In today's modern world, investors are armed with an abundance of tools designed to assist them with financial analysis and investment decisions. One such tool that often goes overlooked is the evaluation of insider trading patterns. By that, I'm referring not to stock trades made by unscrupulous people who attempt to exploit non-public information, but instead to legitimate transactions made by corporate executives, or insiders.

What is Insider Training?

Let's begin with some basic definitions. The Securities and Exchange Commission (SEC) has characterized insiders as either a company's officers or directors, or outside shareholders who own more than 10% of the firm's outstanding shares. These large shareholders are typically institutional owners, such as mutual funds, endowments, pensions, or hedge funds. The SEC has established strict rules that govern insider trading activity among this group of investors. Among other things, these regulations stipulate that all insider stock trades must be reported in a timely manner.

Because they tend to be completely immersed in their company's day-to-day operations, corporate insiders often have intimate first-hand knowledge of their firm's financial performance. As such, if many of these corporate insiders are buying large blocks of shares in their own company on the open market, then that could serve as a positive signal that they believe their stock is undervalued. Alternatively, if a large number of corporate insiders are selling their company's stock, then that could serve as an early warning sign of potential trouble ahead.

As a general rule, it's always best to know a company inside and out before becoming a part owner. A diligent investor should have a firm grasp on all aspects of a company's operations -- its customers, its suppliers, its competitive advantages, its potential weaknesses, etc. However, no matter how many hours of research you devote to the study of a particular company, the bottom line is that you are unlikely to truly understand a firm as well as its top executives. After all, these corporate insiders usually have access to a large amount of private sales data and are regularly involved in all aspects of the company's operations.

Why is Insider Trading Important to Analyze?

When it comes to investing in their own company's shares, these insiders are no different than you and I -- it is in their best financial interest to buy low and sell high. With this in mind, insider purchases and sales can often provide important clues as to whether a particular company is performing well or is perhaps headed for hard times.

A host of market research has proven that insider trading patterns can indeed provide important clues about which direction a stock is headed in the coming months and years. A number of studies have demonstrated this by looking back at years of historical stock price data and discovering that upward price movements were often preceded by strong insider buying, and vice-versa. For example, a recent academic study demonstrated that stocks perform far better in the subsequent months after seeing a significant amount of insider buying.

Are Insider Trading Patterns Always Correct in Predicting Future Share Price Movements?

Although it can often provide us with important clues, insider trading activity is by no means a perfect predictor of future share price movements. After all, in some cases insider trades can have little predictive value. For example, a CEO may simply need to unload shares in his/her company to purchase a new home or to fund a college education. This should not be interpreted as a lack of faith on his/her part in the company's future prospects. Also, given that most insiders are already heavily invested in their firm's shares, stock sales are far more common than purchases. As such, they provide less insight into a company's operations. Finally, it is possible for a stock to move in the opposite direction from what insiders are predicting. Even knowledgeable executives can and do overestimate or underestimate their firm's business outlook.

Factors Insiders Look For

Nevertheless, investors should put some credence in the behavior of a company's insiders, as their purchase and sale patterns have been shown to have strong predictive value. With that in mind, investors need to understand how to analyze insider activity by paying particular attention to the following factors.

Size of the purchase or sale: A block of 10,000 shares may seem large to you and I, but it can be a relatively insignificant amount for an executive who owns 10 million shares. Therefore, when analyzing a particular trade, be sure to place the size of that trade in the proper context. The dollar or share amount in question should always be measured against the insider's current total holdings, and also compared to the size of previous purchases or sales made by that same person. For example, if an insider who routinely sells 1% of his/her total stake every now and then suddenly sells off 25% of his/her holdings, then that could represent a possible red flag that the company is headed for trouble.

It stands to reason that larger trades are placed with more confidence than smaller ones, and are therefore more revealing. If an executive is willing to invest a substantial amount of his/her annual salary in one large trade (or a series of trades), then this likely indicates greater optimism than a much smaller trade would imply. Market studies have confirmed the validity of this theory.

