Profit from Insider Sales by Short Selling: New Evidence

Monkeying insider purchases has been a very profitable investment strategy. Insiders usually own a lot of stocks and/or options in their companies. Increasing concentration of wealth in a single stock usually is not rational. Random events may strike the company and the investor might lose most of the wealth in a heartbeat (i.e. Bear Stearns and Lehman Brothers insiders). So when insiders take the risk of buying more shares, usually it’s because they know something we don’t. That’s why imitating insider purchases is such a rewarding strategy.

On the other hand, selling is the rational thing to do for most insiders even when they think they expect slightly better results from their companies. The benefits of diversification compensate for the loss of future stock returns. Of course selling is the right thing to do when insiders are pessimistic about the future. As a result insider sales is much more common than insider purchases, but the act is much less informative. Insider sales have been intensifying during the past two decades as insiders receive increasing quantities of stock and option awards. There’s now a greater need to diversify compared to 10 or 20 years ago.

Academic research on insider sales has revealed that imitating all insider sales transactions is not profitable. It’s because most insider sales transactions are done for diversification or demand for liquidity. So, the lists of the largest insider sales published in the Wall Street Journal or Barron’s really don’t mean much.

However, it’s possible to get rid of the noise in insider sales transactions and develop a potentially profitable investment strategy. A 2009 research paper by Alan Jagolinzer (Stanford University) analyzed insider transactions conducted under the protection of Rule 10b5-1. The SEC enacted Rule 10b5-1 to protect insiders’ preplanned, non-information based trades from litigation. When Angelo Mozillo was selling his Countrywide shares in the millions, he was doing so under a 10b5-1 plan. Jagolinzer found that insiders participate in these plans preceding negative firm performance. A substantial proportion of plans were initiated before adverse news disclosures. Jagolinzer also found evidence of early terminations of the plans when there was pending positive firm performance.

Jagolinzer also calculated market adjusted buy and hold returns for stocks sold under 10b5-1 plans. These stocks underperform the market by 70 basis points for a 1-month holding period. The underperformance is 220 basis points for a 3-month horizon and 360 basis points for a 6-month horizon. Alternatively, this strategy’s alpha was calculated using Carhart’s four factor model. Insiders who participated in a 10b5-1 plan and sold their holdings had a monthly alpha of 70 basis points (t-stat=-2.28). That’s consistent with buy-and-hold abnormal returns. Insiders who didn’t participate in a 10b5-1 plan and sold their shares in the open market had a negative alpha of 50 basis points (t-stat=1.93) per month, meaning the stocks beat the market after the insiders sold them.

These are very promising results. The only drawback of Jagolinzer’s study is that it covers the 2000-2005 period, a relatively short period from which to draw a definitive conclusion. If the results held up during the post-2005 period, they could be used to create a very profitable short selling strategy.

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