Personal Finance -- Follow The Leaders

Nobody knows more about your business than you. You know the cyclical trends, the order flow, supply and production bottlenecks, costs, and other ingredients of business success better than anyone, including close observers such as competitors and industry analysts. In the stock market, the people with this same intimate knowledge of public companies are called insiders. These include directors and, especially, officers, as well as outside investors such as money-management firms. Increasingly, these outside-insiders can include mutual funds: In June Gabelli Funds of Rye, N.Y., disclosed it had boosted its stake in Standard Motor Products Inc., a supplier of parts for the automotive aftermarket, to 2.6 million shares, or 20.7% of the company's outstanding common stock. Gabelli is a famed value investor; Standard Motor's sales have been declining for five years, but its profits are starting to look up. Insider buying has proved to be a strong, though not infallible, predictor of stock-price appreciation. A recent study by University of Michigan finance professor H. Nejat Seyhun found that heavy insider buying of stocks that are particularly cheap -- with price/earnings ratios in the bottom fifth of the market -- gained an average of 25% in 12 months, compared with gains of 16% among high p/e stocks. "You can basically double your returns" without accepting a corresponding increase in risk using this approach, the professor says. Unfortunately, following insider buying and selling isn't as easy as it looks. Insiders sell for any number of reasons. Microsoft Corp. cofounder Paul Allen regularly sells millions of shares to diversify his portfolio, invest in sports franchises, and indulge in philanthropy in the Seattle area. Sometimes insiders buy to take advantage of stock options. Newly appointed corporate directors are often obliged to own shares in the company; their purchases are irrelevant to outside investors. Investors who track insider buying and selling offer these recommendations for analyzing individual situations:

• Some insiders are better than others. Directors know less about a company's finances than officers. Among these, the key officials are the CEO and CFO. But anyone at or above the vice-president level could be well informed about the company's prospects.
• Lots of trading is a better indicator than a little. One or two insiders at a large corporation don't necessarily make a trend: Three or more do. Solitary trades are less likely to point to a shift in insider sentiment than a large number of them.
• The kind of trading that matters most is open-market transactions. This excludes stock options and other compensation-related matters. "When the insider picks up the phone to call his broker, that's when he's making a statement," Seyhun says.
• Insider trading matters more at small companies than big ones. At small and midsized firms, virtually all insiders are key employees privy to the company's financials. At larger ones information is more dispersed and only the core management team has the big picture.

Insider trades aren't the Holy Grail of investing: Heavy buying in Mattel and Rite Aid in 1999 was followed by sharp declines in the stocks. But it's certainly comforting to buy a stock knowing that insiders also are buying -- or to sell one they're selling. It gives you an edge. Timothy Middleton is a columnist for Microsoft Investor and Multex.com, and market analyst for EDGAR Online.