Insider Trading Information as Investment Tool PDF 2018

Volume 2, Number 5 Research Question Review 4 SEPTEMBER 2018 Can Insider Trading Information be a Useful Tool for Investment Managers? By Christian Koch, University of S...

Volume 2, Number 5 Research Question Review 4 SEPTEMBER 2018 Can Insider Trading Information be a Useful Tool for Investment Managers? By Christian Koch, University of South Florida F or decades, institutional investment by the Securities Exchange Commission. This managers and individual investors have review examines the scholarship surround- searched for different ways to make out- ing legal Insider Trading. Academicians began sized returns in the stock market. Predomi- researching Insider Trading in the 1970s, not- nant finance theories formulated by academ- ing the intimate knowledge that those within ics suggest this task is a company have that not possible because those on Wall Street the market is efficient. lack. This unique un- However, as a schol- derstanding of compa- ar-practitioner with 24 Can legal insider trading disclosure ny information can lead years in the investment data reported to the SEC provide to abnormal returns management industry, an effective tool for identifying in- on investments. Upon I have discovered that vestments at the company level? reviewing the various Insider Trading dis- views of Insider Trad- closure data provides ing noted in the litera- a unique information ture, this review notes signal that can be a use- practical application of ful tool for identifying profitable investments at the practice for investment managers, partic- the company level. ularly in conducting security analysis in light With such high profile legal cases like Martha of new disclosure regulations implemented in Stewart’s, negative attitudes toward insider 2002. Finally, the broader benefits of Insider trading abound in the public eye. However, Trading for the field of identifying investments certain types of insider trading are sanctioned are also noted. Keywords: Efficient Market Hypothesis, Electronic Filings, Ethics, Financial Market Anomaly, Insid- er Trading, Insider Transactions, Inside Information, Information Content, Sarbanes-Oxley Act, Stock Returns. Copyright © 2018, Christian Koch. This article is published under a Creative Commons BY-NC license. Permission is granted to copy and distribute this article for non-commercial purposes, in both printed and electronic formats  Legal Insider Trading When individuals hear of insider trading, thoughts of Martha Stewart and her famous insider trading Methodology conviction often come to mind. Her conviction The main strategy for my research was finding highlights the negative perception held in the pop- scholarly top-tier journal articles relating to in- ular view. Under this view, insider trading is defined sider trading. The starting point was a search as “trading on price-relevant information that is not string that used several different terms, including in the public domain” (Keenan, 2000, p. 71). “insider purchases,” “open market purchases” and The reality of insider trading is less straightforward. “insider information,” to narrow the search. Also, Morland states, “It should come as no surprise to the term “insider trading information” was tak- anyone that insider trading occurs every day in the en from the research question as the main search stock market… what might surprise investors is that term. Based on feedback from the Muma Business much of it is done with the full knowledge and sanc- Review’s Editor-in-Chief, I expanded my search tion of the U.S. Securities and Exchange Commis- methodology to include a broader range of lit- sion” (Morland, 2000, p. xi). erature particularly relating to ethics. My search In contrast to Martha Stewart and others who have string included the terms “insider trading ethics” traded on non-public, material information, we de- and “insider trading law”. fine Insider Purchases as legal open market purchase The second part of my search strategy was choos- orders placed by corporate insiders with their own ing database sources. First, I used ABI-Inform money. This research study focuses primarily on and Google Scholar research databases to find rel- public information from legal insider purchases. evant articles. Then, I refined my literature search A basic objective of any investment manager is to with three additional databases (Scopus, Web of identify and select investments that will outperform Science and Business Source Premier) to find re- the market. However, there are a variety of different cent articles with a higher citation count. ways to approach this task. As a fundamental bot- The goal was to narrow the search to journal ar- tom-up investment manager, I review corporate ticles that were singularly focused on insider pur- financial information to determine if a company is chases within insider trading. I eliminated quite a good investment. A micro-investor is concerned a few articles