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Should You Follow the Insiders?


Most surefire tips for beating the stock market have short lives. They fizzle out as soon as people figure out that there is no magic formula for making money from stocks. But one concept has had a remarkable run: shadowing the trades of those who have the inside scoop on a company--its executives and directors. A small industry of publications and Web services has sprung up to track their required disclosures to the Securities & Exchange Commission since the late-1990s tech boom, when stock became a key part of executives' compensation. It was not lost on the market at large that many people got rich by investing in their own companies. And all the publicity about prescient selling by Enron Corp. brass before the energy company's demise has given the idea a new push.

The idea has broad currency. Many mainstream publications cover the topic, including BusinessWeek, which prints data from Vickers Weekly Insider Reports. Numerous academic studies support the view that an increase in insider buying or selling across a sector tends to point to a switch in the market's direction. Insiders at tech and scientific companies in particular seem to have a much better knack for timing the market than ordinary investors. In the months before the Nasdaq hit its March, 2000, peak, techies were selling actively. Since then, they've sold into shallow, short-lived rallies. A study by researchers from the University of California at Los Angeles and New York University shows that a group of insider buyers, most from tech and pharmaceutical companies, beat broad market indexes by an average of 9.6% in the six months following their purchases.

But for individual companies--which is what the bird-doggers really care most about--there's little solid evidence that insider transactions convey much useful information about the near term prospects for a company's stock. A close analysis by BusinessWeek of a series of trades shows why: Many factors, from regulatory restrictions to the ebb and flow of executives' personal finances, control the timing of an insider's transactions and mask the motivations. Arguably, an executive who is buying is probably enthusiastic about his company's prospects, but a big repeat seller could be raising cash for a tuition bill at Harvard University or the downpayment on a ski lodge in Aspen, Colo. And with companies paying an ever-larger part of compensation in stock options, insiders have more incentive to sell shares to cover expenses.

Besides, SEC filings on insider traders aren't disclosed to the public until several weeks after deals occur--when the optimum time to buy or sell may be past. In addition, brokers are increasingly helping insiders camouflage their transactions by offering them private contracts to stop losses or secretly capture gains. Or they may help them schedule trades months in advance, a tactic permitted by a recent SEC ruling. Moreover, many companies, concerned about impressions of impropriety, limit when their execs can trade so they can't time the market.

Studies, such as the one from UCLA and NYU, that appear to support investment strategies based on insider tracking turn out on closer analysis to be less-than-rousing endorsements. For instance, the reported 9.6% six-monthly lift was skewed by outsize gains at a few companies. When researchers looked at all companies reporting insider trades, buyers only beat the market by 3.6% on average. And that average was also unrepresentative. In each case, only half of all insider buyers outperformed the market by more than a tiny margin. The study shows that investors would need to mimic hundreds of insiders' trades to lock in above-market returns, according to one of its authors, UCLA Assistant Finance Professor David Aboody. "You would need an insider fund. An individual investor would lose his pants," says Aboody.

Even those in the insider-tracking business are willing to acknowledge that their data are ambiguous at best. "You see investor services promoting that Bill Gates sold a large amount" of Microsoft (MSFT) stock, says Lon Gerber, research director at Thomson Financial/Lancer Analytics. "And it generally means nothing."

Indeed, even when executives call their company's stock just right, it's often as much dumb luck as anything else. That became clear in interviews with a number of insiders identified by Lancer Analytics as having had astonishingly prescient trading patterns over the past 15 years, measured by returns over the six months following their trades (table).

Consider the case of David M. Kies, a director of ImClone Systems Inc. (IMCL), a company whose shares plunged after a much-ballyhooed cancer drug failed to pass muster with the U.S. Food & Drug Administration. Kies bought ImClone shares 19 times after joining the board in 1996, and all but once, the stock climbed in the next six months. Last October, Kies made his first sale, at $70, near the stock's high. Nearly three months later, ImClone shares fell below $20. A scared insider bailing? Hardly. Kies sold only 8% of his holdings into a $1 billion tender offer by Bristol-Myers Squibb Co. (BMY) to raise tax money. "If I didn't have the tax liability, I just would have held on," says Kies, adding that he's still a believer in the drug, even though "I can't say I fully understand the science."

The examples also show that many smart-looking buyers never sell--with unfortunate results. William A. Friedlander, a money manager who sits on the board of telecom carrier Broadwing Inc. (BRW), made out fabulously for a while. After each of his 10 purchases, Broadwing shares rose an average of 23% in the following six months. The 24,000 shares he bought in July, 1999, at $21 rose 80%. Friedlander still owned those shares at $10. Why didn't he sell? He says he was mistakenly convinced that demand for broadband services would outstrip supply.

Others, like Paul A. Frame, simply got lucky. The CEO of oil services company Seitel Inc. (SEI) sold shares that he had acquired earlier, mostly through options, over a decade on 16 different occasions--and in 13 cases the shares were down six months later. But, he says, he sold on a schedule determined by the company's restrictions on when he could trade, according to company spokesman Russell J. Hoffman.

Even many tech insiders get it wrong. Far from being the first to jump ship, Nortel Networks Corp.'s (NT) execs and directors bought 34 times in the months since October, 2000--a period when the stock plunged by 90%. At Gateway Computer Inc. (GTW), insiders have bought a half-dozen times since mid-2001, but most did so long before Gateway released a weak sales forecast on Jan. 8, which pushed the stock down nearly 30% in one day. It has continued to fall. And Yahoo! Inc.'s (YHOO) ex-CEO Timothy A. Koogle sold $25 million of Yahoo stock last year, much of it before the shares took off on a 65% rally.

The bottom line: Insider tracking is a lot of work, and it's hardly a sure-fire technique for making money. A pattern of buying or selling might give investors a hint that something's up at a company. But it's still no substitute for dogged research. By David Henry and Timothy J. Mullaney in New York


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