The Significance of Insider Transactions

Important information at bottom of this page

Many studies have been made on this topic. The results have consistently shown that insiders are better informed and make superior returns from their share transactions compared to market averages.

An article in Individual Investor Magazine summarised it well: “Company executives and directors know their business more intimately than any Wall Street analyst ever would. They know when a new product is flying out the door, when inventories are piling up, whether profit margins are expanding or whether production costs are rising…You always hear about the smart money…that is the smart money.”^[1]

The earliest known formal studies to be documented on this subject began in the 1960s. Lorrie and Niederhoffer (1968) found superior investment performance amongst insiders^[2]. Similar conclusions^[3] were found by Pratt and de Vere (1968) and by Jaffe (1974). Jaffe also found that outsiders can profit from insider trading disclosures up to 8 months after such information becomes public.

Recent studies performed by Friederich et al. (2002) and Lakonishok and Lee (2001) found that insiders not only make above-average returns, but can also time their transactions well^[4]. Lakonishok and Lee used a database covering the period from 1975 to 1995.The database includes all the companies on the NYSE, AMEX and Nasdaq markets, and more that 1 million insider transactions overall.

They found that:

• Aggregate insider trading appears to predict market movement.
• The market basically ignored insider transaction information when it was reported. (We have to keep an open mind that any successful trading strategy will become void the moment it becomes widely known)
• Insider trading is a stronger indicator in smaller companies.
• Directors may sell shares for many reasons. It may be to raise cash for a new house or for diversification into other shares. The only time when sales transactions may be significant is when several directors are selling at the same time and they are selling the majority of their shares.

Legal issues

The phrase “insider trading” is often incorrectly associated with illegal trades where company insiders, either directly or indirectly, exploit sensitive company information to the detriment of other public investors. However, company insiders are allowed to buy or sell shares in their own companies provided that they meet certain criteria as specified in Part 7.10 Division 3 of the Corporations Act 2001. The general idea of this part of the Act is to ensure that all market participants have equal access to information and to protect the integrity of our financial markets.

Every director of an Australian listed public company must notify the Australian Securities Exchange (ASX) within 5 business days of changes in interest^[5]. The Australian Securities and Investment Commission (ASIC) has similar requirements ^[6].

Conclusion

There is no complete automatic share selection strategy and some directors do get it wrong. However, on average, directors know what is going on in their companies. Monitoring and analysing director trades can help public investors make better returns on their share investments. World-renowned investor, Peter Lynch once said that “insiders are hardly infallible . . . but there are smart people in business who often know what they’re doing and aren’t inclined to squander money on a fool’s errand. They are also willing to work extra hard to make their own investments pay off  . . . When insiders are buying, its a good sign” ^[7].

References

1. Individual Investor Magazine. February 1998 issue. page 54.
2. JH Lorie, V Niederhoffer, “Predictive and Statistical Properties of Insider Trading” – Journal of Law and Economics, 1968 – JSTOR
3. Pratt, Shannon P., and Charles W. De Vere (1970). “Relationship Between Insider Trading and Rates of Return of NYSE Common Stock, 1960-1966,” in J. Lorie and R. Brealey, eds.: Modern Development in Investment Management, Praeger, New York.
4. J Lakonishok, I Lee, Are insider trades informative? The Review of Financial Studies 2001, Vol 14, No.1 pp79-111.
5. ASX Listing Rules Chapter 3. http://www.asx.com.au/ListingRules/chapters/Chapter03.pdf
6. ASIC Regulatory Guide 194. Notification of directors interests in securities – listed companies.
   http://www.asic.gov.au/asic/pdflib.nsf/LookupByFileName/rg193.pdf/$file/rg193.pdf
7. Peter Lynch (1994), Beating the Street, Simon & Schuster; Revised edition. Page 169.