as some were off topic or identified with identifying company specific trends. Com- only one feature connected to insider trading. For bining reliable financial information, like sales and example, one eliminated article was on insider earnings numbers, with public insider trading data trading and stock returns around debt covenant can create a powerful tool for evaluating a company’s violation disclosures. Overall, 35 articles in the stock for investment purposes. literature were systematically analyzed; I chose 18 In finance theory, insider trading falls within the articles that had the most relevance and rigor on category of anomalies. Goukasian, Ma, and Zhang the subject of insider trading and ethics. state, “because these return patterns are not ex- plained by either Capital Asset Pricing Model concerning insider transactions” (Rozeff & Zaman, (CAPM) or a multifactor asset pricing model, they 1998, p. 43). Better yet, insiders have the ability to are often referred to as anomalies” (Goukasian et al., take action to support their opinions by placing 2016, p. 299). Furthermore, Mahakud and Dash sug- open market purchases in their company’s stock. gest that traditional finance theory, like the Capital Insiders have a discloser requirement by the SEC Asset Pricing Model (CAPM) and Arbitrage Pricing that must be submitted on-line by filing a Form 4 Theory (APT), is in a different category than mar- document within two days of the insider transac- ket anomalies like insider trading. They state, “These tion; a blank form is available on the SEC’s website empirical phenomena are commonly called CAPM (https://www.sec.gov/about/forms/form4.pdf). The anomalies or financial market anomalies” (Mahakud information on the form becomes public and avail- & Dash, 2016, p. 236). able to all market participants. The finance theories above are stated solely to identi- Debate on insider activity has centered on a few key ty insider trading within the scope of this article. Al- points: though defining insider trading within the literature 1. Insiders consistently have demonstrated ab- stream of finance theory may seem trivial, categoriz- normal market returns ing it is crucial because it provides the most accurate 2. The change and structure of the SEC disclo- foundation for conducting practitioner research. sure requirements for insiders, which has In addition, corporate insiders tend to be contrar- improved outsiders’ use of insider trading ian investors, and take advantage of gaps and dis- information. locations in their company’s stock price. Rozeff 3. Ethics relating to insider trading because the and Zaman argue that “profits can be earned when topic brings forth confusion and ethical issues. outsiders act on the publicly available information 56 Volume 2, Number 5  Koch Table 1: Insider Trading Research Findings Finding Sources Insiders do possess special information. Results indicate that much information Jaffe (1974) contained in the trades remains undiscounted by the publication date in the official summary (p. 427). Insider data contains information on future stock prices, a finding inconsistent with much of the research on efficient capital markets (p. 428). The insider assesses the undervaluation or overvaluation of his corporation’s securi- Finnerty ties by the market according to the way he expects a particular piece of information (1976) to affect the future market price of those securities (p. 213). Insiders obtain trading gains from the use of inside information. The answer to this Givoly & question has clear implications for market efficiency: under the semi-strong form of Palmon the efficient market hypothesis, all public information is fully reflected in prices (p. (1985) 69). Insiders outperform the market, thus refuting the strong form of the efficient mar- ket hypothesis (p. 70). Insiders predict abnormal future stock price changes. Seyhun Insiders possess differences in the quality of information. Insiders who are expected (1986) to be more knowledgeable with the overall affairs of the firm, such as CEO, board of directors, or officers, are more successful predictors of future abnormal stock price changes (p. 210). The realizable return to outsiders is examined. Following the public dissemination of insider-trading information, the abnormal return to outsiders, net of the bid-ask spread plus the commission fee is non-positive (p. 211). Concerning strong-form market efficiency, the evidence examined indicated a level Rozeff & of insider trading profits of, at most 5% annually, rejecting the strong-form efficien- Zaman cy in a statistical sense (p. 39). (1988) Outsiders earning abnormal returns by using publicly available insider trading data constitutes a serious exception to stock market efficiency (p. 25). Outsiders can earn significant abnormal returns by mimicking such trades (p. 57). Bettis, Vick- This conclusion is consistent with a growing body of empirical literature that sug- rey, & Vick- gests that the