How To Pick a Good Individual Stock to Buy? – Part 5: Insider Trading

by Hank

You should consider what a company’s executives are buying and selling when picking which individual stocks to buy. I think that most of us know that insider trading is illegal. Just look at Martha Stewart. Martha Stewart, the household guru, was accused of selling shares of ImClone in an insider trading scandal after learning of some impending bad news from her stock broker. According to a Securities and Exchange Commission (SEC) investigation, Stewart avoided a loss of $45,673 by selling all 3,928 shares of her ImClone stock in 2001. The day after she sold her stock, the stock price fell 16%. CNN reported that Stewart’s stock broker ordered his assistant to tell Stewart that the CEO of ImClone was selling all his shares of the company in advance of an adverse Food and Drug Administration ruling which is a clear violation of federal insider trading laws. The problem stemmed from her receiving preferential information before it was made public.

But, have no fear. There is a way to find out legally what the CEO and other top executives think about their company’s future outlook and find out how many shares of stock they are buying and selling. When a company’s leaders buy and sell shares they have to file a “Form 4″ with the SEC, the government regulator of the stock markets, providing details of the stock trades. These forms are public information and can be searched through the Edgar Database at Yahoo Finance also does a great job of listing which executives are buying or selling shares of their company. For example, after entering a company’s stock symbol, click on the “Insider Transaction” link on the left to get a detailed report about recent trades. In June 2008, John Adams a member of Dr. Pepper Snapple’s Board of Directors (Stock Symbol: DPS), purchased 20,000 shares of the company. Is this a sign that good things are imminent? Maybe it is, but it is not a bad sign when executives spend their own money to buy shares of the company. Another great resource is the Inside-Monitor website.

When an executive buys large blocks of his company’s stock, it is a great signal that he thinks the company’s future is bright with wonderful growth potential. It also signals that the stock price is undervalued in relation to the company’s future earnings potential. Maybe the executive in question is buying shares because of a recent R&D success or a new product that is about to be launched. The same can be true for an executive that sells a lot of shares unexpectedly. Many executives receive large blocks of stock options and may just be diversifying his personal portfolio through systematic selling, and that is okay and normal. But, it is the rapid, unexplained, random, and large sell offs that should worry you as a potential investor. Rain clouds may be coming the company’s way in that instance.

While insider trading is not a stand alone attribute that you should consider when picking a new individual stock, it is a signal that can be used in conjunction with others in order to understand the company as a whole. Who knows more about their respective companies than officers, directors, and large shareholders? When these people buy or sell their shares, we should take heed.

Disclaimer: Remember that most of your investing for retirement should be through good growth stock mutual funds. I recommend only invest in individual stocks with a small amount of “fun” money.

Stay tuned for more in our six part series on picking individual stocks. Next time we will talk about reading annual reports and learning what the company is says its going to do in the future and how rosy their past has been.

Six Part Series On Stock Investing Continues…

Check out the rest of the articles in the series if you missed any:

  1. Key Metrics like P/E Ratio
  2. Charts, Graphs, & Averages
  3. Dividends & Dividend Growth
  4. Analysts’ Recommendations
  5. Insider Trading
  6. SEC Filing and Reports

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