are outside."--Gordon Gekko, Wall Street, 1985

You are the proud owner of XYZ Corp., a slow-growing manufacturer of toilet bowl brushes selling at $58 a share. Your broker has just phoned with news of an SEC filing that indicates that XYZ CEO Joe Flusher has sold 8,000 shares of XYZ stock (40% of his stake) at an average price of $65 a share. No other XYZ directors have bought or sold stock in the last 120 days. The stock has declined 5% over the past two months. You must make your buy/sell/hold decision based solely on this information. What's your call?

Yeah, this isn't enough information to make an good decision, but play along anyway. Compare your intuition with the research below. Let's talk about a few of the notable insider studies. Empirical research generally has shown that stocks with insider buying have notably outperformed the market. One of the most comprehensive studies of insider trading to date was done by a UMBS finance professor, Nejat Sehyun. Seyhun studied hundreds of insider transactions and the subsequent performance of the stocks in question. He found that purchases by Chairmen of the Board and officer-directors generated noticeably greater returns than those of any other corporate insiders. Insider purchases by top execs were followed by average excess stock returns of 3.3% over the 100 days that followed. The returns for small-cap stocks were even greater. For firms with market values under $25 million, subsequent returns were double the average at 7%.

Granted, a 3.3% return doesn't seem like much to party over, but 3.3% over 100 days is an annualized return of 12%. That's an annualized 12% that you didn't have before. In addition, if you are a long-term holder, you'll be interested to note that excess returns from insider buys accrued well over 12 months after their transaction date.

More important than the immediate excess returns, however, are the clues that insider activities afford. Let me give you an example. You've likely heard of the Mighty Morphin Power Rangers. Maybe you've even seen their movie (and left early). Well, the stock of their manufacturer, Happiness Express Inc. (ticker symbol: HAPY), has been anything but mighty of late. Over the last 12 months, HAPY has collapsed from $18 1/8 to $4 5/8. The stock's biggest catastrophe came on Sept. 7 when HAPY sank 36% on 26 times its average trading volume.

So why aren't HAPY's stockholders happy? The answer's in the fundamentals. Mighty Morphins are about to be buried in the same toy cemetery as Cabbage Patch dolls and Teenage Mutant Ninja Turtles. Kids are bored with Morphs. Power Rangers have been around the block and back again. Kids want something new.

But that's not what HAPY management would have you believe. Senior executives have been talking up HAPY's prospects gleefully for the past year. Even though Power Rangers account for 75% of revenues, management has been confidently promoting HAPY's "broad" spectrum of other products. So what does all this have to do with insider trading? Well it seems that while HAPY execs were talking up the stock, they were selling at the same time to the tune of 136,000 shares in the two months that preceded the Sept. 7 collapse. By the end of August, investors who paid attention could have easily discovered that seven insiders, including some senior corporate officials, had sold in the previous month. It was bad enough that HAPY had a deteriorating balance sheet, slowing product growth, was being trashed by Dan Dorfman, and had dropped 33% in three months (that's before the 36% crash!). What more did investors need to convince them to sell? When you add the insider selling to the pile, there shouldn't have been a trader within a country mile of HAPY stock as August drew to a close.

The point is, while insider trading is not the missing link to stock selection, it does provide some handy clues about the future direction of your holdings. What's more, in the case of small stocks, these clues are very frequently not discounted into the price.

So when you see a CEO or officer-director selling a stake in his or her company, and the sale is not options related, what do you start asking yourself? You might begin by determining if the insider has made a habit of selling stock. Insider sales by themselves are not automatically a bad omen. Insiders sell for countless different reasons. In fact, insiders are net sellers.

