Most people correctly believe that when corporate executives have special knowledge that's not available to everyone else, they should not be able to profit from it. The playing field should be kept level for all investors, whether it's the insider CEO or the outsider small investor like you and me.
The Martha Stewart-ImClone (Nasdaq: IMCL ) stock scandal was just the most high-profile incident of a rather pervasive problem. Motley Fool Senior Editor Bill Mann recently noted that the executive vice president at Biogen IDEC (Nasdaq: BIIB ) resigned under a cloud of controversy following his stock sale just as the company was announcing some major bad news. The SEC is appropriately investigating the transaction.
However, what if we -- the outsiders -- had access to this "insider information"? Could we profit from it? More importantly, what if that inside information were legal to use and pointed out a stock ready to run? Imagine the money that we could make trading on the news. Not possible? Read on!
In Hidden Gems, the Motley Fool's small-cap growth stock newsletter, Tom Gardner has identified a number of key characteristics that signal when a stock may be a good investment. Growth in sales and earnings. Positive inventory divergence. Strong returns on equity and capital. In fact, Tom has some 70 different criteria he goes through before a company gets his stamp of approval, and the results speak for themselves. In a little under two years, he is beating the market by nearly five to one.
Peek inside a company
One key attribute Tom seeks out is high insider ownership of the stock. When senior management has a significant stake in the company -- when the CEO and the CFO are putting their own money on the line -- it says something about their confidence in the business. Ownership of common stock, not just shares gained through grants of stock options, is what really underscores executive commitment to the company. That's a sign of management interests truly aligned with those of shareholders.
Buffalo Wild Wings (Nasdaq: BWLD ) is a notable example particularly because Tom has recommended the company three times as a great investment. It stands on the idea that investors must constantly look for something new all the time to hit home runs, and follows the Peter Lynch principle that the best company to buy may be one you already own. Equally important, however, is the fact that insiders in "B-Dubs" also own almost 25% of the outstanding shares. If investors had followed Tom Gardner's advice and bought shares at each recommendation, they'd be up an average 35% right now, compared to less than 5% for the market.
Another company that has performed superbly since Tom recommended it is Mine Safety Appliances (NYSE: MSA ) , a maker of safety and protective equipment. Up over 130% compared to the market's 19% increase, Mine Safety also sports insider ownership of around 23% of outstanding shares. And Hooker Furniture (Nasdaq: HOFT ) , which dropped 19% a couple of days ago after reporting first-quarter earnings, is still handily beating the market since Tom picked it out of obscurity. Insiders own more than 35% of its shares, and it will be interesting to see how they respond. (Management just announced a quarterly dividend of $0.07 per share.)
So, obviously, insiders already owning shares are a key component of finding winning investments, but it doesn't help us in our quest to gain that legal advantage of trading on insider knowledge. High insider ownership is just our first check.
Watch out for false signals
Most investors focus on insiders selling their shares. Implying all kinds of doom and gloom if the CEO dumps 40,000 shares of his stock on the market, they sell in a panic only to watch the company continue to perform well and the stock continue to rise. What's up with that? Why is the CEO bailing out on his company if it's doing well?
The reason is, most insider sales mean nothing. They are a false signal. A CEO might have to sell his stock to diversify his holdings, or to buy a new ski lodge in Vail, or to pay for his daughter to attend an overpriced Ivy League college. In fact, because there are so many restrictions on just when management can sell shares that companies often adopt special plans -- called Rule 10b5-1 plans -- that allow them to sell on a regular schedule. Seeing those shares hit the market may be nothing more than a structured diversification of the CEO's holdings. It's not necessarily a time to start selling your own shares.
What you do want to look for is when insiders are buying their company's shares. That is the true signal. That's showing us investors real confidence in the business.
A special part of the Hidden Gems service are the interviews Tom conducts with CEOs, master investors, and academics that shed insight into the world of investments. One of the most popular has been his interview with Dr. H. Nejat Seyhun, professor of finance at the University of Michigan and the author of Investment Intelligence from Insider Trading. Dr. Seyhun points out that insider buying after a rise in stock price shows enormous confidence in the continued growth of the business.
Take a look at CNS (Nasdaq: CNXS ) , the maker of Breathe Rite nasal strips and an early Hidden Gems recommendation. The marketer of those plastic bandages you see sports players wearing over their noses to help them breathe better had been languishing after its recommendation, but slowly started to climb as sales gradually improved. While the company looked beaten down after a lackluster performance, one sharp-eyed subscriber noted on the newsletter's discussion boards that beginning in September and continuing through December of last year, the CFO bought shares even as the stock price climbed. These weren't option grants, mind you, but common shares bought on the open market. This was a bullish sign for all to see, if you were willing to look.
Then on Jan. 20, the company reported that the quarter's profits -- the quarter in which the CFO had been buying -- had tripled! The stock rose more than 12% in a single day, and has since kept rising. It is now up 55% from its recommendation in contrast to the market, which is up 19%. The CFO had sent up a bullish signal as bright as any flare that hinted to smart investors the business was doing well and would continue to do so.
Your legal advantage is freely available
You can do the same type of sleuthing and gain a legal advantage by checking out insider stock purchases on your own. While you could go to the SEC website and look up each company's Form 4 filings -- which report insider transactions -- it's cumbersome to wade through the many other reports a company has filed. It's far easier to use a website such as Form4Oracle, which lists only the insider transactions.
Investing lessons like these populate the pages of Hidden Gems each month and lead to exciting discussions on the dedicated boards. One savvy member even publishes a weekly update of insider transactions. Another Lynchian principle notes:
"Insiders might sell their shares for any number of reasons, but they buy them for only one: they think the price will rise."
The one-two punch of high insider ownership and key insider transactions are the hot tips that give you a real investing edge. By using that special knowledge, you can make big profits and, unlike Martha Stewart, avoid jail by trading on insider scoops. It's all legal and freely available if you just know where to look.
Motley Fool Hidden Gems has compiled a remarkable track record of beating the market by employing its main criteria of insiders having a stake in the company. Take a 30-day free trial to see what other advantages Tom Gardner's service can give you.
Fool contributor Rich Duprey likes two scoops of plain vanilla ice cream. He does not own any of the stocks mentioned in the article. The Motley Fool is investors writing for investors.