Insider transaction data can play a powerful role in investment research. Insiders are some of the most informed participants in the market and studies show that their trading activity is an excellent predictor of future stock performance.
Not all insider trades are created equal, however. To obtain the best results when analysing insider transaction data, it’s necessary to separate the informative trades from the uninformative trades.
In this guide, we look at some ways to identify the most informative insider transactions. By following these strategies, investors can potentially gain powerful insights from insider transaction data which can be used to capture alpha.
1. Focus on purchases more than sales
While both insider purchases and insider sales can offer valuable insights for investors, research shows that purchases, in general, tend to generate more reliable trading signals.
Insider purchases are typically easy to interpret. If an insider is willing to spend their own money on stock, it suggests that they are confident about the future and that they expect the company’s share price to rise. No executive or director spends their own money on company stock if they believe its price is set to go down.
Insider sales, however, are more difficult to interpret. This is because there are plenty of reasons that insiders sell stock that have nothing to do with their companies’ future prospects or share price. For example, insiders often sell stock to pay tax liabilities.
Insider selling is still worth monitoring, of course. In some situations, it can be an indication that business performance is deteriorating or that the stock is overvalued. Overall, however, it’s sensible to give more attention to insider purchases.
"Insiders might sell their shares for any number of reasons, but they buy them for only one: they think the price will rise” – Peter Lynch
2. Look for trades from top-level insiders
Corporate insiders tend to have varying amounts of information about their companies depending on the position they hold within the organization. So, when analyzing insider transaction data, it makes sense to focus predominantly on trades from top-level insiders such as the CEO, CFO, COO, Chairman and Founders. These insiders – who are often very skilled and experienced businesspeople – tend to generate the highest returns from their trades.
This is summed up well by insider transaction expert Nejat Seyhun, who authored a book on the topic entitled ‘Investment Intelligence from Insider Trading.’ In a 1986 paper on insider transactions data, Sehrun wrote:
“Insiders who are expected to be more knowledgeable with the overall affairs of the firm, such as chairmen of the boards of directors or officer-directors, are more successful predictors of future abnormal stock price changes than officers or shareholders alone.”
An example of a stock that has performed well after a purchase from a top-level insider is Dell Technologies Inc. In March 2020, when equity markets were falling due to the coronavirus pandemic, Founder, CEO, and Chairman of Dell, Michael Dell, purchased 828,199 shares in the company, spending $26 million on stock. In the next six months, Dell Technologies stock more than doubled on the back of strong demand for work-from-home technology.
Insider buying at Dell Technologies Inc:
3. Pay close attention to large transactions
When analyzing insider trades, it’s important to focus on transaction size. If insiders are highly confident about a company's prospects, they're willing to commit larger amounts of money to it. Similarly, if insiders are very concerned about the future, they may seek to offload a large proportion of their holding.
Size is relative, however. A $100,000 purchase from the CFO of a small-cap company with a market cap of $200 million could be a much larger purchase for that insider, in relative terms, than a $250,000 purchase from the CFO of a large-cap company with a market cap of $100 billion.
One way to obtain a better idea of the relative size of an insider transaction is to look at the change in the size of the insider’s holding as a result of the transaction. This can provide an insight into the insider’s confidence or lack of confidence. If an insider has just increased the size of their holding by 50%, for example, it shows more commitment than an insider that has just increased their holding by 2%.
A good example of a large insider purchase, in relative terms, is a purchase from Harley-Davidson Inc CEO Jochen Zeitz in May 2020. Form 4 filings showed that Zeitz purchased 51,020 HOG shares, increasing the size of his holding by over 50%. In the next six months, Harley-Davidson stock rose from around $20 to $36 as sales picked up, registering a gain of about 80%.
Insider buying at Harley-Davidson:
4. Focus on cluster buying
One of the most bullish patterns in insider transaction analysis is what’s known as ‘cluster buying.’ This is where multiple insiders are buying stock within a short period of time.
Cluster buying is a strong insider transaction signal because it’s a sign of consensus of insider opinion. If just one insider is buying stock, investors cannot be sure that the outlook for the stock is favorable. That insider may simply be an optimist. Yet if four or five insiders are all buying stock at the same time, there’s a consensus that the stock is undervalued.
One example of a stock that has generated gains after a cluster of purchases is UK consumer goods company Reckitt Benckiser. In March 2020, a number of top-level insiders at Reckitt Benckiser purchased stock including CEO Laxman Narasimhan, CFO Jeff Carr, and COO Harold Van den Broek. Combined, these insiders spent over £2.5 million on shares. In the next few months, Reckitt Benckiser’s share price rose more than 30% on the back of strong earnings.
Cluster buying at Reckitt Benckiser:
*RECKITT chart shows less transactions because we only plot transactions with tradeSignificance >= 2
5. Look for insider buying and selling in small-cap stocks
Finally, it’s worth paying particular attention to the small-cap area of the market when analyzing insider transaction activity. A number of studies on insider transaction activity, including a 1998 study entitled ‘Are Insiders’ Trades Informative?’ by Josef Lakonishok and Immoo Lee, have concluded that the most profitable transactions occur in small-cap stocks.
The reason that small-cap stocks tend to produce the largest returns, is that this area of the market is less researched than the large-cap space. This means there’s more potential for earnings surprises and outsized share price gains.
A good example of a small-cap stock that has generated big gains after insider buying is Upwork Inc. In May 2020, Upwork board member Greg Gretsch – a founding partner and managing director of a venture capital firm that specializes in Series A financings for SaaS and marketplace startups – purchased 542,996 Upwork shares, spending $5.4 million on stock. In the next three months, Upwork shares rose about 50% on the back of strong results. Then, in August 2020, Gretsch purchased another 547,844 Upwork shares, spending $8.1 million on stock. In the next three months, the stock rose another 130%. Overall, Gretsch made enormous gains in a very short period of time.
Insider buying at Upwork:
Using insider transaction data in investment research
Insider transaction data can play a valuable role in investment research. It can be used by both value and growth investors, as well as both fundamental and quantitative investors.
However, to fully capitalize on insider data, it’s crucial that investors identify the most informative transactions. By focusing on high-conviction trades from top-level insiders, and looking for patterns such as cluster buying, investors can use insider transaction data to gain an edge.