This Telling Figure Insinuates Big Pharma Could Be in Big Trouble

Since the stock market bottomed nearly six years ago, the broad-based S&P 500 has tripled in value. Yet, over this same time span the SPDR S&P Biotech ETF has shot higher by a whopping 357%, inclusive of dividends.

Why such a disparity? For starters, the S&P 500 is representative of all sectors, including high-growth sectors such as healthcare and technology, as well as traditionally slower growth sectors like consumer goods. Also, as the U.S. economy has turned around, we've observed investors' appetite for riskier investments growing. Biotech and pharmaceutical stocks tend to be largely valued based on the future prospects of their product portfolio and drug pipelines, so they're a perfect candidate to attract the attention of more aggressive investors in an expansionary environment.

But, could there be trouble brewing in Big Pharma paradise? Based on one indicator I follow on a regular basis, investors in Big Pharma might as well be walking on egg shells.

This indicator says Big Pharma is in big trouble
According to data from Yahoo! Finance over the trailing six-month period, here's a quick rundown on the total number of insider purchases and insider sales at 12 of the largest drug developers in the world by market value (the six largest foreign drug developers by market value were excluded, as data on insider transactions wasn't available).

Source: Yahoo! Finance, author's calculations. 

These 12 companies above represent nearly $1.6 trillion dollars in market value for the healthcare industry. They are healthcare titans that growth and income investors are likely to find in their retirement portfolios, and they're anchors for many healthcare-based ETFs. They're also overwhelmingly skewed toward insider sales rather than insider buys.

Source: Flickr user Insider Monkey.

As you'll note from the above data there were just two (seriously... two!) insider purchases over the trailing six-month period among these 12 industry stalwarts totaling a hair over 18,000 cumulative shares. By comparison, there were 60 times as many insiders selling stock in these companies, with 365 shares of stock being sold for every one share of stock being purchased by an insider. As you can see, the high-flying Gilead Sciences led to 48 insider sales and nearly 2.1 million shares being sold, while Eli Lilly's 20 insider sales accounted for nearly half of the 6.586 million shares collectively sold by insiders in these Big Pharma giants.

"Why does this matter?" you ask? I'd suggest that because insiders (i.e. a company's management team and directors of its board) have a better understanding of the health of their company than even the best Wall Street analysts, their lack of conviction to purchase shares on the open market is a signal to investors that their stock is either fairly valued or perhaps even overvalued. In other words, if the people that run these companies aren't confident enough to hold their own stock or buy more, what message is that sending to existing shareholders?

Keep these finer points in mind
However, I'd be remiss if I didn't mention that not all insider selling is necessarily bad. There can be reasons where insiders dispose of some of their shares for perfectly benign reasons.

For starters, some insiders sell stock to pay their taxes. During the course of the year executives and directors may receive shares of common stock as part of their compensation. As you might imagine, earning multi-millions of dollars each year can result in a pretty enormous tax bill. Some insiders simply don't have enough disposable cash lying around to pay their tax bills, so they'll sell common stock in order to raise cash to cover their estimated taxes.

Source: Flickr user Thetaxhaven.

Another benign reason insiders will sell stock: to diversify their wealth. Keep in mind that some insiders may hold a very large percentage of their wealth in the company they work for or founded. While that does have a tendency to align their interests with investors, it's rarely/never prudent to put all of your eggs in one basket. Therefore, it's not uncommon to see regular sales of stock by insiders in order to help diversify their own portfolio of assets.

Lastly, investors should take into consideration that insiders may simply be exercising options which are about to expire and then selling those shares on the open market. Executing an options contract and then selling those shares isn't necessarily a vote against a company's future so much as a way of ensuring the options don't expire worthless.

So which is it?
By now you're probably wondering which is it: is Big Pharma in trouble or are these insider sales largely benign?

My suspicion is that it's a bit of both. If you look at Gilead Sciences' insider track record, the selling almost always takes place on the first or second of every month. What this tells me is that these are programmed sales, probably inputted at the beginning of the year by insiders, and that they have next to nothing to do with management believing any less in Gilead's ability to succeed over the long-term.

Source: Flickr user Hobvias Sudoneighm.

By a similar token, Eli Lilly's shares disposals come almost entirely at the hand of the Lilly Endowment. In April 2014 the Lilly Endowment began selling shares of Eli Lilly stock for the first time in six years in order to diversify its assets. For decades, the Endowment's sole holding was Eli Lilly shares, which today sort of seems scary. In this instance, the Endowment isn't running away from Eli Lilly with its tail tucked between its legs. Instead, it's merely trying to diversify its holdings. 

Then again, the lack of insider buying tells a completely different story. It signals to me that at least some of the shares being sold probably are due to valuation. The lack of insider purchases is also a warning that executives may simply not see much in the way of value after a nearly six-year bull market.

Keep in mind that insider buying and selling statistics alone shouldn't be the sole determinant of whether you buy or sell a stock. But, keeping an eye on these figures, as well as making an educated guess as to why insiders are shuffling into or out of a stock, could help you gain a step on other investors.

Based on this data I'm admittedly growing skeptical of Big Pharma valuations and would suggest that upside, at least in 2015, may be limited.