The Myth of Insider Trading

July 25, 2006

Greg Forsythe
CFA, Senior Vice President, Schwab Equity Ratings®, Schwab Center for Financial Research

Investors have long been intrigued by the idea of profitably mimicking the legal (and highly regulated) trades of corporate insiders. The rationale is that nobody should know the future prospects of a company better than its top executives. So, the logic goes, if these knowledgeable insiders are using their own cash to purchase shares, they must know that the current stock price does not fully reflect future company results or other positive announcements.

Sounds plausible. But don't confuse anecdotes with systematic research. Numerous academic studies on the predictive power of insider trading data have produced mixed results. Some have found insider buying to be relevant. Others have found the trades of chief executives to be more noteworthy than those of lower-level executives. But none have found insider trading to be the Holy Grail of stock selection indicators.

Schwab's research team believes it has found a better way to capture the valuation sentiment of corporate management that's readily available and effective as a stock selection indicator. Rather than watching the personal trades of insiders, investors should watch the "trades" of the corporation itself by observing changes in a firm's common shares outstanding. In general, corporate buybacks are bullish; share issuance bearish.

Insider trading: overrated signal

So why is insider trading data an overrated signal for investors? First, we must question the common assumption that trades by corporate executives are strictly motivated by the desire to earn trading profits from inside information. Securities and Exchange Commission (SEC) regulations prohibit obvious examples of such behavior. For example, a chief financial officer cannot buy stock the day before the company announces surprisingly strong earnings. Most companies allow their executives to transact in company stock only during limited time windows after quarterly financial results are announced, and never when an executive is in possession of material, nonpublic information.

In fact, many insider purchases are driven by factors such as company loyalty or rules that require executives to purchase and hold a certain amount of company stock. On the sell side, insider motivations are even more ambiguous. Many insider sales are driven by the desire of corporate executives to diversify personal portfolios that are overweighted in their employer's stock. Finally, the popularity of stock option grants over the last 15 years has introduced new insider trading signal distortions when executives exercise their options.

A second problem with insider trading signals is the blind assumption that they represent new and unique information. I can think of at least 10 investment research and newsletter vendors that report or interpret insider trading activity. Such data availability almost ensures that any new information reported to the SEC is quickly reflected in stock prices.

A more subtle point is that insider trades often provide little or no incremental information to the astute investor. Recent academic studies show that insider trading is highly correlated with various equity valuation measures. For example, insider buying is more prevalent among stocks with low price/earnings (P/E) ratios than high ones, while insider selling is more prevalent among high P/E stocks than those with low P/Es. Schwab's own research has found that insider trading signals add little or nothing to the valuation criteria already incorporated into Schwab Equity Ratings.

Corporate trading: the real deal

So why do we believe changes in common shares outstanding is a better investment signal? A firm that reduces its shares outstanding (as opposed to buying in shares to simply offset shares issued via stock options exercises) over the prior year provides a signal to investors that corporate management feels its stock is undervalued. Such firms have historically outperformed the overall market the following year.

On the flip side, stocks of firms that have recently issued the most new shares have underperformed market averages. The logic is that if a corporation decides to finance expansion via stock issuance, the firm signals belief that its stock is low-cost capital. All things equal, low cost to the firm means low return to the investor! Monitoring changes in shares outstanding is one of the valuation criteria used in Schwab Equity Ratings.