Using Insider Transactions to Boost Returns
By Matt Paolucci

Investors are always looking for additional ways to analyze potential investments. Looking at insider transactions may be another tool to help investors uncover prospective investment opportunities.

Insider trading refers to transactions in the securities of some company executed by a company insider. An insider is defined as any officer of director, or an owner of 10% or more of a company's stock. Insiders must report transactions to the SEC by the 10th of the month following the transaction.

Insider purchases are most significant when they are direct purchases by corporate officers involved in the day to day activities of the firm. Purchases due to the exercise of employee stock options at a discount to market price, company buybacks, trades by beneficial owners of 10% or more of a companies stock, transactions less than 100 shares or for a stock price under $2 a share are not considered significant. Research has shown that on average, stocks with significant insider purchases have outperformed the market averages consistently.

Insiders purchase stock when they feel the outlook for the company has improved for a variety reasons, including improved sales and earnings prospects, development and/or approval of new products and takeover speculation.

Although a company insider might theoretically be anyone who knows material financial information about the company before it becomes public, in practice, the list of company insiders is normally restricted to a moderate-sized list of company officers and other senior executives. Smart companies normally warn all employees to be careful when they trade, for obvious reasons. The U.S. Securities and Exchange Commission (SEC) has strict rules in place, which spell out when company insiders may execute transactions in their company's securities. All transactions that do not conform to these rules are, in general, prosecutable offenses under US securities law.

Insider purchases and sales are closely watched. If you see insiders buying a lot of stock on the open market, this might be worth investigating as a buy signal, although insiders are often wrong. Another example is insider sales. Seeing insiders in fairly young companies selling stock, (either selling very cheap stock they've had a while, or same-day exercise of a stock option followed by selling of the resulting stock) may not mean very much. Also, with smaller companies, it may be difficult to find insider transactions, due to disclosure rules.

The timing of sales also means relatively little. Silicon Valley financial advisors tell people to sell some stock every year for tax reasons. Normally, there are at most 4 times during a year when an insider can sell stock anyway, and it is easy for other events to knock this down to one or two times. I've heard of cases in which people got stuck for two years post-IPO not being able to sell one share of stock.

When looking at stocks that have insider buying or selling activity, you need to ask yourself some questions. For example, who is doing the buying, when did the buying take place, and how large was the transaction?

When addressing the question of who the buyer is, here are some questions to think about. Was the person making the purchase the CEO of the company? If so, what was the percentage of the CEO’s purchase in comparison to total holdings? Is the purchase large enough to warrant a move in the stock?

On the other hand, if it were a vice president making a smaller purchase, you have to take into consideration other questions. Is that vice president the only vice president in the entire company, or is he/she one of 200 other VPs? This purchase may not convince investors to buy shares. Brokerage houses, for example, sometimes have hundreds of vice presidents. Finding out the identity of the buyers and sellers is extremely important, so do your homework. Obtaining this kind of information can often times be very tedious.

Regarding the question of when the transaction was made, you really want to find the most recent insider transaction filings. The more current the information is, the better chance you have of taking advantage of any movement in the stock, whether the move is up or down. Also, shifts from insider selling to insider buying, combined with positive price movement (along with the opposite scenario), can often render substantial returns.

Size does matter, especially when it comes to insider transactions. This is not rocket science. Disclosure of a 5,000 share purchase by a director of marketing and communications probably won’t make a big difference in the overall scheme of things. However, a purchase of 100,000 shares by the CEO of that same company will most likely have a greater impact, and could move the stock. The same effect may be achieved through a series of purchases by several officers. It is always nice to see multiple layers of management buying shares of its stock. On the flip side, seeing multiple officers selling shares is a pretty good indication that it’s time to get out.

So why would a company insider want to sell his/her own stock?

Excluding factors directly related to the share price, an insider may sell for estate planning purposes, personal financial needs, desire to diversify an investment portfolio, as a result of an exercise of stock options as part of one's compensation, or other reasons not related to the outlook of the company. However, when there are a number of insiders selling at the same time, especially after a significant price rise or corporate development, you should be alert.

As far as finding Web sites that allow you to see insider transactions, CNBC’s Web site (after clicking on the Stocks section) has an area where you can type in the ticker symbol and see several years of transactions from officers and directors. Yahoo’s Finance Web page offers much the same information.

Keep in mind, looking at the insider transactions of companies is just one tool in the grand scheme of investing. A comprehensive analysis of any investment, which, in my opinion, should include looking at the technical characteristics of a stock, fundamental analysis, and comparative analysis, should always be done. Good luck and happy trading!