The Best "Buy Signal" Out There

There's one buy signal out there that's so strong that sometimes people go to jail because of it.

When insiders (i.e., the CEO, CFO, et al.) buy stock in their own company, they have to be very, very careful ... or risk doing hard time.

And for good reason.

Would you want to be on the other side of a trade with a CEO who secretly knows his company's being bought out in a week?

Me neither.

This information advantage is why insider buying (of the legal variety) is one of the most followed buy signals out there.

But can it make us money?
On the face of it, buying stocks after insiders buy in makes some sense.

Let's remember that even though insiders aren't allowed to trade on material non-public information (like my previous merger example), they are still the folks who set the direction of the business, have access to all the detailed performance reports, and are literally on-site, seeing the operations on a daily basis.

Fortunately, to level the playing field, the Securities and Exchange Commission makes insiders report their trades within two business days.

And using this information, many investors attempt to juice their own returns. Let's put some data behind this to see if they're being smart.

University of Michigan professor H. Nejat Seyhun studied the performance of insider buys from 1975 to 2008. Specifically, he looked at stock performance for 50 days after purchase.

His conclusion? Yes, insiders do indeed beat the market.

In his most recent 10-year period of study (ending 2008), he noted that insider buys enjoy a 3.3-percentage-point advantage over the market.

So why not just follow the insiders?
Those three percentage points may not sound like much, but beating the market by three percentage points over two or three decades makes you one of the greatest investors who ever lived.

You may have already noticed the big problem, though. The period of outperformance is just 50 days -- less than two months.

Quite frankly, that's not impressive at all. There's a better way. Compare that 3.3-percentage-point advantage to the volatility of individual stocks over the course of a year.

Here are the price movements of the five least volatile stocks on the S&P 500 over the course of the last year:

Source: Yahoo! Finance.

If you're paying attention, you're starting to get the idea. But let me hammer this home for you. Check out the S&P 500's five most volatile stocks:

Source: Yahoo! Finance.

You're starting to see why I consider that 3.3-percentage-point advantage the equivalent of a five-second head start at the beginning of a marathon. If we're betting on the outcome of the race, I'd rather spend my time figuring out who the best runners are than figuring out who got the five-second head start and who didn't.

How to find the best runners
All that said, seeing what the insiders are doing isn't completely useless. Remember, I said there was a better way. In fact, Motley Fool co-founder Tom Gardner has said that if you gave him just one metric by which to judge a company, he'd actually go with insider ownership over anything else.

If that sounds contrary to what I wrote earlier, read that again, carefully. Tom's not saying he'd follow daily, weekly, or 50-day buy signals. Rather, he wants to know what percentage of the company is owned, right now, by the people who run the company. Why? Because a management team that doesn't have significant ownership in its company treats that company like a driver treats a rental car.

Insider ownership isn't a guarantee for success, but it's a promising sign. In the ultimate example, the founder still runs and owns a good portion of the company.

When Jim Sinegal, the co-founder and CEO of Costco (Nasdaq: COST), visited Motley Fool's offices, I was struck by his passion for his business. He could seamlessly move from the big picture to the tiniest details of his operation, at one point answering a very specific question on diaper prices. His identity is this business he's created from the ground up. When that's the case, you feel really secure as a shareholder.

It's not just him, either. Sticking with the retail space, John Mackey of Whole Foods (Nasdaq: WFMI) and Kip Tindell of The Container Store exhibited that same ownership passion when we talked to them.

The market-beating power of insider ownership
So it's not surprising that The Motley Fool's own co-founding brothers, Tom and David Gardner, have recommended both Costco and Whole Foods in their Stock Advisor newsletter (The Container Store isn't publicly traded). You shouldn't just blindly buy into companies with high insider ownership, though. Tom and David think you should go further and look at the potential for growth, the strength of the balance sheet, and competitive advantages. In Costco's case, its membership model allows it to lower its prices to levels that pain its competition; as for Whole Foods, it's the premier brand in the organic foods movement.

I invite you to join Tom and David in hunting down the companies with strong ownership cultures by taking a free 30-day trial to Stock Advisor. Since they started their hunt in 2002, they've beaten the market by 60 percentage points per pick. Click here to join us.