The Factory Daily Letter
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Signs from the insiders
In this daily letter, we are introducing a new quantitative tool that focuses on insider trading activity. Insider activity can be considered a “smart money” indicator on the basis that corporate managers and stakeholders are best-positioned to know about the current financial strength of their companies – and are only likely to buy if they are confident it can do well – also a signal that the a share price is undervalued.
Furthermore, and unlike the Hedge Fund 13F reports of fund manager holdings that are filed only quarterly, insiders have just a few days to report their activity to the SEC making the information much more valuable.
In the US, the legal obligation in for directors and key stakeholders in a company’s stock to disclose transaction details dates back to 1939. Insider trading is the trading of a company’s stocks or other securities by individuals with access to confidential or non-public information about the company. It is of course illegal to the extent that it involves trading in corporate stock by someone who has material information that is not publicly available and that may impact its price; the legislation is clearly designed to prevent / penalize anyone in possession of such information from / for using it to either profit from it (or prevent a loss) by trading that stock.
That said, corporates clearly encourage ownership of their stock by officers and employees, so to cover this situation such individuals as well as those that hold more than 10% of any class of a company’s publicly-traded securities are obliged to report purchases, sales, and holdings of the same to the Securities and Exchange Commission (the SEC), usually within a few business days of any trade. Transactions in the company’s common stock as well as derivative securities, such as options, warrants, and convertible securities, are also reported.
Clearly insiders will trade for a huge variety of reasons such as liquidity and diversification. However, these publicly-available filings are nonetheless frequently referred to as a source of clues on insider sentiment on corporate prospects. So today we take a look and see if we can extrapolate any tell-tale-trends that may have emerged across the data.
Insiders buy, while others sell
As we discussed yesterday, US equities are now in a bear market (the S&P500 having fallen more than 20% from its peak) and pessimism seems to be the dominant sentiment among investors. Total long-term mutual fund and ETF fund flows have been abating since March 2021 and they have been suffering net outflows since March 2022. Outflows reached USD 99.6 bn and USD 63.7bn in April and May respectively.
However a look at the insider filings shows that corporate insiders are positioned in the opposite direction, suggesting that while the broader market may have fallen into something of a selling frenzy, the so-called smart money insiders have been buying up ‘their’ company shares at a pace rarely observed.
Below we present a graph that illustrates the number of insiders purchasing the shares of the company to which they are associated across the S&P500. Each point represents the number of buys reported in the past six months. Because insiders typically only buy if they have confidence that their company (and stock) will do well, insider buying is generally considered a stronger signal than insider selling. So it is that when the buying of corporate stocks by insiders picks up quickly and dramatically, it tends to be a very good sign for the stock market more broadly, so a quick rise in this ratio tends to be a positive sign for stocks.
Are insiders dip-buyers?
Also of note is that generally speaking, insiders are quite active and moreover they have often supported their companies through the tougher times (such as 2011, 2016, 2020). Also, while the aggregate gauge recently fell back to below 2019 levels, the graph illustrates how it seems to have risen again recently, just as the market selloff has gained traction:
Stick with what you know?
The number of insiders selling is a weaker indicator on account of there being arguably more reasons why one might be motivated to sell (liquidation / diversification being the key examples here) other than a more considered investment call. Nevertheless, the number of investors selling is currently extremely low on a historical basis, and it has recently fallen below 1,800 for the first time since 2018 – an observation more marked given the current headwinds increasingly impacting corporate margins and the rising prospects of recession over the coming months. Moreover, such a low insider selling read has in the past tended to coincide with a market trough:
The indicator that combines the two (see the chart below) illustrates how insiders appeared to capitulate six months after the Covid crisis, the gauge’s collapse revealing how at that moment we saw more insider selling than buying. But the ratio has more recently been enjoying something of a comeback, the buyer/seller ratio, at 15%, is its highest level since the Covid bear market (and once again potentially coinciding with a market bottom – as appears to have been recurrent pattern over the past 12 years).
Moreover, since 2010, this ratio has climbed that fast only three times: August 2011, August 2015 and March 2020 with the Covid crisis:
These three situations pointed a local bottom on markets: buying the market at these points would have returned +13% in 6 months and +28% in average in a year:
What might this tell us about the sector story?
The numbers in the table below illustrate how the insider trading ratio (buy to sale) has changed over different periods.
Behaviour varies across the sectors: while buying activity has surged globally, it has been mainly driven by insiders in the communication services, discretionary, financials, healthcare, industrials and real estate. Energy, which is the only sector currently in positive territory (with a year-to-date performance of 49%), has suffered a consistent decrease in its buying ratio over the past six months.
Also of interest is that despite the collapse in tech sector valuations, insiders also seem to be reluctant to buy the dips – the insider buy/sell ratio has remained roughly flat over the past 6 months despite the sector’s -25% year to date performance:
More insiders are currently buying than selling in the consumer discretionary and communication services sectors
As shown in the charts below, consumer discretionary and communication services are the two sectors that have been enjoying high insider buy/sell ratios recently. Insider activity within these sectors has also historically appeared to be relatively good indicators of market bottoms. Also, and while the ratio has continued to edge higher in the consumer discretionary sector (albeit still lower than the levels hit in 2020), in the communication services sector, the ratio has recently risen above the post-Covid crash period and has now reached its highest level since 2012:
However, within energy and staples, insiders have been selling
On the other hand, insiders in energy and staples have been selling as their sector benchmarks have been climbing – an inverse correlation that is particularly marked in the energy sector, in a move that suggests that insiders may consider their stocks to be overvalued at current levels, or outlook uncertain or negative:
Insider buying in tech remains resilient
The tech sector has been leading US equity market gains over the past decade, well supported by accommodative monetary support and negative real rates that have boosted the attractivity of this sector. Moreover, tech companies continuously posted healthy growth and strong fundamentals offering them another significant tailwind.
While recent market conditions have been strongly weighing on valuations as rates have started to edge higher (the Nasdaq Composite index falling into a bear market earlier this year due to its growthier nature and higher sensitivity to rates) it seems insiders continue to prefer to accumulate, insider buying still outpacing selling even in recent months:
What’s the picture in Europe?
Running the same analysis on Europe we first notice the level difference: while the average insider buyer/seller ratio on the Stoxx 600 index has been 0.72 since 2010, it is only 0.10 on the S&P 500. Noting the average number of buyers on the same time range is 570 on the Stoxx 600 while it is 213 on the S&P 500, and keeping in mind this analysis is based on transactions on open markets and that the European index is comprised of around 100 more stocks than the American one, one may conclude that European insiders are more active and keener to invest in their own companies.
Hereafter, we present the buyer/seller ratio on the Stoxx 600 index. Since 2010, the ratio has jumped at the current pace six times: May 2010, August 2011, August 2015, November 2018, March 2020 and October 2021:
Except the last one, October 2021, such a signal has always captured a local market bottom:
Following this signal would have theoretically allowed great returns : +7% in average 6 months later, +14% in 1 year:
On a sector basis, the data in Europe reflects the patterns observed in the US: discretionary, industrials and real estate are among the sectors with the highest insider buyer/seller ratios; while staples and energy have the lowest. However, the technology sector continues to record increasing buying in relative terms:
Below, we present the results of our screenings for those stocks that have been the most bought (and sold) by insiders over the last six months, within each market:
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