Should you follow insiders into stocks?

Before you rush in to investments on the basis that ‘insiders’ are buying, bear in mind three crucial tests, says Tim Bennett.

Stockmarkets have been in defensive mode since Federal Reserve chairman Ben Bernanke hinted that quantitative easing (money printing) might be coming to an end. Yet, as Mark Hulbert notes on Marketwatch.com, "the recent actions of certain corporate insiders provide reasons for hope".

However, he warns that before you rush off to buy stocks, you have to make sure you know which insiders are doing the buying.

According to Vickers Weekly Insider Report from Argus Research, as a group insiders have recently been dumping five times as many stocks as they have bought. Not exactly bullish behaviour. But as Nejat Seyhun, professor at the University of Michigan, notes, not all insiders are equal.

For instance, as well as including company directors (who in theory know more about the prospects for their firms than anyone, and are thus worth watching), the definition often also includes large institutions with block holdings. These exhibit "little ability to forecast where their firm's shares are headed". Strip them out and the market is finely balanced between buyers and sellers, and company directors are most optimistic in the energy, industrials and financials sectors.

But before you rush off to buy these sectors, bear in mind my colleague Bengt Saelensminde's three tests. First, check whether the buy is chunky compared to the director's salary (in other words, is it a significant purchase, or is the director just doing a bit of window dressing?).

Second, check how big it is relative to their overall holding (again, this will show you how significant the move is).

Lastly, look to see whether other directors have been buying as well. A yes' to all three is a good sign. For example, the chairman of Prudential (LSE: PRU) doubled his stake following the recent price dip, and was joined by two other senior directors. That makes the stock well worth closer investigation.

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