Follow the Smart Money

The financial services industry is burdened by paperwork. But stock-jockey brokers should be thanking the Feds in at least one instance: for insider trading data. Insiders company officers, directors, relatives, anyone with access to key company information before it is announced to the public are required to fill out forms when buying or selling their company's shares. This can benefit reps in two

The financial services industry is burdened by paperwork. But stock-jockey brokers should be thanking the Feds in at least one instance: for insider trading data. Insiders — company officers, directors, relatives, anyone with access to key company information before it is announced to the public — are required to fill out forms when buying or selling their company's shares. This can benefit reps in two ways. They can use the filings to generate new investment ideas, and also to prospect for new, high-net-worth clients.

Now that Sarbanes-Oxley shortened the period insiders have to file the paperwork, known as the Form 4 (to within just two business days of the trade rather than as many as 40 days after the trade), the data are even more useful when picking stocks. Insider buying or selling on its own is not necessarily a buy (or sell) signal. But insider data are a great first-screen to determine where to focus your limited research time. The Form 4 records the purchases and sales of insiders when they trade their own company's shares. Academic studies show that firms with significant insider purchasing tend to outperform the indices, and those with insider selling tend to underperform.

Follow…But Not Blindly

Most companies' insider trading are actually full of noise and may not be a hint of future performance. To avoid being bogged down, pass over companies with insiders both buying and selling similar amounts of shares. Also, focus on transactions that are marked specifically as “open market.” Private transactions — gifted shares and any other transaction that didn't begin with the insiders calling their brokers to make the trades — should be considered less significant.

In addition, look for clusters of activity by several insiders. Companies with more than one insider trading similarly over a short period indicate a consensus of insider opinion.

Size matters. Transactions that are large in dollar value mean more than small trades. But also look at the number of shares. Focus on trades that are big in volume (minimum 10,000 shares). It's also key to act quickly, usually within one week of the insiders' trades. By doing so, outsiders mimicking insiders' trades could garner excess returns of 18.6 percent after 13 weeks, says a 1997 study by Carr Bettis, Don Vickrey and Donn W. Vickrey.

Look at the pedigree. Insiders with proven track records with their Form 4 activity should be lent more credibility as a signal than those with little or poor past records.

Other tips I've learned to determine significance: Although insider selling is much more difficult to garner real intelligence from, seeing significant selling in a stock that is well off its yearly highs is one to avoid or, if appropriate for your client, short. Stocks often trade below book value — and even cash on hand — for good reason. But if insiders are buying at these firms, they are more likely to be undervalued unfairly. For income investors, significant buying in stocks with large indicated yields is a good sign that yield is actually sustainable.

Once you're comfortable that you've qualified the insider signal as significant, remember to keep a basic truth in mind. Stocks don't go up and down because insiders buy and sell them. They rise and fall on material company events, such as earnings surprises, new products, new strategies, etc. Although insider activity tends to be a good predictor of when such market moving events occur, it is still up to you to figure out if the company is poised to produce good or bad market-moving events in the future.

Again, never base an investment decision solely on insider data — consider them important input or confirmation. Like any investor, insiders can be wrong. Also, insiders are often early with their trades, so don't expect an immediate pop in the price; company executives tend to be an optimistic lot.

My service, InsiderInsights.com, has a pretty decent stock-picking track record using insider data as a first screen (up 45 percent year-to-date, even with our short positions in place to protect our downside). And there are plenty of other insider data services (see box). But even so, just over a third of the 170 positions we've recommended over the past two years have lost us money. Therefore, as with anything else, consistent success in investing stems from having more winners than losers, and having your winners go up more than your losers go down. No approach can promise an easy home run every time.

Insider data is as good a way as any to narrow down your investment choices, however. And if you're required to fill out a due diligence form for your compliance department to go outside your firm's buy list, being able to state that there was significant insider buying at the time you put your client into a stock certainly can't hurt.

The Happy Prospector

Insider data can also help build your book. Specifically, Form 4 sales, Form 144s (for restricted stock) and Form 3s (see below) all represent events that could mean more business for you. In fact, one long-time broker put it this way: “Some guys aren't willing to spend the money to boost their business, but sooner or later they learn that they need to.” He latched on to using insider data as a lead-generation tool over a decade ago because, “a person (selling) his shares has just generated liquidity. Where else is a better venue to prospect in?”

For identifying wealthy executives, insider data are hardly unknown tools. Many reps already use it, or at least know they could. Other industries also are sniffing for money with the data. Universities, for instance, use the leads to hit up their successful legacies for donations. So, don't expect to be the only message on a wealthy insider's voicemail. But this is a lead that is certainly more qualified than most, and if you really believe you have a good product or service, you should not pass on this cold call.

Some brokers said relying on insider data for prospecting was pointless, figuring that if an insider has filed a Form 4 or 144, he already has a relationship with a broker. True enough. But it doesn't mean the insider (or the non-insider holding unregistered securities in the case of some 144 filers) is happy with that relationship. This is a competitive business. Step into the ring, and pick up the phone.

If new blood is what you're after, though, pay special attention to the Form 3 filings in your territory. This is the form the SEC makes new insiders fill out soon after they become insiders. This form has to be sent in whether or not the newbie actually owns shares, so you have a much better chance to be that insider's welcome wagon.

Some insider-based wealth identification services play up the fact that they can offer an insider's home phone number and price this as a premium feature. That may be so, but in this age of “do not call” lists, the brokers interviewed recommend calling the executive at work.

Get What You Pay For

There are numerous Internet-based sources of insider data these days, and the price to get good quality information is as cheap as it's ever been. Most of the well-known financial Internet portals even have free insider histories going back a year or two that are perfectly good for following the insider activity of stocks you already own. But to find new investments and new clients effectively, it makes sense to pay up for more complete insider services.

For instance, to effectively screen for new investments and prospect for new clients, you need to see what filings came in recently. Only a masochist would type in tickers all day at the free sites to see what just came in. Same goes for scrolling through the raw insider filings at the SEC's free EDGAR Web site (www.sec.gov). Better to subscribe to an online service that serves up the filings in a database format within a day or week of hitting the SEC.

For finding new investments, newsletters and systems that offer qualitative analysis of the data can save a tremendous amount of time. Having some independent fundamental research opinions on top of the data help as well.

To find new clients, you need a tool that can give you the recent Form 4 sales, Form 144s, and Form 3s for your territory. The good prospecting tools will even allow you to search many states or zip codes. They will even give you a contact number. So with just a few clicks each morning, you can hit the phones well before the cheapskate with your territory at a different firm.

There are many insider trading services, from the very expensive institutionally oriented to the cheaper retail-focused research. Below is a sampling.

Insider Trading Services

InsiderInsights

$249.50 to $1,500 212-631-0567 insiderinsights.com

InsideScoop

$200 to $600 408-540-0165 insiderscoop.com

The Washington Service

Call for pricing 202-778-1380 washserv.com

Thompson Equity Strategies

Call for pricing 646-822-3461 thompsonequitystrategies.com

Vickers Stock Research

$165 to $1,980 516-945-0020 vickers-stock.com

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