Investing Hacks: Should You Follow Insider Trades?

If you think about it, Financial independence is really just a life-hack.  A really cool life-hack.  It might even be the ultimate life-hack.

Life hacks, to put it simply, are popular.  Every blogger loves to write about them.  There’s been countless posts devoted to saving time, saving money, and making your life a little better.  And that’s fantastic because a few of them actually work!

But not all of them.

If there’s a category of ‘hacks’ I think gets too little attention, it’s investing hacks!  After all, there’s two pieces of the puzzle that need to fit together before you can reach financial independence — Saving AND Investing.

Probably the most touted investing hack in history is index investing.  That one has gotten a lot of press (for good reason), and it’s made investing way more accessible to the layman.  Everyone’s doing it ‘yo!

But it’s not the end-all-be-all of investing hacks.  There are in fact other investing hacks that exist!

Today, I’m going to discuss one of the oldest investing hacks ever… and I’ll finally revisit the story about why I bought that First Industrial 9-bagger.

The Theory

One the oldest investing hacks of all time is “following insider trades”.  It’s been around since the beginning of public capital markets… but what exactly is it?

The idea is quite simple really — you invest when certain investors called ‘insiders‘ also invest.  When they buy, you buy.  When they sell, you sell.

This is the investing equivalent of looking over the shoulder of “the smart kid” during a school exam.  If you follow along with insider’s moves, the idea is you’re bound to do pretty well.

Insiders are the executives, officers, and directors of a company.  The individuals with enough power, position, and information to presumably make very informed investment decisions.

In theory,  insiders will make better investments in company stock because of their unique ‘inside’ knowledge.

In the U.S., these ‘insider trades’ can be tracked via SEC form 4 filings.  Use that SEC link to search for Form 4 filings in your favorite public companies.  Be certain to click on the “Include” checkbox under the Ownership filter.

The Form 4 document is required to be filed with the SEC a few days after an insider makes a trade.  Just by watching these filings with regularity, we can get a very clear picture of how company insiders are trading company shares.

Sounds like a cool investing hack, right?

That’s the theory… but as I’m often fond of saying: Theory and Reality are two entirely different things.

Wrinkle #1: Securities Laws

Turns out there’s a wrinkle in this investing hack — Securities laws in many countries prohibit insiders from trading on ‘secret’ information.  Executives are not legally allowed to trade shares based upon non-public information.  It’s fraud and a breach of fiduciary duty to shareholders.  Insiders can face both civil and criminal penalties if they’re caught doing it.

However, in practice it might still be happening — Just recently I saw a news report that Intel CEO Brian Krzanich sold $11 million in shares before the Meltdown and Spectre CPU bugs were publicly disclosed.

Hmm… if that transaction was yesterday’s fridge leftovers, it would definitely smell funny.  Did he violate securities laws?  It’s hard to say, but at some point I think the courts are going to decide.  It definitely looks bad.

My point is — insider trading probably still goes on, but it’s often quite subtle.  One frequently used trick to get around these security laws are automated trading rules.  These rules are setup in advance and cause the buying or selling shares without direct insider control.

This isn’t quite as fast as selling shares when you find out there’s a massive bug in your company’s computer chips, but it will probably keep you out of jail.

Wrinkle #2: Taken Out Of Context

The problem with most insider trades is that we lack context for what the insider is doing.  The executive could be selling shares to buy a new yacht for Christmas, or buying that island in the Bahamas.  Or he/she could be dumping shares because they have no faith in the company.

Without context we just don’t know the real reason why an insider might be selling.  There’s plenty of legitimate reasons why an insider could sell shares in his company — one of the most important of which is portfolio diversification.

When you work at a public company, do you put your entire net worth into the shares?  No, probably not.  More than likely you own a few shares of your employer, but you also diversify your holdings into other investments.

It stands to reason that insiders do the exact same thing. 

This reasoning covers most insider sales, but what about insider buys?  That’s a very different story!

When an insider puts his own personal cash into company shares, there’s only one reason why he might do it — To make money.

