Take a minute and think about who knows a company and its future best.
Is it the talking heads who report on the firm’s latest earnings results?
Is it the Goldman analyst who covers every press release and analyses future cash flow?
How about the hedge fund trader who buys shares in the company every quarter?
Or is it your friend who talks about stocks every time you get together?
Well, every one of them has a decent opinion…
But they’re not real “insiders.”
Today, I want to talk about the real investors with “skin in the game”… and how tracking their activity can help to identify investment opportunities.
This could be the most important lesson you learn on the market this month.
I pay very close attention to one set of investors:
I’m always curious if company executives are buying and selling their own stock.
And at what levels?
These insiders know more than anyone else what is going on inside their company.
They know which products are selling and which ones are a bust.
They know about potential new offerings that could boost revenues.
They know if the company is acquisition-minded or maybe looking to sell off some underperforming divisions.
There are rules for when they can buy and sell stock, but insiders know enough about the future direction of the business, they can pounce when the window is open.
Tracking Their Buying Patterns
The best way to get a sense of where executives think the stock is heading is to track something called “insider buying.”
No – this is not insider trading like what Gordon Gekko did in Wall Street.
I’m referring to the term used to describe the buying of company stock by executives. There is often a quick short term move when large purchases are made by top executives like the CEO and CFO.
If the stock meets your other trading criteria, it may be worth jumping into a stock when those purchases are announced.
Traders should also watch something called the “Buy-Sell ratio.”
This is the percentage of stock bought by insiders compared to the sale of stock by insiders.
Most of the time, there is more insider selling than buying at any given point in time. Insiders sell for lots of reasons unrelated to the company’s prospects.
The sale could be related to estate planning, divorce, sending a kid to Harvard, or just giving in to that middle-age anxiety-driven desire to own a Lamborghini.
When insiders are buying more stake that they are selling, it’s a wildly bullish sign that we are at or near a critical market bottom.
In March, the ratio got down to just 0.27 the lowest level since November 2008, the height of the Great Financial Crisis.
Since we had that low reading in Mid-March, the S&P 500 has leaped higher by more than 25% in just a couple of months.
As 2019 kicked off, we had very low Buy- Sell ratio readings in early January that caught the bottom right before the S&P 500 jumped up almost 20%.
It can be an incredible tool for spotting potential market bottoms and is worth a quick check every day to where the absolute level of the ratio is at the moment and which direction it is trending.
When you see concentrations of large insider buying in a particular industry, I always want to explore this trend.
Again, in Mid-March, I saw massive buying in regional banks and Real Estate Investment Trusts. Both of these sectors have bounced quite a bit higher as the Fed rode into the rescue of financial stocks.
Riding the Wave
There is also an exciting way to use insider buying that will have appeal to momentum traders. A recent (November 2019) study called Trading Against the Grain: Why Insiders Buy High and Sell Low found that when stocks with strong momentum see insider buying, great things can happen.
This study uncovers a new way to tell when insiders are trading on nonpublic information rather than just buying because they think the stock is undervalued.
The report argues that most insiders tend to become buyers around 52-week price lows.
The professors looked at stocks and insider buying, starting in 1986 to 2017 and found that insiders are anchored to the 52-week low price. Insiders are far more likely to buy disproportionally more as the stock price moves closer to its 52-week low and sell more as prices rise.
When they buy at these levels, they likely know something significant about the future of the company. It is this information that can drive the stock a lot higher.
It is also true that when insiders are selling near 52-week lows that insiders likely possess negative nonpublic material information of a negative nature, and the stock is going to move lower.
Here is where it gets really exciting.
The professors found that a long-short strategy that buys stocks with insider buying near 52-week highs and selling short those with insider selling near 52-week lows produced average abnormal returns of 23.76% to 31.32%.
In other words, that is, excess returns on top of what an index fund investor could have expected to earn, which historically would be somewhere between 8-10%.
Insider buying is not just a tool for sleepy long-term investors. It is a great tool to find hidden gems in any market.
I’ll add insider trading to the tool chest to help identify the best stocks to target moving forward.