on a strategy that beats the market 75 percent of the time. That’s a great way to boost returns. You can further reduce the risk of underperforming the market average by weeding through trades to cherry-pick only the ones that send the strongest buy signals. We’ll look more closely at strategies to do just that in Section 2 of this book.
When it comes to insider trading, that’s what you get. Market-beating returns that, even in down years for the market, let you keep your shirt.
That’s all great in theory and based on historical data, but with most studies on the benefits of insider trading being made before the most recent financial crisis, it’s important to ask: Does this strategy still work today?
The answer is a resounding yes. It might work even better today, as there are ways to filter out a lot of the static of insider trading to get to the absolute best opportunities.
Now let’s step away from theory and statistics to reveal the practical application of the insider advantage.
The Insider Advantage in Practice
Example No. 1: A 54 Percent Gain Within a Week!
On July 30, 2013, Will Weinstein of Hansen Medical (HNSN) bought over $1 million in his company’s stock, picking up 869,825 shares at an average price of $1.23 per share. That’s a pretty big bet on a company with a $120 million market cap — Weinstein’s buy was for nearly 1 percent of the entire company!
He wasn’t alone. Other corporate officers picked up shares as well at open market prices. What did these insiders know? That the company’s financial future was in good hands. In late July, the company reported that it entered into a purchase agreement with Oracle Investment Management for the tidy sum of $93 million. That sent shares surging by 54 percent within a week.
Take a closer look at the chart of Hansen’s move. Investors reading through the SEC’s Form 4s, which record changes in an insider’s holdings, had plenty of time to get in. In fact, this is one of the rare instances where individual investors could have gotten even better returns than the insiders themselves!
Example No. 2: Strong Insider Buying for a Company on the Mend
Multiple insiders have been bullish on Equal Energy (EQU) throughout 2013. The Canadian company, which owns oil- and natural-gas producing assets in Oklahoma, finally turned a corner toward profitability after years of losses. A cut dividend was reinstated, with a relatively high yield to boot.
But even as the share price started to rise, insiders continued to buy shares. Indeed, there’s been insider buying by corporate officers throughout the year — each and every month. Some of those buys have been option exercises, but many have been open market buys.
Although shares rose over 55 percent through 2013, as long as insiders remain bullish, there’s still the strong likelihood that the market-beating gains will continue at this small-cap energy firm.
Insider Advantage No. 3: 453 Percent Gains on This Misunderstood Company
On May 30, 2013, Tesla Motors (TSLA) CEO Elon Musk bought 1,084,129 shares at an average price of $92.24 per share. Four months later, by the end of September 2013, shares were up a staggering 84.25 percent. Not bad for a 125-day return!
But that wasn’t Musk’s first buy-in on the open market. On October 3, 2012, the CEO made a million-dollar bet by buying 35,398 shares at $28.25 per share. The returns on those shares, through the end of September 2013, rose a staggering 453.48 percent!
While shares of the automaker are down a bit from their September highs, it’s important to note that this level of market-beating returns is rare. It’s the kind of surprise move in a stock that shocks just about everyone except those who have their finger on the company’s pulse on a daily basis — i.e., its executive officers.
What’s more, anyone looking at Tesla based on its fundamentals (myself included) would have reached the conclusion that the stock was overpriced both times the CEO bought in. Anyone looking at the technical charts of the stock at the time Musk bought would have stayed on the sidelines too.
All of the above examples are recent, and they confirm earlier academic studies on the relative outperformance of insider trading. Indeed, as a variety of academic and financial journals have reported, bullish insiders tend to beat the average return of the stock market by anywhere from 6 to 10 percent per year.
Of course, the actual percentage may vary, depending on the sector, the overall return of the stock market, and so forth. For instance, a study from UCLA and NYU nearly a decade ago revealed that a group of insider buyers in the technology and pharmaceutical sectors beat the average stock market indexes by 9.6 percent in the six months following their purchases.
I’ve found that weighing in the few trades that underperform across every investment sector, investors today should expect about an 8 percent relative outperformance versus the overall stock market.
In 2013, with the S&P 500 index up more than 23 percent, the average insider-based buy returned over 30 percent. In some of the market’s down years, the relative outperformance of insider buys meant smaller losses.
Worst-case scenario, it’s closer to the low range of 6 percent per year. But that’s still a huge level of outperformance! Over time, this advantage is clear. An investor with a $50,000 nest egg in index funds earning the market average of 8 percent per year will end up with $246,340 in 20 years.
That’s not bad.
But with the worst-case scenario of outperforming the market by only 6 percent per year above the market average makes for a 14 percent annual return. That same $50,000 compounded over 20 years will grow to be more than three times larger! The total comes out to just over $800,000!
That’s the real power of investing alongside insiders. It’s not just any single trade; it’s the power of using this tool repeatedly to beat the market year after year.
This strategy is safe. And over time, it’s powerful.
In the next chapter, we’ll look at the illegal side of insider trading. It accounts for less than a fraction of 1 percent of insider trades, yet it’s the one that gets the headlines and scares investors away from this powerful strategy.
2
The Difference Between Legal and Illegal Insider Trading
“It takes a crook to catch a crook.”
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