"Insiders might sell their shares for any number of reasons, but they buy them for only one: they think the price will rise." -- Peter Lynch
Thanks to quick quips like the one above, insider buying is treated as a holy grail -- a signal from the heavens that a particular stock might be cheap. The logic follows that if insiders are buying (and with better information than outsiders have) then a stock is likely to rise in value.
But history is full of examples in which following insider buying would have sent investors on a wild ride of losses. Enron executives were buying right up until the company was exposed as a fraud. Tyco insiders bought the stock heavily, only to spend years in prison for crimes as substantial as grand larceny when it was revealed that the financials were overstated.
That's not to say that insider buying is indicative of fraud. Rather, that there are multiple reasons for insiders to buy their own stock. Sometimes, insider buying can be used as an inexpensive ploy for insiders to project confidence that all is well, even when it isn't.
Why insider ownership matters more
Many investors turn first to annual and quarterly reports to find good investments. While these financial documents are a valuable source of information, I think proxy filings are a better way to find truly great companies to invest in for the long haul.
Proxy filings are dense. They are often as long as a company's quarterly report, and often far more detailed. Inside, you'll find data on everything from key shareholder votes to compensation schemes and insider ownership of the company. And these filings are where you'll see what really incentivizes management.
All management teams know how they're paid. They know what metrics are most important to maximizing their compensation. And all of them will do what they can to maximize that compensation -- it's only human.
What you want as a stockholder is a management team that has an incentive to grow the value of a company. The management teams that have an incentive to grow the value of a business are the management teams that have the biggest vested interest in a company's value -- those that own the most stock.
It's all about behavior
Unfortunately, corporate managers usually have more to gain from their compensation than they do from their stock price. Thus, they're incentivized to swing for the fences with a company's capital, knowing that it's a "heads I win, tails I don't lose" situation.
If they produce big wins, that will be reflected in their bonus compensation. If they lose... well, they don't own enough stock to feel the pain.
The point of insider ownership is to get an idea of how much of every dollar a company has, and how much of every dollar it will earn over time, is owned by the management team. If a management team owns 10% of a company, it's unlikely that compensation will exclusively guide its decision making. Instead, executives will focus on what they can do to increase the value of the business, and thus the value of their ownership.
Perhaps more importantly, given that businesses are valued based on their potential over a period of decades, managers who own a large part of the companies they work for will have an incentive to make decisions that benefit their employer over the long haul. They won't, like most managers, seek only to make a single quarter or year look good. A single quarter or year doesn't define a company, but it can define a bonus.
While I would encourage every investor to mind their 10-Ks and 10-Qs, I'd also recommend they spend the time with DEF 14As -- the proxy filings that reveal how invested a management team really is in the company's long-term market value. Significant ownership promotes behavior over the long haul; compensation promotes behavior over an accounting period.