Tracking the Smart Money: Screening for Insider Activity

    by Wayne A. Thorp

    One popular indicator used to gauge a stock's potential is insider buying activity.

    The logic is appealing—who else would better know the future prospects of the company and how this may impact future stock price movements? Insiders are privy to information regarding new products, competition, and operating environment, oftentimes long before the companies become large.

    On the other hand, studies have shown that insiders have been able to outperform the market on their buys, but not on their sells.

    Why would buys be more significant?

    Insiders sell shares for a variety of reasons including estate planning, portfolio diversification, paying taxes, or funding a college education or a new roof. Insider sales also occur routinely—insiders normally sell two to three shares for each share purchased.

    On the other hand, insiders typically buy their shares on the open market for one reason—the stock is a good buy!

    Who Is an Insider?

    In legal terms, the Securities Exchange Act of 1934 defines an insider as:

    • An officer or director of a public company, or
    • An individual or an entity owning 10% or more of any class of a company's shares.
    Thus, the term "insider" refers to a wide-ranging number of people including: large shareholders, directors, and company officers.

    Large shareholders, or "beneficial owners" as they are sometimes termed, are those persons or entities that own more than 10% of a class of a company's stock. Although they are insiders in the legal sense, they are not privy to the same kind of information that top-level employees of the company have access to.

    • Market capitalization for the last fiscal quarter (Q1) is between $50 million and $1 billion;

    • Companies traded on the over-the-counter (OTC) market are excluded;

    • Companies in the miscellaneous financial services and real estate operations industries are excluded;

    • At least three insiders have purchased shares over the last six months;

    • The number of net shares purchased (shares purchased minus shares sold) by insiders over the last six months is greater than zero;

    • Insiders have placed more buy trades than sell trades over the last six months;

    • The 30 companies with the highest net number of shares purchased by insiders over the last six months as a percentage of the total number of shares outstanding are included in the final results.

    Directors are members of a company's board of directors.

    Officers are those individuals at a company occupying the highest positions—CEO, chief financial officer, president, vice president, and others.

    Insider Responsibilities

    As Martha Stewart recently illustrated, "insider trading" carries with it a negative connotation. Under the securities laws, it is illegal to buy or sell the stock of a company based on material, non-public information; this type of trading is often referred to as insider trading.

    On the other hand, trading by insiders based on non-privileged information is legal, albeit highly regulated by the government.

    Insiders are required to report their transactions in company shares to the Securities and Exchange Commission (SEC). These filings [see box] are usually done electronically via the SEC's EDGAR system. In addition, the 2002 passage of the Sarbanes-Oxley Act requires insiders to file relevant filings on a timelier basis.

    Insider Screen

    It would be foolish to base your buy and sell decisions solely on insider data. However, before you buy or sell a stock, it may be useful to see what the smart money is up to.

    Stock Investor Pro—AAII's fundamental stock screening program and research database—includes a built-in screen that focuses on insider buying activity by looking for smaller companies with a minimum level of insider buying that also exceeds the level of insider selling.

    Figure 1.
    Insider Buys
    Screen Performance

    The companies passing the insider buys screen have been reported and tracked on the AAII Web site since January of 1999, with mixed results.

    Figure 1 shows that those companies passing the insider buys screen have managed to outperform large stocks (as represented by the S&P 500 index) since January of 1999. However, they have lagged the performance of the MidCap 400 and SmallCap 600 indexes over the same period.

    Overall, the insider buys screen has generated a cumulative return of 42.8% over the period January 1999 through June 2004. The screen's positive performance over the period is due largely to the 86.8% gain it generated in 2003. Without it, the screen would have lost 23.6%.

    Portfolio Characteristics
    The characteristics of the stocks passing the insider buys screen are presented in Table 1. Table 2 shows the 30 companies passing the screen as of July 2, 2004, that have the highest net number of insider buys as a percentage of shares outstanding.

    The median price-earnings ratio for companies passing the insider buys screen is 29.9, significantly higher than the 20.2 for exchange-listed stocks. However, only four of the 30 companies have a price-earnings ratio that was calculable; the other 26 all had negative earnings for the trailing 12 months. This provides an indication of the riskiness of this group of companies.

    TABLE 1. Insider Buys Screen Portfolio Characteristics
    Portfolio Characteristics Insider
    Price-earnings ratio 29.9 20.2
    Price-to-book-value ratio 2.4 2.1
    EPS growth rate (hist 5 yr) -0.8% 7.80%
    EPS growth rate (est 3-5 yr) 22.50% 14.60%
    Market cap (million) $156.60 $354.80
    Relative strength vs. S&P 500 -2.0% 9.00%
    Monthly Observations
    Average no. of passing companies 26  
    Highest no. of passing companies 23
    Lowest no. of passing companies 30
    Monthly turnover 31%

    In order to be considered for the insider buys screen, a company must have a market capitalization (stock price multiplied by shares outstanding) of between $50 million and $1 billion. Overall, the companies passing the screen lie at the lower end of that spectrum, as the median market capitalization for the group is $156.6 million. In comparison, these companies are dwarfed by the typical exchange-listed stock, with a median market cap of $354.8 million.

    In a typical stock screen, there will be criteria that impose some minimum of financial strength—growth in earnings or sales, debt levels that are low relative to some historical or industry benchmark, for example.

    However, beyond looking for smaller companies, the insider buys screen only concerns itself with the level of insider buying that has taken place. There are no qualifying screens for financial strength or liquidity.

    As a result, in this group we find companies short on positive earnings and institutional following. Those companies passing the insider buys screen have a median five-year decline in earnings of 0.8%. The median earnings growth for exchange-listed stocks is 7.8%. Only 19 of the 30 companies have been in existence long enough to have a five-year earnings growth rate, an indication that many of the stocks passing the screen have only recently come into being.

