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Insider Buying: How to Use it to Your Advantage

Insider trading immediately brings two thoughts to mind - 1) high-profile scandals, such as those perpetrated by Ivan Boesky in the 80s, and more recently by Martha Stewart and the scalawags at Enron, and followed just last week by insiders at DHB, the armored vest maker, whose stock rode high, then collapsed; and 2) the legitimate buying and selling of stock by company insiders, which may provide opportunities for individual investors to profit. It is this second type of insider trading that I want to discuss today.

Theoretically, a company insider might be considered as anyone who knows material financial information about a company before it is publicized. But the SECs official definition of a company insider is an officer or director of a public company or an individual or entity owning 10% of more of any class of a company's shares.

In its attempt to keep insiders on the straight and narrow, the SEC developed three specific methods of reporting insider holdings and trading activities.

Form 3 - An insider of an issuer that is registering equity securities for the first time must file this form no later than the effective date of the registration statement. If the issuer is already registered, the insider must file the form within 10 days of an investor becoming an insider.

Form 4 - This document is used for changes in ownership and must be filed within two days.

Form 5 - This form, that reports any transactions that should have been reported earlier on a Form 4 or were eligible for deferred reporting, must be submitted to the SEC within 45 days after the end of the company's fiscal year.

Since it contains all recent insider trading activity information, Form 4 is the most important of all documents for individual investors who wish to profit from insider trading activity. Fortunately, one of the provisions of the 2002 Sarbanes-Oxley Act significantly changed the timeliness of reporting insider activities to the SEC. Prior to the act, it took an average of 41 days for the data to reach the SEC. After August 29, 2002, that window was narrowed to 2 days after the transaction occurred - a tremendous change that benefits investors.

Once these self-filed forms reach the SEC and are processed, investors can access them through the SECs web-site: www.sec.gov, and then subsequently through many other financial web-sites that I will list at the end of this report.

Insider Buying and Selling: What it Means to the Individual Investor

In the past few years, the business of watching insider buys and sales has given rise to a whole industry of companies who do nothing but that. Newsletters, web-sites, and intricate trading models have emerged to advise investors on which insiders are buying and selling. The reason is that people believe that insider trading activity often indicates the future direction of a companys stock price. After all, who could possibly be better informed as to the intimate details of a company's fortune?

When I analyze companies, I like to see company insiders who express their belief and confidence in their products by owning a portion of the companys stock. If they put their own money at risk, especially if they are buying shares in the open market rather than at discounted prices through options or warrants, it gives me an indication that they are optimistic about their companys future. And if there is a sudden flurry of buying, especially large volume purchases, it draws my attention for further investigation, as it is generally a good indicator of coming good news.

Here are a few helpful hints: Insider buying at small companies is often a better indication of higher future stock prices than at larger businesses. Why? A small company - unlike the General Motors and the Intels of the world - usually has a very limited number of insiders. And those insiders are pretty intimately acquainted with the companys activities. Further, because most small companies receive very little attention from the main-stream media and Wall Street, their news and trading activities are often ignored and/or misunderstood.

Pay attention to which insider in the company is buying. Studies indicate that the insiders who reap the best performance gains, in order, are the Chief Executive Officers, company officers, members of the board of directors, then large shareholders. It is therefore to your advantage to make note of CEO purchases.

Insiders tend to buy early. Studies have indicated that most of the extra price appreciation insiders realize arrives more than 30 days after they make their purchases. That means, you probably wont see an immediate increase in share prices.

The more shares insiders are buying, the better the companys prospects look. If several insiders are purchasing a large volume of shares, that could be significant.

You would naturally think the opposite conclusion could be drawn if insiders are dumping their companys stock. However, that is not necessarily true, because insiders may sell for a myriad of reasons, many of which are not related to the future prospects of the company:

1. Need the money for a new house, childrens education, taxes, or any number of other uses.

2. Diversification. I know of several CEOs who sell a portion of their company stock each year, just to ensure that their portfolio is diversified and not too heavily weighted in any one investment.

3. The exercising of options. A good proportion of insiders compensation comes from options and stock grants, which they periodically unload for no other reason than that they need the money. Even if you see that a CEO has sold stock and now has 0 shares left, that doesnt show any of the vested options on a million shares that he may own. Perhaps he just exercised a few options and sold a small percentage of his shares.

4. Release of restrictions from an IPO. After an initial public offering (IPO) or a private placement, insiders are subject to numerous limitations on their ability to sell; often as long as one year. Frequently, many sell a lot of their shares as soon as possible at the end of the restricted period.

5. Trading outside of reporting period restrictions. Many companies heavily restrict insider trades in months 1 and 3 of a companys quarterly reporting period. They often permit no trades during month one until the quarterly report is publicly issued. Then add a few days for public digestion. By month three, a company generally has some idea of how well the quarter went for them, so that month is also restricted. That leaves just 4 months out of the year in which insiders can freely trade their companys stock. Trading is further restricted if there exists material information that might affect the stock that is not yet public. Result: When given the opportunity to trade and especially if in need of cash, insiders just snatch the chance and sell at random times.

The bottom line: Tracking insider trading can pay off for the investor and is a good indication of an insiders faith in his company. Just be careful how you interpret the data you gather. Ive done some research to help you begin.

Click the Insider Buying header link above to learn more.

Good day and have a good new week.

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