Imagine if every time you bought a stock, you knew exactly what the company’s CEO, CFO, board of directors and even its legal team thought about its future. Maybe the CEO would pull you aside and say, “Listen, next quarter is going to be a big one. We just landed a multi-million dollar contract with a brand new client. When Wall Street finds out about it, our stock will double.” If you had this kind of “insider information” you’d be rich, right? You’d always know what to invest in and when. There is no limit to the money you could make.

The only problem is, you don’t have access to a company’s top management on a daily basis. And even if you do, they SEC prohibits them from doling out such crucial information.

Stinks doesn’t it?

Well, there is a way to know what the insiders are thinking before you ever buy another stock.

Thanks to Section 16 of the Securities Exchange Act of 1934, insiders are obligated to reveal any trading of company shares by the 10th day of the month after they bought or sold their company stock by filling out something called a “Form 4.”

On these Form 4s, the insider is required to disclose how much stock he bought, at what price and when he bought it. This is all crucial information. And you have access to it all.

By scouring the market’s Form 4s everyday, you can know exactly what stocks the insiders are bullish on. You can know exactly where the so-called “smart money” is betting the highest returns will be. And you can put yourself in the best position for outstanding returns.

By the way, financial sites like Yahoo! Finance, investor.com and morningstar.com all have an “insider transaction” link you can click on to see if insiders in any given company are buying or selling stock. These sites simply download information from the Form 4s and publish it for their readers.

So it sounds simple. Everyone with access to the Internet can be on top of what stocks the insiders are loading up on thanks to these Form 4s and financial Web sites. That’s the good news.

The bad news is, it’s not as easy as it may seem to decipher the insider transactions you see on the Form 4s or the financial Web sites.

Knowing a Good Signal From a Bad

For starters, there are hundreds (if not thousands) of insider transactions reported in a given day. So it would literally take you ALL day to go through them. And even then, you have to know what to look for. Unfortunately, not all insider activity is useful — even the reported “buys.”

Many times an officer or manager in a company receives stock options as part of his compensation package. These options can total in the millions of dollars. And every time a CEO cashes in on an option, he must file with the

SEC using a Form 4.

With that in mind, you may pull up a Form 4 and see what looks like a whole lot of insider buying by a CEO or CFO in a company. But in reality, he isn’t using his own money to buy stock in his company. He is simply using his options he was given by the board of directors to “cash in.”

This is not the kind of insider buying you want to look for. You want to look for the stocks that the insiders are loading up on with their own money — and enough of it that they would feel the pain if they lost out.

Another mistake many novice investors make is they bite at the first hint of insider buying. For instance…

If one insider buys a few shares of stock in his company, the last thing you want to do is blindly buy that stock as well — especially if the insider only put a small amount of money down and several other insiders are selling when he is buying.

Between 1958 and 1976 five prominent insider-buying studies were published by Rogoff, Glass, Devere, Jaffe and Zweig. They all wanted to show how much money you could make by buying the same stocks the insiders bought – shortly after they laid their money down.

In each study these gentlemen followed two hard and fast rules. First, there had to be more than one insider buying stock in the company – known as “cluster buying”. And second, the number of purchases had to significantly exceed the number of sell transactions. By following these rules, they were able to beat the market by a 2:1 margin.

And there’s another rule you need to follow as well…

Three Rules to Always Follow

Here are three rules you should remember if you’re looking at insider buying:

Rule No. 1: There must be a cluster of buying by the insiders. That means at least two different insiders must be buying at about the same time. And it should not just be directors (who tend to be paid in company stock in addition to a salary). We’re looking for top management putting up their own money.

Rule No. 2: The total number of buy transactions must significantly outnumber the total sell transactions.

Rule No. 3: The insiders must lay down a significant amount of their own money in the stock. And actually, there is a fourth rule that should seem glaringly obvious to you…

The Power of Small-Cap Stocks

Everyone knows that small-cap stocks have dominated the market — outpacing the large caps in each of the last seven years. But what many investors may not realize is that this is NOT a fluke. Historically, small-cap stocks have always led the market.

In a famous study conducted by Ibbotson Associates in the 1990s, they found that small-cap stocks outperformed all other stocks 56% of the time — including the blue chip stocks that get all the media’s attention — between 1926 and 1996. The average return in any given year was 14% for small-cap stocks. It was just 9% for large caps. And the longer you held your small-cap stocks, the better off you were.

Since 1926, there has NEVER been a period of 25 years or more where investing in large-cap stocks has proven more lucrative than investing in small-cap stocks. Of course, there are many reasons for the large small-cap returns.

1) There are a lot more small-cap companies on the market. About two-thirds of all the companies on Wall Street have a market cap of $1.5 billion or less. So as a small-cap investor, you have a much wider universe to find moneymaking opportunities.

2) Because there are so many small-cap companies, the major brokerage firms and institutions don’t have enough analysts to cover them all. So they simply ignore some of the fastest-growing companies on Earth. As a result, there are some tremendous companies trading for virtually nothing. And over time, all good bargains get discovered. We look for them before that discovery happens.

3) Good small-cap companies can adapt to the changing marketplace and react quicker than their larger, stodgier large-cap peers. They are nimble.

4) Simple math tells you that it is a lot easier for a $200 million company to double than it is for a $255 billion company to do the same.

Knowing most of the true bargains on Wall Street are in the small-cap universe is a huge advantage over your large-cap peers. And when you combine the explosive small-cap market with the insider buying strategies I talked about earlier, you give yourself a great chance to make some tremendous gains.

– James Boric
February 27, 2006

Your Secret Connection to the Insiders was originally featured in the Penny Sleuth.