When performing due diligence on a stock there are a lot of bases to cover. From financial statements and earnings releases to research reports and chart analysis, forming an informed opinion on a company requires much homework.
One of the most valuable pieces of information is insider trading. This is the buying and selling activity of corporate executives, board members, and anyone else that owns at least 10% of the company’s outstanding shares. Unfortunately, this is often one of the most overlooked aspects of stock research.
Tremendous insight can be gained by monitoring insider trades. Like a traffic signal at a busy intersection, these buys and sells can indicate whether or not a stock is a “go”.
Why Do Corporate Insiders Buy and Sell Stock?
Company executives, directors, and major institutional shareholders trade stocks for the same reasons regular investors do. They buy when they think the stock will go up and sell when they think the stock will go down.
There are some added complexities to consider though. While members of management and board members are free to use their personal funds to make trades, they often transact in shares that are tied to their compensation. Common stock, restricted stock units (RSUs), and stock options are all securities that can be awarded to these insiders as part of their employment contracts.
Since insiders can receive equity ownership as part of their compensation packages, investors should be aware of how certain transactions are classified on the SEC Form 4. For instance, when an insider receives vested stock options, he or she can choose to exercise the right to buy and sell. The exercise of an option immediately followed by a sell decision appears as separate buy and sell transactions that investors should distinguish from regular buying and selling activity.
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What is SEC Form 4?
The Securities and Exchange Commission (SEC) requires that a form be filed when a company insider has a material change in their equity holdings. This is referred to as SEC Form 4, or the Statement of Changes of Beneficial Ownership.
The document must be submitted within two business days of a material transaction and is typically submitted electronically through the EDGAR system. Failure to provide a completed SEC Form 4 could result in civil or criminal actions.
SEC Form 4 provides the regulatory agency with important information about insider ownership. The reporting person must disclose their relationship with the company and the particulars around recent stock buying, selling, or options activity. Transaction date, transaction code, share amount, execution price, and resulting share ownership are among the key data fields along with footnotes that explain these entries in greater detail.
Is Insider Buying or Insider Selling Data More Valuable?
Except in situations where an insider acquires new shares or exercises call options, buys are performed because the insider is bullish, or optimistic, about a company’s prospects. They may be aware of some future growth catalyst or think their stock is undervalued in the market.
Insider selling actions are less straightforward. There are various reasons why an insider may sell. Many times, a company executive will create a trading plan that prescribes a certain amount to trade at pre-determined intervals. This reduces the perception of trading impropriety. The timing of these sell orders does not necessarily reflect how the person feels about the stock’s value. There are also times when an insider will sell simply to diversify their personal investments, a prudent portfolio management strategy for anyone.
There are indeed cases where an insider will sell for the sole rationale that they think a stock is overvalued or will do down. But since there are several other potential reasons behind insider selling, the action is not always clear. Insider buying tends to be more valuable information for investors because the purpose is usually straightforward and indicates a positive signal about a stock’s potential.
How Should Investors Use Insider Buying Information?
When an insider purchases shares of the company they intimately know in the open market it implies an expectation of higher stock prices. It is considered a show of confidence in the company’s growth opportunities within their industry. Investors should interpret this as a bullish event and a good reason to buy. A management team that has significant “skin in the game” has its own interests aligned with those of shareholders.
Magnitude also matters when it comes to insider buying. This means that insider buys of large dollar values carry more weight than smaller purchases. Similarly, when multiple insiders buy around the same time, the power of the bullish signal increases.
Staying in tune with insider buying activity can be a very helpful indicator of where a stock is headed. This is why a stock can go on an extended rally after an influential insider makes a significant trade. While insider trades are important, they should generally be used as a supportive piece of an investment thesis rather than the primary decision driver.