Academic evidence on trading strategies and insider transactions
Insiders often buy or sell shares in their companies.
These events are considered by many as indicative of future performance.
However, academic evidence shows mixed results stemming from insider trading strategies.
Here we propose six lessons that can be learned from academic evidence.
This article will summarise our current understanding of trading strategies and signals based on insider transactions.
Insider trading involves trading in a public company's stock by someone who has insider information. The executives who hold this information are called insiders. While regulations vary from country to country, in general insiders are legally allowed to purchase stocks of their companies on the condition that they do so without an unfair advantage, namely using private information about the company. However, in practice there is a thin line between private and public information. For example, executives are not allowed to make transactions based on an M&A proposal. On the other hand, they do receive information about everyday business progress which is not considered private, yet it is extremely valuable. In a situation where a company experiences a surge in demand for its products, the CEO could base their trading decisions on this fact. With this in mind, it is not surprising that when insiders buy shares, the market usually reacts positively.
In this article, I share some of the academic responses to the phenomenon of insider trading to showcase the value of scholarly research for this corporate practice.
Before diving into the academic takeaways, it is worth noting that a very interesting relationship exists between macro trends in insider trading and overall market direction. As evident in the graph below, taken from www.openinsider.com, insiders generally sell (red) many more shares than they buy (blue). However, when this trend is reverted, it is usually a strong buy signal.
Specifically, the chart reveals strong spikes in the periods of:
- November 2008 - March 2009 - August 2011 - August 2015 - December 2018 (weak signal) - March 2020
Looking at market performance, we can see that in October 2008 the S&P 500 stood at approximately 800, 15% from the absolute bottom of the crisis, and almost 50% from the top achieved a year earlier (S&P at 1560). Hence, this signal was already pretty accurate, however it became even more so with the second wave of purchases in March 2009. This period represents the rock bottom of the stock market and those who had purchased shares at that level have ended up with generous profits (S&P tripled in the following eight years).
Further, in August 2011 the market corrected due to market uncertainties in Europe. The S&P 500 fell from approximately 1350 achieved in July to 1120 in August. Again, buying shares at that level would have proven very profitable with the share value doubling over the next five years. Finally, insiders bought back substantial amounts of shares during the correction of August 2015. S&P 500 prices declined from 2120 in July 2015, to 1920 in August, approximately 10%. However, they then reached new highs within a few months. A year later, values reached almost 2200, an increase of 15%.
Similarly, buying during the market correction of December 2018 would have generated 30% returns in one year. Even stronger returns would have been generated by investing during the insider transactions spike of March 2020 during the COVID-19 pandemic. It goes without saying just how insightful these transactions have been.
When it comes to micro-trends, they can be traced at the company level. Just one illustrative example is J.P. Morgan (NYSE: JPM). Back in January 2016, CEO Jamie Dimon bought a staggering 500,000 number of shares worth $26M. The stock chart below shows that JPM shares did not fluctuate much between 2014 and 2016. However, once Dimon purchased his shares, the stock price started climbing. He bought the shares at an average price of $53, approximately half of the current share price of $102 (100% return in 4 years, plus 3.6% of dividends per year). More recently, we have discussed the insider transactions happening in Store Capital.
Evidence from Academia
As an academic researcher with a particular interest in entrepreneurial finance, I value reviewing the academic literature and extrapolating empirical findings as a way to better understand certain phenomena. Here are only some of those key findings related to insider trading strategies:
Finding 1: Insider transactions generally do not predict short-term movements, but rather long-term stock price changes.
Lakonishok and Lee (2001) set out to answer the question “Are insider trades informative?”. To do this, they examined insider trading activities of all companies traded on the NYSE, AMEX and Nasdaq between 1975 and 1995, and concluded that very little market movement is observed when insiders trade and when they report their trades to the SEC. The authors do not observe any major short-term (3 months or less) stock price changes around the time of insider trading or around the reporting dates. This is very surprising given the attention that insiders' activities receive from both investors and academics. Nevertheless, the authors find that insiders' trades are informative for longer investment horizons, suggesting that the market under-reacts to this information. Furthermore, the paper shows in detail how insiders' activities predict long-term stock returns and how firms with extensive insider purchases during the prior six months outperform companies with extensive insider sales by 7.8% over the following 12 months.
Finding 2: Insider transactions are more effective in predicting returns for smaller companies.
Their study also finds that insiders seem to be able to predict cross-sectional stock returns. The result, however, is driven by insiders' ability to predict returns in smaller firms. In addition, informativeness of insiders' activities is coming from purchases, while insider selling appears to have no predictive ability.
Finding 3: Insider sales do not offer a strong trading signal.
Interested in the viability of mimicking corporate insiders, Bettis, Vickrey, and Vickrey (1997) show that outsider investors can in fact earn significant abnormal returns by following insider traders. However, the authors find that insider buys are more predictive signals than sales. It means that a long-short strategy might not work, but a long-only one can boost portfolio returns.
Finding 4: Insiders are generally contrarian investors.
Insiders, in aggregate, are contrarian investors. However, according to the graphs above, they predict market movements better than simple contrarian strategies. Periods with significant insider transactions followed market corrections.
Finding 5: Only relatively large insider trading can offer a valuable signal.
In “Investment Intelligence from Insider Trading” (2000), Nejat Seyhun demonstrates that following every insider transaction is neither feasible nor profitable. The author explains that “while most trading by outside directors or large shareholders is uninformative, it is still quite possible that large transactions (over 10k shares) are informative”. This means that we cannot interpret the actions of those insiders who buy only a few shares as a signal to follow suit. Adding to this point, I believe that in the case of large transactions, it is important to evaluate their significance by contextualising them. For example, if a CEO owns 10M shares, and buys 50k additional shares, he might not in fact be sending a strong signal and may be just trying to push up the price of his holdings.
Adding to this point, Seyhun shows that specific newsletters can be poor performers as well. For example, between 1980 and 1992, the insider-trading newsletter Market Logic gained 339%, while the Wilshire 5000 gained 432%. The underperformance was also coupled with greater volatility.
Finding 6: Aggregate insider trading is more informative than individual insider trading.
Closely linked to the previous finding is Seyhun’s claim that aggregate insider trading provides us with the most informative signal. In his research articles published in 1988, 1992, and 1998, he demonstrates that aggregate insider trading significantly predicts market movements. What we can conclude here is that multiple insiders buying shares send a stronger, more informative signal than when a single insider does.
In this brief summary we have observed some of the current evidence available on investing signals generated by insider transaction activity.
Focuses on long term investing
Invests in smaller firms
Focuses on insider stock purchases (rather than sales)
Focuses on large insider transactions
Focuses on aggregate transactions
While investments should not be based solely on insider transactions, having insight into their workings can only help us make better informed decisions in the future.
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I want to thank Vukan Jokic for his help with this article.