(Sticklers will point out there’s one other possible reason why an insider buys — Many company bylaws now require executives to own a certain number of shares.  A newly appointed executive or company director might need to buy shares to meet those requirements.  Technically though, they’re still buying shares to ‘make money’.)

Unfortunately, true insider buys where an executive uses personal cash is quite rare.

Wrinkle #3: Just Employees

Sadly, many insiders are only only token owners of company stock.  They might only maintain a million dollars in shares, but their actual salary is in the tens of millions and private net worth is in the hundreds of millions.

That’s what I call not-significant.  This is the difference between an owner and a employee.  Many executives today are merely employees.  They are there for the salary, and are not large owners of the company.  Often times CEO’s hold considerably less than 1% of a company’s shares.

This leads to another wrinkle in the insider invest hack — You don’t want to be following the trades of an executive with very little “skin in the game”.

These days, insiders very rarely hold a significant number of company shares.

Instead, they work for shares in the form of stock compensation plans.  This is the most common way executives acquire company shares — as part of annual grants or stock option plans.  This way they avoid entanglement with securities laws, and can frequently “buy” shares at a significant discount to market price.

Rarely do these compensation plans lead to significant (10%+) ownership in company shares — The options are executed and shares are sold almost immediately.

A Counter Example: My FR Story

So now that I’ve totally poo-poo’ed on this idea of investing with insiders, I’m going to give a counterexample from my own portfolio.  A time when watching insiders actually worked out really really well.

Back in December, I wrote the first part of this story in my post entitled “Let Your Best Investments Run“.  I was buying up shares of First Industrial Real Estate Trust  back in 2009, at very cheap prices.  This was during the height of the Great Recession, and I rode those shares to nearly a 900% return.

The part I didn’t tell you was why I had the confidence to quadruple-down on a stock that was falling like a skydiver without a parachute.

I was watching company insiders, and one insider in particular — Jay Shidler.

Don’t worry, you’ve probably never heard of Shidler or The Shidler Group before.  Nor have you probably heard of the five public companies he’s spun-off from the Shidler Group.  The man is practically a legend in the Hawaii real estate community, and is known for making shrewd real estate investments.

The University of Hawaii’s Business School is named for Shidler, and he’s often listed as the richest resident of Hawaii.  But hardly anybody has heard of him.

Usually guys like this sell shares to the public when their companies IPO, but here he was buying millions of shares on the open market during the Great Recession.  Essentially buying up real estate for pennies on the dollar.

I paid attention.

Over the span of a few months in early 2009, Shidler purchased nearly 4 million shares of FR at prices ranging from $2-$10.  One particular transaction of his made me sit-up straight and go “Oh damn!  This is the time to buy!”

So I did.  If anyone could save the troubled company from death, it was going to be him.

Let me be very clear though — situations like this are exceedingly rare.  Most of the time I completely discount minor stock transactions from company insiders.

Why?  This is what I call Wrinkle #4:  Most insiders are NOT good investors.

They might have inside information, but insiders are human too.  Most of the time they’re not any better at investing than the rest of us hopeless schmucks.  They sell at the wrong times, and succumb to market emotion just like any other retail investor.

It’s only the very rare bird that’s a true investor.  When they sing, pay attention.

Conclusion

So, do I use this classic investing hack and follow insider trades?  No, not really.  Only once in a blue moon do I see something interesting happening.  It’s quite rare.

While I do watch the insider trades of companies I’m interested in, most of the time it’s useless information.  I prefer to make certain insiders have the right incentives.  It’s a far more reliable indicator of future performance.

Don’t get me wrong, the theory behind the insider investing hack is a good one.  In practice though, there are far too many issues with it to be useful with any frequency or regularity.

It might have worked well at one time (before insider trading laws existed), but today insiders rarely trade shares on the open market.  Most of their money is made in other ways — Salary, stock options, and compensation plans.

That’s probably a really big hint about what matters most to insiders.

Have you ever invested with insiders and realized amazing profits?  Please share your experiences in the comments!

[Image Credit: Flickr1, Flickr2]