Insider Transactions: More Noise Than Signal

Insider transactions are one of those indicators that have the potential to get investors excited—indeed, insider buying or selling is information worth incorporating.

It is not that insider transactions are insignificant; they are just a lot more complicated than most investors expect, and hence, their significance can be difficult to gauge.

Understanding Insider Buying

Let’s start with insider buying. As one has probably learned in school, insider buying is not that effective as a signal. This is quite understandable. Many insiders are already heavily invested in the company, so further increasing your exposure to the source of income might lead to even more
concentration risk than is prudent. Moreover, insider buying that coincides with secondary offering sometimes involves insiders getting a loan.

The company will probably disclose that loan, but it is not disclosed in the databases that most people use.

For example, if you go to Yahoo Finance, you will see the insider buying but not that the insider got a loan of 100% of the value of the securities
purchased. That form of insider buying differs from the insider buying stock with his savings. In most instances, the only conclusion we draw after an insider reports buying is that the stock is relatively cheap – not that it has enormous potential to increase.

The Reality of Insider Selling

Moving on to insider selling, which is much more exciting—at least, most people believe this. Indeed, it could be until one realizes how the process works. Many insiders nowadays have a special program where they regularly sell a predetermined quantity of stock or a predetermined amount in dollars. Such predetermined programs are much less valuable information to investors than an insider’s “timing” of the stock.

Unfortunately, it is not easy to keep track of such programs. They are disclosed, but insiders can amend them, and the amended terms are, again, difficult to track. Sometimes, it may seem that an insider is selling a lot more than previously. However, that increase may be due to the rise in the program – something that is not easy to find.

Hidden Insider Transactions

But this is not the reason why we largely ignore insider transactions. The reason is that those transactions, especially insider selling, can be hidden. And many legal practices allow this to occur. Imagine the following scenario – you are the CEO of a publicly listed company. Still, most of your wealth comes from ownership of the publicly listed company, which you do not necessarily want to sell, and if you do, you certainly would not like to be reported. Suppose you open a private client account with 5MM USD cash, entitling you to all the excellent services the private banking industry offers. One of those services provided to private clients is called “short against the box.”

Short Against the Box: An Example

Short against the box is a service where the client pledges his shares against a loan from the company. The company then borrows the shares from the market. Let’s use some numbers to make that clear.

The imaginary CEO pledges 1MM shares, currently trading at 100 USD a share. He receives a loan worth 100MM USD. The bank hedges its exposure by selling short the 1MM shares at 100 USD. In three years, the imaginary CEO pays off the loan by selling his 1MM shares in the company to the bank, which covers its short position. In this fictitious scenario, what gets reported is the sale to the bank, which comes three years later than the original stock pledge.

The important thing is that 1MM shares will be reported but reported after three years, with price – the prevailing market price at year 3. It could be 20 USD/share or 300 USD/share, but the sale occurred three years earlier at 100 USD/share.

An important note here is that “short against the box” practices are used in cases where shares are fully vested, and an insider has the option to sell, but also in cases where the shares are not yet fully vested or the insider is not allowed to sell the shares outright, like the six-month period following an IPO.

Distorted Reports Through Options

Another practice that distorts the report on insider sell transactions is to sell short deep-in-the-money calls.

Again, the imaginary CEO pledges his 1MM shares at 100 USD/share, then sells short 1MM shares notional of 50 strike calls at 50 USD/share. The option sale is not reported. At the option’s maturity date, the CEO buys back the options and sells the stock at the prevailing market price.

In reporting, the CEO will appear to be selling his shares at the maturity date of the option, but in reality, he effectively sold his shares when he sold the call options.

The Challenges of Tracking Insider Transactions

We believe that keeping track of insider transactions is valuable. However, insider transaction reporting can be legally delayed and even inaccurate. In most cases, it cannot be easily interpreted correctly, even if it is adequately reported.

In general, we believe that institutional ownership is a much better indicator that correctly incorporates insider transactions.