Inside Trading

Buying up the shares of low-priced and depressed stocks – usually selling below one dollar – has been a specialty of a friend of mine for many years now. Over that time, he has repeatedly told me he owns nine percent of this company or that. Nine percent? Why not seven percent or ten percent? Why nine? The reason, of course, is quite simple. He doesn’t want to be an insider, one who is required by SEC regulations to submit paperwork every time he buys or sells. By owning less than 10 percent of a company, he is no different than an investor who buys 100 shares. His investment activities are not monitored by a government agency and he can quietly go about buying and selling as he sees fit.

Because I've been privy to some of his investment advice, I've been able to benefit from knowing when to buy and sell. The fact is, he isn't an insider, but his finger is on the pulse of any company he chooses to make a big investment in. As a result, we've made some spectacular profits by buying early and selling when the company's story gets out before the public.

By definition, an insider is anyone who has knowledge about a company that has not yet been released to the public. Most importantly, insiders include company executives and directors or any shareholder who owns 10 percent or more of a company's stock. An insider could also be the printer who publishes confidential documents concerning a company that has yet to be released to the public. I once had a job working at a financial public relations firm. In order to write up the press releases and quarterly and annual statements, we needed to know the numbers to be published. Moreover, if a client company wanted to issue a press release, we would be the first to know. We were insiders. As a result, we were prohibited from acting on the news and telling anyone about the news prior to its release.

Can you see how having information related to an important company event can give you a significant edge? That's why it is prohibited to act on such information. The investor deserves a level playing field. When ImClone's CEO told his family and Martha Stewart about the DEA's impending denial of his company's drug application before the news was released, he was violating the insider trading rule. That's why he is in prison today.

Having said this, it is important to stress that there are important legal ways to track insider activities that can have a benefit for the small investor. Obviously, the scandals get the publicity. But perfectly legal insider transactions take place everyday. And, because of the safeguards in place by the SEC and other regulatory agencies, the activities of these individuals can be easily tracked… just like footprints in the sand.

Who are the important insiders? Those people who run the company and are in control and monitor day-to-day operations – namely, the chief executive officer CEO and chief financial officer (CFO). When these individuals buy and sell it can mean something is up with the company. A member of the board of directors may buy a few hundred shares from time to time, but this is meaningless in the general scheme of things. Depending upon the size of the company, there are many people who may think they understand what is going on. But, despite the protestations of those CEOs and CFOs who claim they had no idea what was going on when they were caught with their hands in the cookie jar, they are typically the only ones who have a complete overview of the company. For this reason, you want to know when they buy and sell.

Finding out what the insiders are up to is simplicity itself. The easiest way is to go to Yahoo Finance's web site and enter the symbol of the stock you are tracking. Then click "Insiders" under "Ownership" and you will see who was buying and selling how much stock on what dates. The one drawback with this method is that there is a time lag between when the activities take place and when they are reported to the SEC.

To show you how useful this information can be, I recently went back and looked at some of the insider transactions in a stock that I owned, Input/Output (IO). On December 5, 2003, an Input/Output director by the name of James M. Lapeyre, Jr. purchased himself a total of 2,150,000 shares at a price of $3.48. Three months later, on March 5, 2004, the price of IO had more than doubled to $7.41 a share. Mr. Lapeyre's profit was almost $8.5 million in three months!

Chart I

In another insider transaction, Input/Output's CEO, Robert P. Peebler, purchased a more modest 25,800 shares on May 3, 2005 between $5.85 and $5.95 per share. Six months later, on November 3, 2005, IO shares closed at $8.45 a share.

Chart II

I want to stress that these were perfectly legal, fully-disclosed transactions. But the inference to be drawn is clear. Insiders have a pretty good idea when their companies' fortunes are about to change for the better or the worse. In the two examples above, one clue was the size of the transaction; the other clue was who was making the transaction. I selected Input/Output because I was familiar with the company and owned the stock. But there are many, many more examples of intelligent insider buying that you can find simply by noting when the purchases were made and tracking the progress of the stock.

The SEC does its own compilation of insider transactions and publishes the information in its monthly Official Summary of Security Transactions & Holding. The drawback is that the information is dated and sells for $111 a year.