LITMIR.BIZ

      1

       The Benefits of Insider Trading

      “You want more insider trading, not less. You want to give the people most likely to have knowledge about deficiencies of the company an incentive to make the public aware of that.”

      — Milton Friedman

      In the 1987 movie Wall Street, the arch-capitalist Gordon Gekko addresses an annual meeting for Teldar Paper, the firm he’s been buying shares of hand over fist to become the largest single holder of stocks.

      In a room full of everyone from guys in suits to little old ladies who own a few shares, he spells out part of the problem with the company: the proliferation of management. In his address to the shareholders, Gekko reveals that the company has nearly three dozen vice presidents and that all they seem to do is send reports back and forth to each other. Their salaries? Over $200,000 per year.

      Gekko points out that part of the reason why the company is faltering is because that money could be put to better use for the shareholders. By the end of Gekko’s speech, which includes the best-known line in the film, the audience is applauding.

      Insider Advantage No. 1: Aligned Interests Between Management and Shareholders

      Fast-forward 25 years and nothing’s really changed. One of the biggest problems with corporate America is with its management. Simply put, there tends to be a conflict of interest between the managers of a company, such as the CEO, CFO, and Board of Directors, versus that of the shareholders, who actually own the company.

      Shareholders want the company to grow, to continue paying a dividend (if it’s paying one), and so on. But most major companies have thousands of shareholders, so their voice is diffused. Management wants to get paid, and handsomely so, for the work it does. Shareholders don’t have a say in day-to-day management, whereas the executives do.

      Sometimes, however, management’s interest is aligned with that of the shareholders. Typically, this happens when a manager or managers own a large percentage of the company. The standard-bearer is Warren Buffett, who has maintained control of Berkshire Hathaway for nearly half a century.

      But most owner-operators who own such a substantial stake in a business are rare. It’s more common for corporate executives to receive stock options as a form of compensation, which they can cash out and pay capital gains taxes on, rather than taking the hit of higher income tax rates.

      That’s why the bulk of insider transactions, as reported to the SEC, are sales. Fair enough. Insiders have plenty of reasons to sell. It’s part of their remuneration.

      Furthermore, investors’ wealth should never be tied up in only one company, especially one they work at. Enron employees who contributed to their 401(k) plan ended up getting burned twice when the company went under — they lost their jobs and their Enron stock went to zero. Diversification is important, even for employees of the most financially secure companies.

      Finally, corporate insiders may cash out simply to buy a new home, take a vacation, buy a sports car, put a kid through college, pay for a divorce, and so on.

      So what reasons do corporate insiders have to buy shares of their company on the open market? Really just one: the expectation of higher share prices in the future.

      It’s a powerful incentive aligned with their specialized knowledge. High-level corporate insiders know when sales are going well before it becomes a materially important statement. They may have a gut feel for how a hot new product is going to perform. They know before the market if a major customer just left a competitor for them. They might know that a recent downgrade from a Wall Street firm was based on outdated information and the wrong conclusion.

      The specifics might matter to some financial analysts, but insiders don’t have to disclose the specific reason why they’re buying — it still comes down to the fact that they expect the share price to go higher.

      Insider Advantage No. 2: Market-Beating Returns

      Let’s get down to business. When it comes to investing, higher percentage returns are better than lower returns. Of course, there’s a trade-off: Investments that beat the average market returns in a given year tend to have a higher risk to them.

      Much of this risk can be mitigated over time. You’ll never lose money in stocks over a 20-year period or longer. But anything shorter means having a risk-management plan in place. If you need cash in a few months, it’s too risky to invest in stocks when you could be invested in cash, short-term notes, or certificates of deposit instead.

      Investing with corporate insiders confers a huge advantage to investment returns over the short term, while at the same time lowering risk.

      When you invest alongside corporate insiders, you can easily obtain market-beating investment returns within a matter of days, or weeks in some cases. For the most part, the advantages of insider trading play out over periods of a few months to a year.

      As for the risk — yes, some insider trades won’t perform well. But a study analyzing aggregate insider purchase activity for the 20 years between 1974 and 1994 revealed that simply investing an equal amount of money into every insider purchase would lead to a market-beating return 75 percent of the time.

      In only five of those 20 years did buying alongside insiders lead to a worse performance than the market, but the worst underperformance was by only 2.1 percent, and two of the five underperforming years lagged by less than 1 percent.

      So by investing alongside insiders, you’re betting on a strategy that beats the market 75 percent of the time. That’s a great way to boost returns. You can further reduce the risk of underperforming the market average by weeding through trades to cherry-pick only the ones that send the strongest buy signals. We’ll look more closely at strategies to do just that in Section 2 of this book.

      When it comes to insider trading, that’s what you get. Market-beating returns that, even in down years for the market, let you keep your shirt.

      That’s all great in theory and based on historical data, but with most studies on the benefits of insider trading being made before the most recent financial crisis, it’s important to ask: Does this strategy still work today?

      The answer is a resounding yes. It might work even better today, as there are ways to filter out a lot of the static of insider trading to get to the absolute best opportunities.

      Now let’s step away from theory and statistics to reveal the practical application of the insider advantage.

      The Insider Advantage in Practice

      Example No. 1: A 54 Percent Gain Within a Week!

      On July 30, 2013, Will Weinstein of Hansen Medical (HNSN) bought over $1 million in his company’s stock, picking up 869,825 shares at an average price of $1.23 per share. That’s a pretty big bet on a company with a $120 million market cap — Weinstein’s buy was for nearly 1 percent of the entire company!