Nonetheless, it is one thing to sell some stock to pay for grandma's nursing home bill, but it is quite another to sell 100,000 shares every two months. Follow up your investigation by checking to see whether the transaction represents a large portion of the individual's holdings. Transactions of less than 5-10% of an insider's holdings should generally be ignored (unless they total up to a much larger sum over a six-month period). Similarly, don't lend too much weight to insider transactions under $15,000-$20,000. Often you'll see a CEO buying $10,000 worth of stock as a PR gesture. This posturing is especially spurious when the exec is pulling in a big six or seven-figure salary.

A good rule of thumb for evaluating insider activity is to apply the three2 rule. This rule was first made popular by Martin Zweig in the 1970's, but it continues to be effective today. Generally, consider it a positive when three or more insiders have been buyers during the previous three months and there have been no sellers. Consider it a negative when three or more insiders have sold within the past three months and there have been no buyers. If, however, you find four buyers and one seller within the last three months, this is still a positive. But, insider trades are most telling when there is unanimity of trading.

One thing to keep in mind about insider trading is that most insiders are not stupid. Most don't trade on blatantly obvious insider information. Research has supported this fact. Studies tracking the release of news after insider purchases have found that in the majority of cases, good news didn't immediately follow insider buys and bad news didn't immediately follow insider sales.

Most often, the insider has an understanding only of the general prospects of his or her company. Insiders themselves rarely trade on specifics. That being the case, it's understandable why dated insider information (insider trades are released to the public 30-45 days following the transactions) remains useful months down the road.

As mentioned above, another point to remember is that insiders are net sellers. Peter Lynch notes in his book, One Up On Wall Street, that corporate insiders normally sell 2.3 shares for every one share that they buy. That makes insider buys all the more important. Conversely, insider sales, being more common, offer less forecasting value.

As we noted previously, excess returns tend to be largest when a top executive is the one making the insider transaction. There are caveats to this rule, however. Often it's more beneficial to the stock price if three or four vice presidents are buying versus only one president. In such a case, investors have more positive evidence on which to base their opinions.

Also it should be noted that CEO stock sales are an exception to the general rule. Robert Coulson, author of Stock Market Inefficiencies, notes a study that found CEO stock sales were actually followed by increases in share price (of 0.7% over two months, 1.8% over six months, and 6.1% over twelve months).

Lastly, and as expected, Seyhun's studies suggest that insiders purchase larger volumes of stock when the likelihood of large returns increases. Use this fact to your advantage by examining the quarterly volume trends of insider transactions over the last few years (you can get the raw transaction data from Vickers, Bloomberg, Dow Jones News Retrieval, or the SEC). You can then tell if increases in net insider buying are material.

Insider trading inquiries afford you one more tool with which to analyze a stock. And I can't emphasize how important your own analysis actually is. If you had been listening to HAPY analyst recommendations, you would have ridden HAPY down as much as 70% in one year. One analyst even made a buy recommendation just weeks before the crash. Do your own digging. That's what separates you from the crowd in the small stocks arena.

Fidelity Stock Picking Seminar and Beacon Investments Discussion

The Investment Association is cooking up a prime-time doubleheader this Tuesday, November 7. Market experts will be on hand from both Fidelity Investments and Beacon Investment Management to answer your every stock-picking question.

The first seminar will feature Bruce Herring, assistant director of research for Fidelity Japan. Herring is in town from Japan and has offered to stop in and share his insights on picking stocks. This will be a great opportunity to find out how institutions move markets, and how you can effectively compete with million-dollar mutual funds. Come and ask questions of one of Fidelity's top researchers. The seminar will start at 5:00 p.m. in room B1270.

Immediately following the Fidelity presentation will be a brief IAM membership meeting in room B1276 at 6:05 p.m. We'll then quickly move to a discussion with money managers from Beacon Investments. Beacon, an abundantly successful multi-million-dollar asset management firm will tell you how to screen successful stock plays. They'll follow up with a brief Q&A.

This is what we talk about when we refer to membership benefits. Come and find out what professional money managers like to see before they buy. As usual, there'll be an assorted cornucopia of treats on hand.

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