market is not efficient in the semi-strong form (i.e., is not efficient rey (1997) with respect to all publicly available information) (p. 57). Insiders in aggregate are contrarian investors: however, they predict market move- Lakonishok ments better than simple contrarian investors (p. 79). & Lee (2001) Company executives and directors know their business more intimately than any Wall Street analyst ever would. Investors benefit from observing what insiders are doing (p. 79-80). Information content after Sarbanes-Oxley Act of Form 4 filings leads to greater Brochet abnormal return and trading volumes versus pre-SOX. (p. 419). (2010) SOX has increased the information content around Form 4 filings (p. 420). The move to electronic filings improves research and data analysis (p. 1). Sidgman Electronic filing of changes in ownership began by insiders on June 30, 2003 (p. 3 (2014) footnote 4). The concept of efficiency is central to finance. For many years, academics and Titian (2015) economists have studied the concept of efficiency applied to capital markets, with efficient market hypothesis (EMH) being a major research area in the specialized literature (p. 442). Financial market anomalies are found to be inconsistent with the predictions of Mahakud & traditional efficient markets and rational expectations asset pricing theory (p. 236). Dash (2016) There is a common pattern of underreaction to information contained in preceding Goukasian, insider trading activity (p. 229). Ma, & Zhang Return anomalies speak directly to the efficient market hypothesis (p. 239). (2016) Muma Business Review 57  Legal Insider Trading The research question: “Can Insider Trading Infor- cannot earn abnormal profits net of trading costs” mation be an effective tool for investment manag- (Seyhun, 1986, p. 210). Seyhun concluded that, “This ers?” is important because as Chan, Ikenberry, Lee evidence is consistent with market efficiency: outside and Wang state, “previous papers have found evi- investors cannot use publicly available information dence that insider trading is indeed informative and about insiders’ transaction to earn abnormal prof- that managers indeed possess timing ability” (Chan its” (Seyhun, 1986, p. 211). Some would suggest that et al., 2012, p. 60). I always have believed that track- Seyhun’s work is outdated as bid-ask spreads have ing and monitoring insider purchases is a great start- narrowed and commission levels have substantially ing point to building a solid investment portfolio. declined to $4.95 per transaction. Furthermore, an argument can be made that post Sarbanes-Oxley Act Literature Summary of 2002, insider information is more valuable and timely to outsiders, which creates profit opportuni- Table 1 provides a review of important contributions ties for outsiders. to the insider trading literature. The sources are list- Eleven years later, Bettis, Vickery, and Vickery ed chronologically, starting with the earliest and demonstrated that outsiders who mimic insiders moving to most recent. can, in fact, profit from using publicly traded avail- able insider-trading data. Bettis, Vickery and Vick- Discussion ery argued that “Seyhun was forced to use less-pre- cise dates of widespread public availability because Based on this review, the academic literature suggests at the times of their studies, services that conveyed a high degree of consensus that investors can benefit insider-trading data to investors on timely basis from following insider trading. The communication were not available” (Bettis et al., 1997, p. 58). In their structure of insider data has changed over the years study, Bettis, Vickery and Vickery (1997) showed due to updated SEC requirements and law chang- that insiders’ abnormal returns persist for extended es like Sarbanes-Oxley. time periods. However, the timeless Lakonishok and Lee stud- principles of insider in- ied information content formation knowledge re- The academic literature suggests a in insider trading data main valid today. high degree of consensus that in- and had several interest- This literature dated back vestors can benefit from following ing observations. They found that, “In spite of to the early 1970s when insider trading. the extensive coverage academics started to use information technology that insiders’ activities re- to study insider trading ceive, the market basically data and develop statistical models to interpret their ignores this information when it is reported. More- findings over a period of time. over, there is very little action around the time when insiders trade” (Lakonishok & Lee, 2001, p. 107). Ba- Seminal work from Jaffe argued that, “Academicians sically, Lakonishok and Lee (2001) contended that are interested in the amount of special information no one jumps to take action on this information insiders possess, as well as in the profit they earn right away and this valuable information is ignored from such knowledge”. He concluded, “The data by market participants. suggests