An Outsider's Guide To Inside Investing
Of all the stocks to crash this summer, perhaps the most horrifying was Ciena, the fast-growing maker of fiber-optic gear. After unveiling plans in June to merge with another hot telecom outfit, Tellabs, Ciena went from less than 58 before the news to more than 92 on July 20. Then trouble hit, first in the broad market's retreat, next in the defection of a key client, AT&T. By Aug. 21, the day shareholders were to approve the merger, Ciena had nosedived to 26 1/4. Three weeks later, Tellabs scotched the deal, and Ciena plunged to 12 1/4.
Ciena burned arbs and amateur investors alike. Yet one group skirted the damage, cashing in Ciena stock at average prices near 61. Nine insiders, including Ciena's chief financial officer, a director, and five vice-presidents, sold 303,500 shares for more than $18.5 million during two weeks in June. Had they held on, those shares would now be worth less than $4 million.
What's remarkable is that the sales, all perfectly legal and reported by July 10 to the Securities & Exchange Commission, did little to interrupt the ascent in Ciena stock. What should have looked like a big red flag to investors went widely ignored. One big reason: The data on corporate insider trading that's gathered and made public by the SEC is a confusing mess.
True, more such information is becoming available on the Internet (table). But conscientious investors like Toronto computer programmer Peter Friedrichsen, who often check insider-trading patterns, still have trouble fathoming which trades are meaningful. "I find it very difficult," Friedrichsen says. "How does the individual really know what an insider trade means?" Nor is it a cinch for the experts. Newsletters such as The Insiders, which picks stocks based on insider moves, routinely fail to beat the market after adjusting for risk, confirms newsletter evaluator Mark Hulbert.
Now, though, help is on the way. A book due out Nov. 1, Investment Intelligence from Insider Trading (mit Press, $29.95), is the result of 15 years' research by H. Nejat Seyhun, chair of the finance department at the University of Michigan business school. By examining more than 1 million trades insiders made in the open market from 1975 to 1996, Seyhun found that insiders, on average, have proved prescient. Stocks they bought outperformed the market by 4.5%. Stocks they sold went on to underperform the market by 2.7%.
BETTER ODDS? Seyhun has his doubters. Finance professors Josef Lakonishok of the University of Illinois and Inmoo Lee of the Korea Advanced Institute of Science & Technology also have studied insider trades and view their relevance more coolly. Says Lee: "If you try to invest every time on an insider trade, you will be very disappointed." Seyhun doesn't dispute that point. He concedes that "if the price has fallen after the insider has bought, or has risen after an insider's sale, those transactions don't have much [predictive power]." But Seyhun insists his findings can help investors improve their odds.
How should you follow Seyhun's findings? Under SEC rules, several classes of insiders, including company executives, outside directors, and large shareholders who own at least 10% of the stock, must disclose trades. Seyhun found that trades made by top executives with companywide responsibilities, such as chief executive or chief financial officers, outperformed the broad market by the widest margin, 5% over a 12-month span. Lower-level executives and directors did somewhat worse, while big stockholders' moves beat the market by just 0.7%. So if you care to mimic insiders' trades, focus on those of top executives. Among them, "cfos are best," says Robert Gabele, research director at CDA/Investnet, a major supplier of insider-trading data. "They know the numbers," he adds, and are less publicity conscious than chairmen and ceos about their trading.
As with Ciena's $18.5 million in aggregate insider trades last June, a cluster of many insiders either buying or selling heavily in unison is a plain signal. But such cases aren't common, so Seyhun looked at how predictive individual trades of various sizes were. Trades of 100 shares or fewer, it turned out, didn't mean much. Trades of 1,000 to 10,000 shares beat the market by 4% over the ensuing year, and trades of 10,000 or more did even better. But just as trades by large shareholders didn't prove that informative, so were the largest trades of, say, more than a million shares not that helpful. Seyhun found that they beat the market by just 0.8% over 12 months.
The biggest trades often are made by corporate or institutional shareholders, and, says Jonathan Moreland, owner of the Web site InsiderTrader.com, "there are other reasons for their trading," such as corporate business strategy. Seyhun's rule of thumb: Individual trades become less and less meaningful as they grow in size past 100,000 shares.
RISKS. One of Seyhun's clearest conclusions is that mimicking insiders works best in small-company stocks. When he analyzed his data by company size, he found that insider trades in companies with market capitalizations under $25 million beat the market over 12 months by 6.2%. That's twice as much as the next group of companies, those with market caps of $25 million to $100 million. Companies with market values over $1 billion outperformed by just 1.7%, perhaps because the market in their shares is more efficient.
For many investors, this creates practical problems: Trading volume in small-cap stocks often is low, and information about their prospects can be scarce, making investments in them more costly and risky. If you wade into small caps, Seyhun suggests protecting yourself by using limit orders, in which you specify a price at which you're willing to buy or sell, instead of the more common market order, which directs a broker to trade on your behalf at whatever price prevails in the market. The risk is that your trade won't get executed right away, but Seyhun found timing isn't critical. Even though 26 days typically pass between an insider's trade and its disclosure, "the reporting delays do not completely eliminate the profit opportunities," says Seyhun. "Good news for outsiders."
Overall, the soundest approach is to use a variety of factors in combination, Seyhun suggests. For instance, if you're not comfortable with trading small-company shares, focus on bigger companies, but look for those where top executives are trading blocks of 1,000 shares or more. Better yet is to combine fundamental investing criteria, such as price-earnings ratios, with insider-trading signals rather than relying on them alone. And diversify. It would take a portfolio of 50 to 100 stocks, Seyhun calculates, to cut your risk of losing money.
One way to diversify cheaply is through a mutual fund that focuses on insider trading. So far, however, there's only one: Bear Stearns Insiders Select, which celebrated its third birthday recently. Senior Managing Director James McCluskey says the fund uses strong insider buying as the first criterion of stocks to buy. For example, he recently bought shares of Dun & Bradstreet, whose chairman and ceo, Volney Taylor, purchased 25,000 shares in July. Before McCluskey buys a stock he also checks such traditional measures of value as low price to cash flow and price-earnings multiples. For all of McCluskey's attention to insider filings and fundamentals, however, the fund has shown only mediocre performance. This year, it's down 4.7%, vs. an 8.4% loss for its benchmark, the Standard & Poor's Midcap 400 Index.
For investors keen on picking their own stocks, Seyhun's research strongly suggests that it's worth paying attention to insider-trading disclosure. But "they should use it with everything else that they consider about a stock," he adds. Happily, insider information is becoming more widely available via the Internet, sometimes for free. Now, it may be easier to fathom, too.