Uncertainty on Wall Street can grow or shrink moment to moment. But this much stays constant: As a group, corporate insiders--mainly top executives and directors--beat the market when buying and selling stocks of their own companies. That's why a whole sub-industry is devoted to tracking and interpreting the trading reports insiders are supposed to make to the Securities & Exchange Commission. With the Web and the spread of sites (including BusinessWeek Online) posting free insider-trading data, it's a snap for individual investors to clue in to what insiders are up to.
But are we cluing in to the right data? A "window" of insider trades, spanning the past 3, 6, or 12 months, is what popular personal-finance spots on the Web, including pages featured by America Online (AOL) and Yahoo! (YHOO), typically focus on. Now, new research suggests insiders begin dumping stock over two years before a company's earnings fall. If more research bears out and broadens this finding, investors may need to rethink how they assess insiders' moves.
Researchers Bin Ke and Steven Huddart of Pennsylvania State University and Kathy Petroni of Michigan State University note that despite vast evidence of insiders' trading beating the market, there is little academic research explaining just what insiders know before the rest of us. For instance, they wondered, do insiders correctly anticipate declines in companies' profits? To find out, they looked at 3,952 companies that from 1994 to 1997 broke a string of quarterly profit gains. Had insiders dumped stock before the break in profit gains?
They did, often and early. Insider selling, the researchers discovered, jumped markedly above its average level as early as nine quarters before a break in profit increases. Stocks of growth companies saw more intense selling, and it started even earlier. Insider sales of growth stocks on average shot up 11 quarters before the decline in profits (chart). At its peak, four quarters before a break in profit gains, insider selling in growth stocks nearly quadrupled its usual rate. "The longer the string [of profit gains], the more evident is the insider selling. And insider selling is higher prior to long breaks" in profit gains, Huddart told me. "Insiders as a group know a long time in advance when their corporations are going to suffer an earnings drop."
WHO KNEW? If this inference is correct, do these trades cross the boundary into illegal insider trading? The researchers do not assert that, and regulators are not anxious to paint bright lines around what makes an illegal trade. As an SEC spokesman put it to me: "We're not going to tell people how far back we look or don't look." Less scandalous explanations exist. Instead of relying on hard, "material" inside information about, say, a sudden drop in sales--one hallmark of illegal trades--insiders are as likely to be acting on "soft" information, says University of Michigan finance professor H. Nejat Seyhun, a longtime leader in insider-trading studies. Examples might include a gradually narrowing technological lead or the onset of new competition--slow-moving trends, in other words, that an alert outsider also might exploit.
More and more, courts are having to sort out the propriety of insider trading cited in private lawsuits. One prominent example is Cisco Systems (CSCO). Among other charges, multiple suits filed this year allege that insiders knew Cisco had trouble ahead yet began selling $595 million in stock, at prices above $80, 18 months before the shares cracked in February. Cisco shares are now trading below $12. A Cisco attorney told me the suit has no merit, cast doubt on the reliability of the $595 million figure, and added: "We are going to defend ourselves vigorously."
What should you do? Defend yourself, too. Before you trade, check what the insiders have been up to. Keep clicking and scrolling to see the record over the past few years. (You might start at www.nasdaq.com. After getting a stock quote, you can click on the "Holdings/Insiders" link.) Insiders don't emit perfect buy and sell signals. But it's beginning to look as if they are far more prescient than we had imagined. By Robert Barker