that insiders possess special information” (Jaffe, 1974, p. 410). Two years later, Finnerty’s study More recent studies by Sidgman and Brochet report- concluded that “Insiders do rely on future financial ed that changes in insider trading disclosure rules and accounting information but that, the relative and the move to electronic filings have had a large magnitudes of that information are also important” positive impact on trading volumes and abnormal (Finnerty, 1976, p. 213). returns by insiders (Sidgman, 2014). According to Brochet, “Abnormal returns and trading volumes Ten years later, Seyhun attempted to distinguish around filings of insider stock purchases are signifi- between insider and outsider profits. He defined cantly greater after the Sarbanes-Oxley Act of 2002 outsiders as market participants who can purchase than before” (Brochet, 2010, p. 419). stock following insiders’ purchases using publicly available insider trading information. He acknowl- Prior to 2002 and SOX, insiders were only required edged that prior studies “conclude that insiders earn to disclose their trades after 10 business days. After significant abnormal profits by trading the securities SOX, the new disclosure rule was put in place that of their own firms” (Seyhun, 1986, p. 189). required only two business days. According to Sidg- man, “Trades that, prior to SOX, would have been Seyhun also agreed that the finding of abnormal spread over a 40-day reporting period but filed on profits by insiders contradicts the efficient markets a single Form 4, are now broken down into larger hypothesis. However, he asserted that, “Outsiders numbers of smaller trades that are routinely filed”. 58 Volume 2, Number 5  Koch Sidgman stated, “Recent evidence also suggests that many opposing opinions regarding this theory; a more timely disclosure of insider trades is relevant for each article that confirms the hypothesis, there for pricing securities” (Sidman, 2014, p. 3). In sup- is another that invalidates it” (Titan, 2015, p. 442). port of this view, a cluster pattern effect that can be Keenan articulated one such opposing opinion by described as a stronger signal has been observed. stating, “Market efficiency is not a univocal term. For example, group of insiders, when considered to- The allocative efficiency of markets is to be distin- gether, could send a stronger signal to the market by guished from the informational efficiency of mar- their open market purchase behavior than just one kets” (Keenan, 2000, p. 72). individual alone. Finally, the topic of insider trading brings forth con- Bodie, Kane, and Marcus discussed portfolio strate- fusion with regards to ethical issues. For example, gies and market anomalies highlighting the neglect- answers to simple questions such as: “Is insider trad- ed-firm effect, liquidity effects and inside informa- ing illegal?” or “Is insider trading unethical?” can be tion. They described inside information as follows extremely baffling. As noted in the introduction, the (Bodie et al., 1993, p. 387): widespread perception is that anything to do with It would not be surprising if insiders were insider trading is, in fact, not legal and has led to an able to make superior profits trading in their epidemic of fraud in capital markets for decades. firm’s stock. The ability of insiders to trade According to Ma and Sun, “It is important to under- profitability in their own stock has been stand that insider trading is not all based on private documented in studies by Jaffee, Seyhun, information. For this reason, not all insider trading Givoly & Palmon and others. Jaffee’s was is illegal or unethical” (Ma & Sun,1998, p. 68). In- one of the earlier studies that documented deed, the subject is hotly debated within the field, as the tendency for stock prices to rise after in- illustrated in Table 2, which provides a short review siders intensively bought shares. of Insider Trading Ethics research findings. Gitman and Joehnk described market anomalies as McGee emphasized that “A typical case of insider “irregularities or devia- trading occurs when a buy- tions from the behavior er with inside information one would expect in an efficient market” (Git- Answers to simple questions such calls his stock broker and tells him to buy, knowing man & Joehnk, 2008, p. as: “Is insider trading illegal?” or “Is that the stock price is like- 409). They discussed the insider trading unethical?” can be ly to rise as soon as the in- January effect, small- extremely baffling. side information becomes firm effect, earnings an- public” (McGee, 2008, p. nouncements and be- 207). According to Skaife, havioral finance as forms Veenman, and Wangerin, of market anomalies. However, insider trading was “Managers are responsible for the effectiveness of absent from their discussion. Some popular finance their firms’ internal control as well as the reliabili- textbooks discount the importance of insider trad- ty of external financial reporting. These same