Corporate insiders have access to information about their companies long before outside investors. Several studies have shown that they earn higher returns when trading their own companies’ stocks than most investors do. But, even though their actual trading activities are widely reported, there is some doubt about whether investors can profit from following insider trades.

Insider trading is all over the map. Some executives may buy company shares because they think they’re undervalued or they want to support the share price. In some cases, they’re simply looking to confuse the market or mask their real intentions. Increasingly, though, thanks to the popularity of stock options, raising cash or prudently diversifying away from company risk are becoming more common.

All of which means, for those who want to take a cue from insiders, that it is increasingly important to figure out what information these trades really contain, says James Scott and Peter Xu, analysts at Newark, N.J.-based Prudential Investment Management Services LLC.

In a recent study, the authors attempted to differentiate among types of insider trading.
Their theory is that insiders with a negative take on their company will probably sell a larger percentage of their holdings than if the sale were for liquidity or
portfolio-management needs. Selling only a small fraction of their holdings is actually a bullish sign, the authors suggest.
Using insider transactions in the U.S. for every quarter from 1987 through 2002, excluding insider purchases through the exercise of options but including any subsequent open-market sales, the researchers calculated the number of shares purchased or sold for each company over the previous six months. The performance of the stocks in the subsequent three months was then measured against the broad markets.

The authors then looked at the size of these trades relative to the insiders’ holdings.
They found that the larger the percentage of shares sold compared with the shares owned, the better the quality of the information and the larger the potential for excess returns. The results were similar, they maintain, even after controlling for company size and price/book ratios.

When insiders sell a large number of shares and a large portion of what they own, they are more likely to be motivated by perceived overpricing of their stocks, the authors conclude. However, a small volume of sales up against the total holdings may indicate that the owners need to raise money but still think highly of their company, they say.

Typically, insider sentiment in the aggregate is measured by the sell/buy ratio. A low sell/buy ratio indicates bullish insider sentiment; a high sell/buy ratio portends a downturn.

In recent years, however, researchers have worried that the widespread use of stock options has distorted this picture, making the sell/buy ratio artificially high because it is based solely on purchases or sales at the market price.

Options are cashed in at a specified price and, therefore, are not counted in the ratio.
But they are included when an insider sells shares subsequently acquired by exercising the options.

Looking at the four years 2000 to 2003 inclusive, University of Michigan finance professor H. Nejat Seyhun recently tried to determine how much these ratios may have been skewed by the exercising of options and their subsequent sales. Before 1991, insiders were not allowed to exercise options, then immediately sell the stock; they had to hold the shares for six months.

Seyhun found that including options-related sales caused the sell/buy ratio for the period to drop to slightly more than 2:1, on average, compared with 6.5:1 without them. The lower number is right in line with what used to be considered normal prior to the increased use of options, he says.

Investors should take his findings into account if they want to compare recent insider selling data with the long-term average, he says, adding that a high ratio in earlier periods probably reflected more pessimism about prospects for the insiders’ companies than it does today. IE