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When Insider Selling Means 'Buy'
Corporate officers now dump shares in the face of good news, not bad. In
some cases, those sales can be extra sunny.
By Craig Columbus
Negative earnings surprises are becoming a rare event as companies get
better at guiding securities analysts' forecasts. Executives often begin
warning of slower growth a couple of quarters ahead of the actual impact
on the company's income statement, and analysts oblige by ratcheting
down their projections.
To get just as far ahead of the downward curve, research at Disclosure
Inc. suggests that investors should look carefully at the sales of stock
by insiders. But not in the places they might imagine.
Disclosure studies show that insiders frequently sell in the last good
quarter -- before the company's fundamentals begin to erode. Similar
results have been found in other research, including an article
published in the June 1995 edition of the Journal of Business, Finance
and Accounting that showed most insider selling occurs after the
announcement of good earnings.
Why do insiders sell on good news?
A recent study conducted by finance professor Carl Bettis of Arizona
State University showed that the vast majority of publicly traded
companies have formal guidelines governing insider-trading activity.
Almost all companies have some policy that restricts their insiders from
trading immediately before or after the announcement of earnings (often
10 days in either direction). As a practical matter, many high-level
insiders impose even tighter restrictions upon themselves when it comes
to selling shares.
To be sure, top corporate officers clearly do want to get the best
prices for their shares; they know when the firm is on the verge of
losing a major client, or when capital-equipment expenses have gotten
out of hand. But rather than wait until the bad news shows up on income
statements, they sell much earlier than widely believed. Two top
reasons:
* With increased media scrutiny and the proliferation of hungry securities
lawyers, no executive wants to be seen as bailing out just before a
stock's retreat.
* Securities laws have generally been effective at deterring corporate
insiders from selling too closely to a negative earnings surprises.
Nike (NKE) and Amgen (AMGN) insiders illustrated this type of behavior
recently. The July insider sales at each company were well-timed, but
certainly not improper. All the companies reported earnings in line with
analyst expectations for the quarter in which insiders were dropping
shares.
However, these stocks experienced subsequent weakness when analysts
predicted slower growth for each in the latter half of 1997. These are
excellent businesses with solid long-term growth potential. Unlike
insider buying, the market rarely reacts to only insider sales because
they seldom point to cases in which the sky is falling. Instead, the
sales can be used as an early heads-up to cases in which revenue growth
may be slowing two or three quarters down the road.
Insider Selling: Sometimes a Bullish Indicator
There are times when insider selling can actually be used as a bullish
indicator, however. That happens when companies are the target of
shareholder lawsuits surrounding prior insider trading.
Shareholder suits against inside traders often share some common traits:
They frequently claim that management made some kind of
misrepresentation -- either via its financial disclosures, public
comments or shareholder communications.
Then, as investors relied on this information, executives capitalized by
selling shares shortly before the stock dropped sharply. 3Com (COMS),
Informix (IFMXE) and America Online (AOL) have each been the target of
such suits over the past couple of years.
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No matter how frivolous, shareholder suits alleging improper insider
selling creates a cautious climate throughout a company -- and must be
disclosed to shareholders.
In the case of 3Com, several insiders displayed excellent timing in
December 1996, when they sold over 800,000 shares at around $80. The
stock subsequently lost more than half its value over the next two
months amid fears of greater competitive pressures. On March 24, 1997, a
class-action suit was filed. The shares subsequently rebounded above
$50, and insiders again began selling in earnest. Since August, 3Com
executives have sold or filed to sell nearly 2.5 million shares, mostly
in the $50-$54 range.
In most cases, shareholder litigation alleging improper insider selling
creates a more cautious climate throughout a company, regardless of the
merits of the suit. No matter how frivolous, this type of lawsuit, as
well as other litigation, must be disclosed to shareholders. And no
company likes those kind of disclosures.
Therefore, evidence suggests that when executives in these companies
return to the market to sell again, they probably do so with greater
confidence that there are no major negative surprises looming on the
horizon.
Even if the insiders doing the latest selling were not alleged to have
participated in the prior malfeasance, the current sellers are still
likely more vigilant. Companies are becoming increasingly concerned with
the way their insider trading is perceived by the market.
Investor-relations professionals are now quick to react to any major
development -- from sending out press releases to announce large
purchases by key executives to calling insider analysts to put the best
spin on heavy selling.
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Snapshot
Price History
Overview
Earnings Estimates
A company that recently caught our attention: American Power Conversion
(APCC), the maker of uninterruptible power-supply equipment such as
surge protectors. A review of the company's SEC filings reveals that in
February 1996, two shareholders filed a suit against present and former
officers and directors of the company.
The suit alleges that the "individual defendants traded in the stock
allegedly in breach of their fiduciary duty to the company." The
allegations stem from insider sales (over 400,000 shares around the $20
mark) that occurred in June 1995, before the release of poor
second-quarter results. Trading above the $25 level in early July,
American Power Conversion closed out 1995 below $10.
Shares of American Power Conversion rebounded nicely, however, breaking
the $30 level in early 1997. After refraining from any trading in the
first quarter of 1997, insiders sold over 300,000 shares in May and June
at prices from $20 to $23. The stock since performed quite well,
climbing to as high as $32 after reporting solid second-quarter results.
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Wall Street can't stand slower earnings growth -- no matter what the
reason.
-- Casey Alexander
Casey Alexander, special situations analyst at Gilford Securities and a
longtime bull on American Power Conversion, recently downgraded the
stock. "This company has been growing earnings at 30-40%, but the next
two quarters look like they are going to be weaker," says Alexander.
Sound familiar? The company intends to introduce new products during
that time, likely driving up its sales expenses. Alexander believes that
management has been cautioning the Street to expect lower operating
margins as a result. But he adds, "Wall Street can't stand slower
earnings growth -- no matter what the reason."
American Power Conversion, in other words, neatly fits the earlier
description -- insider selling well in advance of any potential
weakness. In this case, the presence of prior litigation acted as
short-term support. Investors scared off by insider selling earlier in
the summer would have missed the move to $32. Patience can, in fact, be
a virtue.
When you see insider selling in cases like this, think of it as
insurance for the quarter -- a window of time in which you can trade the
company's shares with a measure of downside protection.
To find companies at which insiders were sellers of stock even though
earnings were rising sharply and soundly beating analysts' expectations,
we screened in Investment Finder for firms that reported year-over-year
and quarter-over-quarter earnings gains of greater than 20%, a recent
quarterly surprise of greater than 20% and net insider sales. Here are
the top 10 stocks that fit the screen. Subscribers can see the full list
in the Investment Finder.
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