offi- ing information. cers are able to transfer wealth from shareholders to However, conclusions regarding the potential value themselves by trading on their private information” of insider information to outsiders are not unani- (Skaife et al., 2013, p. 107). mous. Advocates of the efficient market hypothesis As is expected when facing any source of potential certainly would take issue with the argument that risk, investment managers need to take ethics and legal insider purchases can create abnormal returns loss of reputation into consideration. The return/risk over time. Titan states “In the modern theory of fi- equation needs to be balanced like any other invest- nance, a good starting theory is that of efficient cap- ment opportunity. One view considers Form 4 open ital markets” (Titan, 2015, p. 442). Fama developed market purchases as neither unethical nor illegal. the framework for three forms of the efficient mar- This public information form creates a signaling tool ket hypothesis: 1) weak form; 2) semi-strong form; that market participants appear to be overlooking. 3) strong form (Malkiel & Fama, 1970). Keenan Batten, Loncarski, and Szilagyi take the stance that argued, “The distinction between strong and semi- “Ethical behavior is instilled at home, in school and strong form tests maps the distinction between in society, and there is a need for ethical responsibil- market behavior with and without insider trading” ity at the personal level and organizational level to (Keenan, 2000, p. 72). complement legal rules and enforcement” (Batten et The debate of the efficient market hypothesis is be- al., 2018, p. 779). Going forward, changes to public yond the scope of this article. However, Titan ar- policy and insider trading regulation could illumi- gued, “Even if many tried to find the truth behind nate the view that insider trading is illegal and un- the EMH, no ultimate conclusion exists. There are ethical. Muma Business Review 59  Legal Insider Trading Table 2: Insider Trading Ethics Findings Finding Sources Opponents of insider trading seem simply to believe that insider trading is Ma & Sun (1998) inherently immoral (p. 67). Proponents, on the other hand, assert that insider trading is a viable and effi- cient economic means and can be used to serve the best interests of sharehold- ers and the economy at large (p. 67). They argue that insider trading is not necessarily unethical or illegal (p. 68). Whenever the term insider trading is used, the average listener/reader imme- McGee (2008) diately classifies it as a bad practice or something that is immoral or unethical (p. 207). The strongest criticism that has been leveled against the U.S.’s insider trading legislation is that the term insider trading was not defined. That omission was deliberate, perhaps because Congress could not clearly define what insider trading was (p. 214). Commentators make it sound like all insider trading is illegal. Yet, some McGee (2009) forms of insider trading are perfectly legal and some kinds of insider trading are not unethical. In other words, there is a widespread misperception on the part of the public about insider trading (p. 65). Arguments against all insider trading say it is inherently immoral to trade on inside information because making a large profit with such little effort is somehow wrong (p. 71). Another argument against all insider trading takes the position that insiders have some fiduciary duty not to benefit from the information they have access to as part of their position with the corporation (p. 71). Trading on undisclosed price-relevant information is in breach of moral Keenan (2000) rights and duties derived from the principle of respect for individual autono- my. It follows that insider trading is an immoral practice (p. 81). Reliable financial reporting is an important mechanism used by firms to Skaife, Veenman, communicate creditable information to outsiders for their use in evaluating & Wangerin (2013) management’s performance (p. 91). Insider trading profitability is significantly higher in firms disclosing material weaknesses in internal control over financial reporting (p. 92). They argue that unless the existing compliance-based system of regulatory Batten, Loncarski, rules and industry standards come to reflect core ethical values, then insider & Szilagyi (2018) trading and other illegal and unfair market practices will remain common- place (p. 780). Conclusions The literature provides evidence that insider pur- chases produce abnormal returns. These insider sig- Insider trading information has practical applica- nals should provide value to the army of security an- tion for security analysis. It can be used as a tool for alysts, portfolio managers and individual investors narrowing investment choices and separating win- who choose to follow insider moves. ning stocks from losing ones. Insider trading infor- mation is often overlooked as a domain. However, These findings have important consequences for