The more I talk to Fool co-founder Tom Gardner, the more I hear about the importance of insider ownership. Tom is a self-described "Peter Lynch disciple," so that's not really a surprise. After all, Lynch's seminal One Up on Wall Street, a bible for individual investors, says that "When management owns stock, then rewarding shareholders becomes a first priority."

Simply put, there are many factors that correlate with insider ownership that benefit outside shareholders like you and me. Most important, insider ownership is indicative of:

  1. CEO tenure that is much longer than today's average of just five years.
  2. Companies with a name and reputation to uphold.
  3. Companies focused on long-term success.

Did we really need a study to prove that?
A recent New York Times article by Mark Hulbert -- editor of The Hulbert Financial Digest -- reported a study that proves aggressive insider buying is one of the best indicators of a stock poised to outperform the market. The study (available by clicking here) also proves that insiders are smarter than analysts, particularly when analysts are bearish and insiders are bullish.

And if you think that tracking insider buys could be a career in itself, consider that insider sellers currently overwhelm insider buyers, according to The Dallas Morning News (registration required). Sellers sold approximately $46 for every $1 of buys in November 2004.

What's inside pays
Lynch once wrote, "There's no better tip-off to the probable success of a stock than that people in the company are putting their own money into it." Why? Because board members and company officers are truly partners in the business in which they are investing. They know about operations, long-term risks, and potential long-term rewards. These qualitative factors just aren't discernible by price-to-earnings or price-to-book ratios, return on equity (ROE), the 200-day moving average, or any of the other analyst metrics.

According to the study, "Insiders in aggregate buy more shares when their firm's stock is downgraded or unfavorably recommended by analysts than when it is upgraded or favorably recommended." That's the essence of contrarian investing, and it's the method behind the madness of Warren Buffett and Charlie Munger -- investors who are almost wealthy beyond comprehension.

To wit: Consider that insiders at Ameritrade (NASDAQ:AMTD) and Agilent (NYSE:A) were snapping up shares of their companies when both were out of favor back in 2001 and 2002, respectively. But the insiders saw the bright futures ahead of these companies when no one else did. Ameritrade is up nearly 250% since the end of 2001 and Agilent is up nearly 200% since the end of 2002.

Use the SEC cheat sheet
So how does Joe Fool track insider buying? One way is Form 4, the SEC filing that all insiders and major shareholders must use to report changes in beneficial ownership. As for which company insiders are buying now, consider these candidates:

Company Insider buy transactions* Insider shares net gain*
Midway (NYSE:MWY) 130 10.3%
Global Signal (NYSE:GSL) 13 15.8%
Ark Restaurants (NASDAQ:ARKR) 16 4.8%
United Industrial (NYSE:UIC) 13 4.2%
RedEnvelope (NASDAQ:REDE) 15 5.7%
*Past six months. Data provided by Capital IQ.

All five of these stocks have swooned recently, and Global Signal and RedEnvelope have each been downgraded by analysts in the past six months. The situation at online gift retailer RedEnvelope is particularly interesting. The bulk of the buying is being done by Scott Galloway, the company's co-founder and now dissident shareholder. Moreover, the company has had a disappointing year and delayed its regulatory filing in July to review accounts payable.

Yet Tom Gardner, who heads up the Motley Fool Hidden Gems newsletter service, once thought highly enough of this business to recommend it to subscribers. And although the investment has been disappointing to date -- down some 15% -- Tom is holding and recent events make this an interesting proposition.

The tricks of insider trades
Unfortunately, following insiders to profits isn't as simple as running a rudimentary screen and firing up the money machine. A few types of insider "buys" are not necessarily votes of confidence.

First, watch out for insider buys that are actually options exercises. These folks may be buying shares at a deep discount. Second, watch for insider buys where the purchase funds were actually loaned by the company. Although this sounds ridiculous, it happens more than you might think. Finally, always beware the double-edged sword that is insider ownership. When you own a small part of a company that is mostly owned by insiders, you depend on their good governance to protect your interests since you are unable to counter their whims with a shareholder vote.

That edge recently cut Tom and fellow analyst Bill Mann at Hidden Gems. Fight as they did, they were unable to stop Saucony from agreeing to be acquired by Stride Rite. While subscribers still more than doubled their money, Tom and Bill continue to aver that Saucony was a winner taken from them in its prime.

Foolish final thoughts
Insider buying is one rough screen the Hidden Gems team uses to identify small cap opportunities. If you need to wade through more than two pages of Form 4 sells before you hit a 10-Q, walk away. On the other hand, if you've got two pages worth of buys before you hit a 10-Q, start your due diligence! All in all, the practice makes a great complement to the six criteria that define the Hidden Gems strategy:

  1. Founders with large personal stakes.
  2. Easy-to-understand financial statements.
  3. A solid asset base with little or no debt.
  4. Price ratios that significantly undershoot growth rates of free cash flow.
  5. Dominant positioning in a profitable niche.
  6. Plenty of room to grow.

That's truly a recipe for success. To date, the team has posted 25% average returns and has outperformed the S&P 500 by 18 percentage points. To view their more than 40 recommendations, read hundreds of pages of buy reports, and interact with thousands of investors who are following the active picks, click here to take a 30-day free trial. You'll also have access to the brand-new six-month review, which identifies the two best picks for new money now. All that, and there's never an obligation to subscribe.

Tim Hanson owns none of the companies mentioned in this article. At The Fool, no writer is too cool for disclosure ... and Tim's pretty darn cool.