However, this knowledge is only useful up to a certain point. Extremely large transactions are likely to garner media attention, and this can often have a dramatic impact on share prices. If price fluctuations already reflect the insider activity, then the potential benefit of that insider information is already likely to have been lost.

Identity of the insider: When looking at insider transactions, remember that some shareholders' decisions should carry more weight than others. For example, the trades placed by key officers such as CEOs, CFOs, and COOs are often the most telling. Meanwhile, those made by large institutional owners often have the least predictive value.

Obviously, a company's officers will usually have a deeper understanding of their firm's future direction. Not only will they possess better and more detailed information than the general public, but they should also have a better ability to analyze and draw more accurate conclusions from that data. By contrast, insiders that are not employees of the firm (such as institutional owners) merely have access to the same data that is available to the public. This may explain why the buying patterns of these insiders are less powerful in predicting a stock's future direction, particularly when compared to the firm's officers. Studies have concluded that investors should scrutinize the trades made by a company's top executives and place less emphasis on trades placed by large shareholders.

Size of the company: Larger firms are typically followed by a group of equity analysts who monitor the company's every move. As such, the general public usually stays well informed about the financial health and growth prospects of large-cap firms. By contrast, smaller companies are usually not placed under the microscope of the analyst community. In addition, there is generally much less public information available on these smaller firms. With less data to assess the health of smaller companies, the decisions made by their insiders should obviously be watched more carefully.

With this in mind, the insider trading activity for a relatively small firm can prove to be much more useful in predicting the future direction of both the company and its share price. As a rule, smaller firms with positive insider activity tend to outperform larger firms in the same situation.

Consensus among insiders: Sometimes, one insider may be selling while another is buying. In this scenario, it can be difficult to ascertain what the company's leaders are thinking. Therefore, it is always important to search for consensus among a group of insiders. One insider sale may not be very predictive, but if several insiders are moving in the same direction -- either buying or selling -- then that may be quite reflective of what's happening at the company. However, it is worth noting that new board members or officers are often required to purchase company stock. Obviously, these types of transactions contain no useful information and should be dismissed.
Sometimes, the lack of insider trading can be a positive sign in and of itself. In many cases, corporate executives already hold a sizeable stake in their company and will refrain from purchasing additional shares even if they have a very upbeat outlook. In these cases, a lack of corporate insider sales can be viewed as positive, particularly when it comes to stocks that have already risen dramatically in price.

Putting it all Together

Before I continue, here is a quick recap of what I have discussed so far:
-- Stocks often perform better following a large amount of insider buying.
-- The activity of a company's officers is more instructive than that of other insiders.
-- The smaller the company, the more predictive its insider activity.
-- If several insiders are moving in the same direction, then this should be considered more revealing than the activity of a single insider.
-- Sales are more common than purchases and provide less insight into a company's operations.
-- Larger trades should be given more credence than smaller ones.
-- Inactivity should be taken as a positive sign when a stock is rising.

When all of these factors are carefully considered, insider trading activity can provide a window for investors to view how bullish a company's top managers are. However, even if you and the inner circle both reach the same conclusion, it may still take a while for all the pieces to fall in place.

Patience in Critical

Throughout my investing career, some of my most profitable investments did not materialize until after I had taken a second or third position in a stock (in some cases after it had dropped significantly from my original entry point). On that note, if you find a company attractive at a certain level, then it should only look better after a 30% drop -- assuming, of course, there have been no significant changes in the firm's underlying fundamentals and insiders have kept from selling. In that case, it may make sense to add to your original position, thereby reducing your cost basis and increasing your chances of earning a spectacular return.

It may take considerable time for a company's true value to be unlocked, during which time you may feel a little foolish. Above all, though, value investors must trust their instincts and be patient. Wait until a stock reaches its fair value before you sell, and along the way be sure to practice good money management techniques. The behavior of irrational investors is often what causes stocks to become undervalued in the short term. Exploit their mistakes, and never let misplaced emotion impact your own bottom-line results.