the in practice, insider data has broader application for broader domain of investing. Market participants investment managers within the financial services tend to act irrationally versus rationally from time to industry. time in relation to their money and the markets. In my view, insiders take advantage of investor irratio- The applicability of this data has changed over time. nality by making purchase decisions based on their Prior to the SOX regulation in 2002, insider trad- unique understanding of their firm’s long-term pros- ing data was reported monthly. Today, information pects. In conclusion, in the words of Jaffe, “Insiders is filed electronically and timely. This change, post do possess special information” (Jaffe,1974, p. 424). SOX, relates to the speed and structure of insider in- formation. 60 Volume 2, Number 5  Koch References Mahakud, J., & S. R. Dash (2016). Asset pricing models, cross section of expected stock returns Batten, J. A., Lončarski, I., & Szilagyi, P. G. (2018). and financial market anomalies: A review of the- When kamay met hill: Organisational ethics in ories and evidences. Journal of Management Re- practice. Journal of Business Ethics, 147(4), 779- search, 16(4), 230-249. 792. Malkiel, B. G., & Fama, E. F. (1970). Efficient capital Bettis, C., Vickrey, D., & Vickrey, D. W. (1997). Mim- markets: A review of theory and empirical work. ickers of corporate insiders who make large-vol- The Journal of Finance, 25(2), 383-417. ume trades. Financial Analysts Journal, 53, 57-66. McGee, R. W. (2008). Applying ethics to insider Bodie, Z., Kane, A., & Marcus, A.J. (1993). Invest- trading. Journal of Business Ethics, 77(2), 205-217. ments (2nd ed.). Homewood, IL: Irwin. McGee, R. W. (2009). An economic and ethical look Brochet, F. (2010). Information content of insider at insider trading. Insider Trading, Global Devel- trades before and after the Sarbanes-Oxley Act. opment and Analysis, 35-48. The Accounting Review, 85(2), 419-446. Rozeff, M., & Zaman, M. (1988). Market efficiency Finnerty, J. E. (1976). Insiders’ activity and inside and insider trading: New evidence. The Journal of information: A multivariate analysis. Journal of Business, 1, 25. Financial & Quantitative Analysis 11(2), 205-215. Seyhun, H. N. (1986). Insiders’ profits, costs of trad- Givoly, D., & D. Palmon (1985). Insider trading and ing, and market efficiency. Journal of Financial the exploitation of inside information: Some em- Economics, 16(2), 189-212. pirical evidence. Journal of Business 58(1), 69-87. Sidgman, J. (2014). Form 4 electronic submissions Goukasian, L., Ma, Q., & Zhang, W. (2016). What and the Thomson Reuters insider filing data feed: is common among return anomalies? Evidence Discrepancies and their impact on research. Jour- from insider trading. Journal of Behavioral Fi- nal of Information Systems, 29(3), 1-33. nance, 17(3), 229-243. Skaife, H. A., Veenman, D., & Wangerin, D. (2013). Gitman, L., & Joehnk, M. (2008). Fundamentals of Internal control over financial reporting and investing: The financial system and financial mar- managerial rent extraction: Evidence from the kets (2nd ed.). Upper Saddle River, NJ: Pearson profitability of insider trading. Journal of Account- Custom Publishing. ing and Economics, 55(1), 91-110. Jaffe, J. F. (1974). Special information and insider Ţiţan, A. G. (2015). The efficient market hypothesis: trading. The Journal of Business, 47(3), 410-428. Review of specialized literature and empirical re- Keenan, M. G. (2000). Regular article: Insider trad- search. Procedia Economics and Finance, 32, 442- ing, market efficiency, business ethics and exter- 449. nal regulation. Critical Perspectives on Accounting, 11, 71-96. Lakonishok, J., & Lee, I. (2001). Are insider trades Review informative? The Review of Financial Studies, 1, This article was accepted under the strict peer re- 79. view option. For futher details, see the descrip- tions at: Ma, Y., & Sun, H. L. (1998). Where should the line be drawn on insider trading ethics? Journal of Busi- http://mumabusinessreview.org/peer-review-op- ness Ethics, 17(1), 67-75. tions/ Author Christian Koch, for more than two decades, has had a hand in investments, either as a staff equity research analyst, managing director, and now president and CEO of KAM South, a firm that invests in individual securities. His firm manages $80 million in assets, with a track record of successful returns. His research interests include the topics of value investing and how risk is defined within portfolio the- ory. He has co-authored three books and is currently collaborating with Larry King to co-author a fourth: The Big Question. He received a bachelor’s degree in Business Administration at Stetson University in Deland, Florida, and a master’s degree in Business Administration at Jackson- ville University in Jacksonville, Florida. He is a graduate of the Advanced Man- agement Program at the Harvard Business School in Cambridge, Massachusetts. Muma Business Review 61