Making Sense of the Insider Sell

Savvy investors love to see executives holding and buying large amounts of their own company's stock. It signals faith in an investment about which an executive knows a lot: his own company.

On the other hand, when an investor sees a company selling off shares, some see it as a harbinger of doom. But few take the time to understand what may be motivating a sale and how that might affect the performance of the company in the future.

Not all insider sales are alike
A 2004 study by Prudential's James Scott and Peter Xu entitled "Some Insider Sales Are Positive Signals" offers a novel approach to looking at what exactly may be behind a sale and what it might reveal about the company's future. The two researchers propose that sales of a small percentage of total ownership present a very different signal than sales of high percentages of ownership. That's because, in their opinion, small sales of ownership -- on a percentage basis -- are likely motivated by interests of personal diversification for the executive or for purposes of liquidity.

This stands in stark contrast to what we commonly believe to be the reasoning behind an insider sale: that is the unique knowledge of a future problem. The two surmise that when an insider has come across information that may lead to poor future performance, these individuals tend to sell a higher percentage of their stake in the company. ImClone's (NASDAQ:IMCL) staggering insider sell-off before its crash in late 2001 is a perfect example.

The reality is more complex
Scott and Xu studied thousands of companies and thousands more insider trades from 1987 to 2002 and compared future stock performance against different types of trades. As suspected, sells that were a high portion of ownership (i.e., the ones that suggested that the executive knew something) revealed a future of negative performance. No newsflash there.

But here's where it gets interesting: Sales that were a small percentage (i.e., those based on non-informational motives) correlated with superior future performance.

Why? Scott and Xu theorize that any insider who is selling a small percentage is only selling exactly what they need to in order to fund whatever it is they want to fund. But because they're only selling a small percentage of their stake, it means that they suspect the rest of the holding will continue to rise. And that makes sense. If they thought the stock was dead money, they'd sell most -- if not all -- of it.

Who's selling small?
While we can quibble with the line between a "big sale" and a "small sale," the study is certainly worth thinking about. After all, if we know anything about corporate insiders, it's that they're always acting in their best interest.

So I know you're dying to know companies with insiders who are selling small portions of their holdings:

Obviously, I don't recommend an investment purely on the data of this screen. But knowing the results of Scott and Xu's study, these results make me reassess my view of how insiders at these companies see their futures.

Bringing it full circle
A high percentage of insider ownership is one of the key criteria behind Tom Gardner's Motley Fool Hidden Gems small-cap stock picking service. Part of his fundamental investment thesis looks for executives who are making (and keeping) sound financial commitments in their own companies. And it's a strategy that's working -- Hidden Gems picks are beating the market by nearly 30 percentage points on average.

But as Scott and Xu prove, tracking insider transactions isn't necessarily as straightforward as it seems. If you'd like to learn more about the importance of insider ownership and what it can mean for your portfolio, click here to join Hidden Gems free for 30 days. There is no obligation to subscribe.

Fool analyst Nick Kapur owns no shares of any company mentioned above. Netflix is a Motley Fool Stock Advisor recommendation. Eli Lilly is an Income Investor recommendation. The Fool has a disclosure policy.