While doing the research for our 1998 Prentice Hall book, “Contrarian Investing: How to Buy and Sell When Others Won’t and Make Money Doing It,” co-author Anthony M. Gallea and I made a discovery that’s dominated my work as an investment writer.

And here it is…

[ad#Google Adsense 336×280-IA]Of all the “Buy” indicators you can use – and there are thousands – insider buying is the most powerful.

In fact, it’s the best signal you’ll find anywhere.

Think about it this way…

Why Company Insiders Buy Their Own Stock

Insiders sell part or all of the shares they hold in their own company for lots of different reasons.

They sell to diversify their holdings. They sell to buy second homes. They sell for estate-planning reasons – and even for tax reasons.

But they go out and buy shares of their own company pretty much for only one reason – to make money.

And when I say “to make money,” I’m not talking about a point or two. They buy because they believe their company’s stock price is headed for hefty gains.

And let’s face it, they’re in the best position – of anyone – to know. And thanks to the generous policies most big public companies have for restricted stock grants, stock options, or appreciation rights, most corporate officers and corporate board members already have big personal stakes in their own companies.

So the fact that they’re going out of their way to overtly add to this stake by making purchases in the “open market” is a sign that they believe big things are coming.

This isn’t just my opinion.

The Research Says Insider Buying Works

In one paper, professors Carr Bettis, Don Vickrey, and Donna W. Vickrey found that “outside” investors who mimicked the moves of insiders would have outperformed other stocks of the same size and risk by nearly 7% per year – even after factoring in transaction costs.

Beating the market by seven percentage points: Doing that over long stretches is how fortunes are made.

In a second study, University of Houston Professor R. Richardson Pettit and P.C. Venkatesh from the Office of the Comptroller of the U.S. Currency found that insiders tend to increase their net purchases up to 24 months before a stock generates an above-average return.

New research that’s appeared since Prentice Hall published our book continues to make a bullish case for insider buying.

Independent researcher Market Profile Theorem (MPT) showed that insider trading trends signal an up-and-coming shift in market sentiment. To spotlight those trends, MPT analysts use a device known as the “Brooks Ratio,” which divides total insider sales of a company by total insider trades (purchases and sales) and then averages this ratio for 2,500 stocks. If the average Brooks Ratio is less than 40%, the market outlook is bullish – but a ratio that exceeds 60% is bearish.

Obviously, MPT’s research is focused on the overall market. But it lends credence to what Tony and I found for individual stocks.

And University of Michigan Professor Nejat Seyhun, author of “Investment Intelligence from Insider Trading,” came to the same conclusion that Tony and I reached: Stock prices rise more after insiders add to their holdings than they do after insiders sell.

The bottom line: Insiders make money from this perfectly legal type of “insider trading.” And the returns they reap exceed those of the general market.

Here’s My Easy-to-Learn Strategy

So when you’re searching for “insider buying” stocks, what do you look for? How do you know what’s relevant and what’s not?

In their research, Pettit and Venkatesh found that the average insider purchase was about $59,000. So I doubled that figure – to $120,000 – as a good rule-of-thumb “Buy Trigger” threshold.

And I developed a pretty simple “Good, Better, Best” strategy you can employ to single out the best opportunities. By that, I mean:

Good: A corporate officer buys $120,000 worth of his or her own stock.
Better: Two insiders purchase $300,000 of their own shares.
Best: Six insiders buy and aggregate $500,000 of their own shares.

The message here, of course, is that “more is better.” More insiders… buying more shares.

Given the uncertainty we’re expecting for the new year, this is one strategy that can help bring clarity to an unclear market.

— William Patalon III


Source: Money Morning