    Insiders are required to report their transactions in the company's shares to the SEC. They become public information and are available on the Web at These include Forms 3, 4, 5, 144, and Schedule 13D. The forms that tell you the most about an insider's intentions are Forms 4 and 144, which reflect actual purchases and sales (Form 4) and intentions to sell (Form 144). Here is a brief description of the forms:
    • Form 3 is the Initial Statement of Ownership, which must be filed when an individual attains insider status in a company, even if the individual does not own any stock in the company at that time. It must be filed within 10 days of the company going public, and/or within 10 days of an insider being appointed an executive officer or director. Additionally, Form 3 is filed for anyone attaining a 10% or more holding of a stock's outstanding shares.

    • Form 4 indicates a change in share ownership. This may include purchase or sale on the open market, granting of stock options or the exercise of stock options. Under the Sarbanes-Oxley Act of 2002, a Form 4 must now be filed electronically via EDGAR within two days of each transaction.

    • Form 5 is the Annual Statement of Change in Beneficial Ownership. Activity listed on this report includes "exempt" transactions not required on a Form 4. It must be filed within 90 days of a firm's fiscal year-end.

    • Form 144 must be filed by anyone, whether or not they are an insider, who intends to sell restricted or unregistered stock. It provides notice of intent to sell more than 500 shares or $10,000 worth of securities within the next 90 days. Form 144 shows only intent and does not obligate the seller to complete the sale. Restricted stock is awarded or acquired from the issuing corporation, and is usually granted as part of an executive's compensation package. Private investors may also receive restricted stock through a private placement. Such securities are generally unregistered, meaning the shares have not been approved by the SEC for sale on the open market. Filing a Form 144 is part of the process of removing this restriction. It must be filed on or before the actual sale date, but does not show the actual sell transactions. If and when the securities are actually sold, a Form 4 must be filed. In practice, Form 144 and Form 4 are often filed simultaneously.

    • Schedule 13D outlines the activities of those persons or entities that hold more than 5% of the outstanding shares of a class of a company's securities. If an individual or entity acquires more than 5%, a 13D must be filed within 10 days.

    In terms of estimated growth prospects, the future for these companies appears to be brighter. The median estimated earnings growth rate is 22.5%, compared to 14.6% for exchange-listed stocks. Tempering this, however, is the fact that only four of the 30 companies have analyst coverage. Because the screen limits itself to companies with market capitalizations of $50 million to $1 billion, it is not surprising that many of them have not garnered analyst attention. Gander Mountain has a 36.7% estimated earnings growth rate, while Midway Games, which has not been profitable in five years, is estimated to grow at 12.5% per year over the next three to five years.

    The companies passing the insider buys screen have failed to consistently outperform the market, and Table 1 shows that the current group of passing companies are continuing the trend. Looking at the relative strength versus the S&P 500, the companies passing the insider buys screen have underperformed the S&P 500 by 2.0%. Meanwhile, exchange-traded stocks have outperformed the index by 9.0%.

    Passing Companies
    The insider buy screen looks for companies whose insiders have purchased more shares than they have sold over the last six months. For the companies that passed the screen as of July 2, 2004, the median number of net shares purchased by insiders was 1.3 million (Table 2). Of the passing companies, Midway Games Inc., the maker of such popular video games as Mortal Kombat, Centipede, and Asteroids, leads the way with net insider purchases of 32.8 million shares.

    Padding this number are the 33.2 million shares purchased by Sumner Redstone between January 6, 2004, and July 2, 2004 (according to CompuShare). Redstone, the chairman of Viacom, Inc., has announced his intention to take Midway private or to acquire more than 80% of its outstanding shares. As of July 2, Redstone owned 78.5% of Midway's shares. The companies that make the final cut for the insider buys screen are those that have the highest net insider shares purchased as a percentage of shares outstanding. For backtesting purposes, this number is adjusted on a monthly basis until 30 companies pass the screen. As of July 2, 2004, the cut-off was 3.5%. The current roster of passing companies has a median value of 9% for net insider buys as a percentage of shares outstanding.

    Inhibitex, Inc., a developer of products for the prevention and treatment of bacterial and fungal infections, has seen net insider share purchases over the last six months that account for 116.5% of the company's average outstanding shares (in Stock Investor Pro, average shares outstanding is used, which accounts for the value greater than 100%). Inhibitex shares started trading publicly on June 4, 2004, but, according to SEC filings, company insiders and beneficial owners bought almost 14.5 million shares of the company the day before.

    While the companies that passed the insider buys screen have not fared well as a whole in term of price performance relative to the S&P 500, there are individual issues showing strong price momentum. Looking at the "Price as % of 52-Week High" column, we see that nine of the 30 companies listed are within 10% of their high for the year. Twenty-seven out of 30 are within 50% or better of their 52-week high (as of July 2, 2004).

    Metabasis Therapeutics, Inc. tops the list at 96% of its 52-week high. At the other end of the spectrum, Salton, Inc.—the marker of George Foreman electric grills—is at only 35%. Overall, the median level for the passing companies is 80%.


    The insider screen is not meant to independently generate a list of investment candidates. Instead, these are 30 small-cap companies that are experiencing above-average insider buying activity—a signal that they may warrant further analysis.

    To buy or sell strictly on the basis of insider activity is not a smart investment strategy. However, to ignore what the insiders are doing may be unwise as well. By keeping an eye on what the insider money is doing, you have one more piece of the investment puzzle that may help aid your investment approach.

    Wayne A. Thorp, CFA, is financial analyst at AAII and associate editor of Computerized Investing.

→ Wayne A. Thorp