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Watching the Insiders

When it comes to investing, everyone's always looking for an edge. Financial institutions spend millions of dollars to find the best analysts and to provide them with the best access to the information they need to make informed decisions. Individual investors rely on public news sources and streaming quotes from their brokers, but they also pay plenty for premium sources of information. Their hope is that better information will lead to better investment returns.

In looking for the best source of information on a particular company, perhaps the most obvious place to look is to the people who work for that company. Company insiders have plenty of reason to understand their business; heir compensation is directly linked to how well they run their business and to the positive impact their efforts have on their company's share price. And because company insiders are required to report stock transactions they make, you can get the inside scoop on the financial decisions they're making.

Insiders and stock transactions
Obviously, corporate executives have a big advantage over the average investor. They're often the first to find out about new business opportunities or problems within their organizations. They have access to financial results and other information that can result in big moves in the price of their company's stock when it's released. These insiders could make huge profits if they were allowed to trade on an unrestricted basis, and they could also use their knowledge of imminent bad news to sell shares with the intention of buying them back at lower prices after the news was made public.

To make sure that insiders can't profit from their inside information, the SEC imposes restrictions on their stock trading. Specifically, no one may use important private information obtained as a result of a special relationship with a company for personal profit. Corporate insiders also have a duty, imposed by securities laws, to report any trades they make in their company's stock.

To facilitate legitimate trading among insiders, most companies establish trading policies that allow insiders to set up pre-arranged trades. These policies may prohibit trading during certain parts of each year, such as immediately before the release of quarterly financial statements and other important information. With huge fines and even jail time among the potential consequences, companies take insider trading extremely seriously.

Doing what the insiders do
Because insider transactions are available to the public through the SEC, many investors look closely at these reports as an indicator of possible stock movement in the future. If corporate insiders are buying shares, then outside investors may conclude that the insiders believe that the company's prospects are good. Conversely, if insiders are reporting substantial sales, then the company may be facing challenges that could hinder its success.

The insider-transaction indicator is so popular that one exchange-traded fund, Claymore/Sabrient Insider ETF (AMEX: NFO  ) , uses it as a primary tool for choosing investments. Some of its holdings include Allegheny Technologies (NYSE: ATI  ) , SunPower (Nasdaq: SPWR  ) , and MGM Mirage (NYSE: MGM  ) . In addition, some analysts, including the Fool's own Tom Gardner of Motley Fool Hidden Gems fame, look for high insider ownership of shares as a gauge of whether a company will make a lucrative investment.

While the logic behind looking at insider transactions makes sense, there may be other factors behind those transactions. With the dramatic increase in the use of stock options as compensation, many corporate executives end up with highly concentrated positions in their employer's stock. As a matter of prudent financial planning, diversifying executive portfolios often requires substantial sales of stock. Even with these sales, most executives still have a great deal of exposure to movements in their company's share price. In companies that pay relatively low salaries in comparison with their equity-based compensation, executives may have to sell stock just to generate liquidity to pay ordinary living expenses.

Because insiders may be selling shares for personal reasons rather than as a reflection of pessimism about their company's prospects, you should look more closely at reports of sales to confirm the net result of an insider's transactions. For example, to exercise their stock options, executives may need to come up with large amounts of cash. To do so, they may sell shares while planning to replace them with the shares they obtain from exercising their options. As a result, what looks at first glance like a sale may actually prove to increase an executive's stock position in a company.

On the other hand, insider transactions that involve buying shares are a more credible statement of optimism about a company's future. Because executives are putting their own money at risk, it's less likely that there are reasons other than financial gain to explain the purchase. Nevertheless, you should realize that executives are aware of the psychological impact that an insider purchase can have on outside shareholders. It's always possible that an executive's purchase may be an attempt to bolster confidence in the company.

When considering a new investment, it's easy to take a look at what company insiders are doing. Knowing whether insiders are buying or selling shares can be a useful way to confirm your investment decisions.

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If you want to know more about how Tom Gardner makes his Hidden Gems picks, all it takes is a click of your mouse. Your 30-day free trial will give you a chance to see everything that goes into this high-performing newsletter service. Check it out for yourself today.

Fool contributor Dan Caplinger watches the insiders quite closely, although he doesn't always agree with them. He doesn't own shares of any of the companies or ETFs mentioned in this article. The Fool's disclosure policy gives you the inside scoop.

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