James Boric discusses the Insider Trading Strategy — keep an eye on what company insiders are doing, and follow their lead.

“When several insiders are buying the company’s stock at the same time, it’s a positive.”
– Peter Lynch

If you put a gun to my head and told me I had to choose one investment strategy to follow for the rest of my life, I would be hard-pressed not to choose an insider buying strategy.

When a company insider — defined as an officer, director or owner of 10% or more of a class of shares in a corporation — lays down his own money to buy shares in his own company at market prices, chances are that there is a very good reason.

Company insiders have intimate knowledge of a business’ innards. They know when sales are likely to rise. They know about a new marketing strategy that could boost the company’s bottom line. They know about industry conditions that may be changing for the better. And they know the company’s balance sheet like the back of their hands. So when a CEO, CFO, COO or director invests his hard-earned money in his own company, you should pay attention.

Peter Lynch, the longtime Magellan fund manager, once famously declared there is “no better tipoff to the probable success of a stock” than insider buying. And countless studies over the years prove Lynch is correct.

Insider Trading Strategy: What Has Worked in Investing

In Tweedy, Browne’s must-read report What Has Worked in Investing, the New York-based brokerage firm (made famous by brokering Ben Graham’s investments in the 1930s) highlights its five all-time proven investment strategies. They include:

1)    Buying stocks that are selling for less than their true asset value.

2)    Buying stocks that are cheap relative to earnings.

3)    Buying stocks that suffered a major decline in price.

4)    Buying small-cap stocks with high growth rates.

5)    And buying stocks with a significant pattern of insider buying.

This morning, I revisited the section on insider buying.

Citing four well-known studies by Rogoff, Glass, Devere, Jaffe and Zweig, Tweedy, Browne answered this question: If you only bought stocks that the insiders were accumulating (shortly after they bought), how would you do relative to the overall market?

To answer that question, they insisted on following two hard and fast rules. First, there had to be more than one insider buying stock in the company. And second, the number of purchases had to significantly exceed the number of sell transactions.

With those rules in mind, lets look at what they discovered…

During the periods highlighted above, investors who would have bought just after the insiders did would have outperformed the market by an average margin of more than 2-1.

That’s great. But I know what you are thinking…

“What about some more recent data? Those studies are from the 1950s, ’60s and ’70s! Does this insider strategy still work in today’s market?”

The answer is yes.

Insider Trading Strategy: Follow the Insiders

Investopedia.com (an online investing resource) published an article on Dec. 3, 2003, titled “Can Insiders Help You Make Better Trades?” The authors proved that in the wake of the Enron and WorldCom debacles — not to mention the tech collapse of 2000 — investors who followed insiders in and out of the market would have avoided big losses and set themselves up for nice gains.

Take a look at the chart below…

This chart shows you the ratio of insider selling to insider buying between 1997-2004. When the bars are high, the insiders were selling stocks. That’s when you should have been getting out of the market. And when the bars are low, the insiders were buying stocks. That’s when you wanted to be heavily weighted in stocks. For instance…

If you bought at points 1, 5 and 12 you would have done very well:

–   From April 1997-April 1998, the S&P 500 rose 46%

–   From September 1998-September 1999, the S&P 500 rose

–   And from September 2001 to now, the market is up 12%.

And if you sold when company insiders were selling in bulk (see points 11 and 17), you would have avoided the 100 point sell-off between June and December 2001. But you would have missed out on the profits between October 2003 and April 2004. Hey, you can’t always be perfect! But in all seriousness…

More than not, following the insiders is a great way to make(and avoid losing) money on Wall Street.

Corporate officers know when their businesses are overvalued and set for a fall. And they also know when their stock is cheap and ready to rise. And as an investor, you would do well to follow their lead. It isn’t rocket science.

Insider Trading Strategy: Four Simple Rules

Of course, you can’t blindly just invest in any stock with the hint of insider buying. There are some simple rules you should follow:

1)    Look for insider buying from CEOs, CFOs and COOs, versus directors or institutions. Many directors are required to buy and hold stock in the company. And institutions are often terrible buy or sell indicators — in any capacity. But a CEO, CFO or COO is an investor like you and me. So when they use their own money to purchase their own stock at market prices (not through stock options), that is a very bullish sign.

2)    Make sure the insiders are buying significant amounts of stock. If a CEO already owns 5 million shares in his company and adds another 5,000, that may not be worth getting excited about — especially if it is a $1 or $2 stock. But it is a bullish sign to see a CEO (who is making $500,000 a year) plop down $200,000 in his own stock.

3)    Look for what I call “cluster buying.” It’s one thing to buy a stock just because a CEO buys. But when a CEO, CFO and a COO all buy around the same time and at the same price, you should pay attention: Those who are most intensely involved with the day-to-day operations of the company are all bullish at the same time. That’s your clue to buy.

4)    Finally, look for insiders continuing to buy even as the stock price rises. If a corporate officer spends $1 million of his own money to buy a stock at $5 and then spends another million to buy more stock at $7, that’s a bullish sign.

Great, so you have some historical data and a few rules to help you build an insider screen of your own. So where are the insiders putting their money right now?

Barron’s publishes a list of the top 20 companies with heavy insider buying in every issue. In the Jan. 2 edition, I noticed something you should be aware of. Sixteen of the most heavily accumulated stocks on the market right now are small caps — with a market cap of $1 billion or less. Or to put that another way…

80% of the best insider buys on the market are in the small-cap market. Here are those 16 companies (in order from the most insider buying to the least):

Republic Property Trust (RPB)
Carolina National Corp. (CNCP)
Gateway Financial Holdings Inc. (GBTS)
BCB Bancorp Inc. (BCBP)
Integrated Security Systems Inc. (IZZI)
Emeritus Corp. (ESC)
RedEnvelope Inc. (REDE)
National Mercantile Bancorp (MBLA)
CSK Auto Corp. (CAO)
First Community Bank Corp. of America (FCFL)
Synergy Financial Group Inc. (SYNF)
Midwest Banc Holdings Inc. (MBHI)
ValueVision Media Inc. (VVTV)
Enbridge Energy Management LLC (EEQ)
Eaton Vance Senior Floating-Rate Trust (EFR)
Newkirk Realty Trust Inc. (NKT)

I’ll be watching these companies for you in the weeks to come. I’ll also be paying attention where the insiders are putting their money in the future — and letting you know what those companies are in upcoming Sleuths. And soon, I’ll be introducing you to a brand-new tool to help you capitalize on this insider trend.

This spring, I am going to unveil a service for serious small-cap investors only. It doesn’t have a name yet. But the service will be straightforward. Anytime a CEO, CFO or a major shareholder makes a significant purchase in his own company, I’ll let you know about it — in as close to real time as you can legally get.

I have no doubt this service will prove to be invaluable to you. And of course, as I get closer to the launch of this new “insider” service, I’ll let you know more details.

That’s all for now…

James Boric
January 05, 2006

James Boric

James Boric began his finance career by successfully picking winning stocks. With time and experience, James realized his goal- to figure out how an average, everyday investor with little capital could become wealthy. The trick, he discovered, was to look to the quickest moving, most exciting and lucrative group of stocks in Wall Street history -- small-caps. Special Report: HOW YOU COULD TURN $200 INTO $1.2 MILLION!

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