Profit by Tracking Insider Buying

There's just one hitch: The average returns are so high because of the runaway success of a relative few. A recent Morgan Stanley study suggests that if you mimic a single boss's purchase, your chances of outperforming the market are little better than even odds. In other words, the profits can be plentiful, but only if you can tell which executives' purchases to take an interest in and which to ignore.

Bosses undoubtedly know more than the rest of us about near-term prospects for their companies' shares. They know whether an important new customer is all but signed and whether a new drug trial is showing early promise. It's illegal for them to trade shares based on such facts, generally referred to as "material, nonpublic" information. But there are some gray areas. Is the fact that phones in the sales department are ringing incessantly "material"? Can knowing that a newly hired marketing head is awful be called "nonpublic"? It's reasonable to assume managers invest based on facts that are both unknown to most of us and important to stock returns. In fact, their purchases perform an important informational role, turning private information into public displays of confidence.

Stock purchases signal confidence because they're made with personal funds. (Sarbanes-Oxley squashed the dodgy practice of using company loans to buy shares.) They must be reported within two business days on a document called a Form 4, which details who bought what and when, how much they paid, the nature of their relationship to the company and the specific type of transaction (option exercise, grant of shares, straightforward buy and so on). Tracking Form 4s is easy. Stock screeners like the one at SmartMoney.com list the largest buys and sells from recent weeks, in terms of both the number of shares and dollar amounts. Top executives aren't the only ones who must report their trades; so too must board members and what are called "beneficial owners" — shareholders with more than a 10% stake (often mutual funds or other institutional investors). The closer insiders are to day-to-day operations, the more likely their buys will work out. Corporate execs fare the best; board members don't do nearly as well.

It's with further sorting, though, that the money is made. The Morgan Stanley study, for instance, found that insiders in certain industries did better than those in others. Energy execs were particularly successful; media moguls and car makers were anything but. The study's authors speculate that the latter might have used purchases as a show of confidence (albeit a pricey one) even if fundamentals were dim. I'm not sure I'd write off entire industries based on the study, but I would write off large companies in general. Insider buys are most informative — that is, they predict the greatest stock gains — when made at smaller companies with limited analyst coverage.

Now for some new findings. Last year Citibank's quantitative-strategies department (stock screeners, essentially) in London studied 9,000 insider transactions made at U.K. companies since 1994 to determine which types of trades would have been most worth following. Larger buys, they found, predicted larger stock gains — no surprise there. But they also found that buys that were too large (as a percentage of outstanding shares) did poorly, perhaps because other shareholders feared the managers were buying their way into long-term entrenchment. Multiple purchases by several execs within the past three months signaled big gains to come, as did, predictably, purchases at small companies with limited analyst coverage. Buys that followed recent upside earnings surprises paid off nicely. And the biggest returns were found after insider buys of undervalued stocks (judging by price/earnings ratios and the like) with strong share-price momentum over the past 260 days. (Combining value criteria and share-price momentum is a strategy SmartMoney also used for this month's stock-picking feature; see "Rise and Shine," page 80.) Citibank's back-testing of a strategy combining all of these observations produced annual returns of 23.5%.

Investors can use this information in two ways. First, when researching a particular stock with recent insider purchases, they can check for the most promising traits. Second, they can cram all of the aforementioned findings into a stock screen designed to find the most promising buys. SmartMoney has run past insider-buying searches, and to profitable end. Four stocks recommended in May 2005 have since gained an average of 161% (one soared sixfold in value). Eight listed in this column last February have climbed 13.9% and topped the S&P 500 index by 3.2 percentage points.

I started with companies valued between $300 million and $10 billion that had topped earnings estimates in their most recent quarter and whose shares had outpaced the broad market over the past six months. I looked for more than one insider buy within the past 12 weeks and made sure price/sales ratios were below industry averages. Then I went through the results by hand, looking for purchases by executives and eliminating cases where insiders bought shares at below-market prices. I ended up with seven stocks.

TreeHouse Foods is the country's largest seller of private-label pickles and powdered creamer. Trouble is, sales for both products are growing at low-single-digit rates. So last year management bought its way into the soup and baby-food business. Early results for the new products have exceeded Wall Street's expectations. The company's president has bought 4,000 shares since June. Last March its financial chief also bought 4,000. Playtex is best known for tampons but also makes hand wipes, sunscreen, dishwashing gloves and more. It doubled its new product offerings in 2006 and plans to continue diversifying in 2007. Investment funds, a board member and two top executives have bought shares since June. The stock since then is up more than 25%.

Commercial printer Cenveo has been under new management for a year and a half, and the improvements are showing. Current CEO Robert Burton helped wage a shareholder battle that ousted the former management team in September 2005. Moore has since streamlined operations and slashed costs, doubling the stock price in the process. Burton and a board member who joined on with him made big additions to their stakes in November.

Gehl makes compact construction vehicles: loaders, diggers, pavers and so on. The company says it's seeing strong global demand despite a slowing housing market in the U.S. and that it's keeping costs down. Sales for the first nine months of 2006 increased 11%, and its earnings from operations, more than 40%. The treasurer, a director and a top investor have all bought shares recently.

Kite Realty Group develops and operates shopping centers and, as an investment trust, passes almost all of its profit on to shareholders as dividends. Its shares yield 4.2% and have increased in value by more than 30% since their August 2004 debut. Chairman Alvin Kite and his son John, the chief executive, have both recently added to their holdings. NRG Energy is an electric power wholesaler with 60 oil, natural gas and nuclear plants. Most of its profits have historically come from the Northeast, but the company sees room for expansion in Texas, where it bought a power producer last year. The top executive and financial officer both bought shares in November. Finally, Hudson Highland Group is a specialty staffing company spun off from Monster Worldwide that's run by the former No. 2 manager at Manpower. It's a work in progress, but a sharp stock decline since late 2005 reversed course in August. Permanent job placements are up, corporate expenses are down, and two top execs and two board members all increased their stakes in November.