Friday, June 27, 2008

Insiders Are Buying...Should I?

We constantly hear reports from the media about insider buys, signalling that its time to jump into such and such company. The idea is as follows: if managers and directors are buying (selling) the company's stock, it's probably because they know something the rest of us don't. Since they know more about the company than anybody else, we should see this buying (selling) as an indicator of where the stock is going.

The Brooks Ratio was developed to measure this very phenomenon. The equation is simple:

(Insider Sales $) / (Total Insider Trades $) = Brooks Ratio

If the Brooks Ratio is less than 40%, this signals that insiders are buying. If the ratio is greater than 60%, beware, insiders are selling!

Unfortunately, research by Market Profile Theorem, an independent research firm, suggests that although this works to an extent on individual stocks, its best application is on the market in the aggregate. The reason this doesn't work so well with a small sample (i.e. at the individual stock level) is because there are so many reasons why insider buying or selling may not be a clear signal in either direction.

First of all, managers and directors have their own lives to worry about. They may be buying a house, may be looking to diversify, or may have just come into some money from salary/bonus or otherwise. Just because they are buying or selling does not mean they are particularly bullish or bearish about the company.

Even if managers are buying (selling) because they think the stock will go up (down), it doesn't mean they're right! For example, home builders were buying their own stock in droves when things turned soft last year...only later did they reverse course and believe in the downturn the public saw first.

Finally, managers and directors are often paid in stock options. Simply exercising these options is officially a buy transaction, but this signals nothing about the stock, as these managers are simply cashing their bonus or salary cheques.

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