Understanding insider trading by top executives: buying and selling by top managers isn't always what it seems. True insider information is actually a very small motivator, an MIT professor finds.

Anyone following the business press over the recent months has been inundated with reports about illegal insider trading by top executives. Contrary to the media impression, most insider trading is legal and can provide rare insight into how managers are thinking about the prospects of their company. At the same time, much of the excitement about the information content of insider trades, and of insider sales in particular, turns out to be overdone.

There is an entire industry of journalists, investment newsletters and hedge funds that tries to take cues from the securities filings that top managers make when buying or selling shares in the businesses they operate. The recent rise in the U.S. stock market has once more been accompanied by an increase in stock sales by company insiders, and by the associated increase in the predictions of gloom and doom this increase allegedly implies.

So, which stock sales by top executives portend bad news? And which stock purchases signal genuine positive inside information about the firm? Answering these questions requires an understanding of what motivates executives to buy or sell shares.

To get at managers' thinking about their own firms, I've analyzed the insider trading decisions of top executives in approximately 2,500 publicly traded firms over the period from 1993 to 2001. Probably the most surprising finding is that true inside information--the kind that tends to get insiders into trouble with the SEC--plays at most a minor role in the insider trading decisions of top executives. This small role is reflected in the finding that insiders' returns, properly measured, aren't really all that much better than what an outside investor could get by following a few simple rules. (The study was published last December as Market Timing and Managerial Portfolio Decisions. It can be accessed at www.mit.edu/~djenter.)

Most insider trading decisions are motivated either by a desire to diversify executives' portfolios away from the firm, or by a general assessment of whether the firm appears undervalued or overvalued relative to its ability to generate earnings. Corporate executives, as a class, turn out to act like classical contrarian investors. They tend to be on the buy side in the stock categories that have traditionally outperformed the market: small stocks, high dividend stocks, and value stocks. They tend to sell shares in large firms, in firms with high price-earnings ratios and in firms with high market-to-book ratios.

I found that an outside investor could have simply bought a diversified portfolio of small-cap stocks with high yields and low price-to-earnings ratios, and would have received almost the same return (with lower risk) as the group of insiders in my study. It is clear that managers sometimes use value-relevant information that outside investors do not have, but probably less often than was thought in the past.

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Why don't managers do better with their insider trading? Common sense suggests that if anyone understands a business's prospects, it would be the chief executive and other top managers. At the same time, executives are legally prohibited from trading on concrete inside information. Many firms have established internal procedures that restrict insider trades to short windows after quarterly earnings announcements, with the goal of preventing managers from taking advantage of short-term inside information.

These restrictions imply that inside trades are rarely motivated by specific inside information that would violate insider-trading laws. Rather, top executives are using long-term assessments of their own companies to determine whether the market is giving them values that are too low or too high. And in these long-term assessments, managers' advantage relative to outside investors turns out to be small. It is enormously difficult even for a CEO to predict where his or her stock price will be in 12 or 24 months.

An added difficulty in extracting useful information from executives' insider trades is the increased prevalence of equity-based compensation for top managers: most top executives these days receive significant grants of stock options and restricted stock, and hold considerable amounts of both vested and unvested equity in their employer. The effect of option grants to executives and option exercises by executives on insider trading is substantial and needs to be taken into account when interpreting insiders' decisions.

I compensated for variations in option grants and option holdings across executives and across time in the study by using detailed data on equity compensation from the Standard & Poor's ExecuComp database. Unsurprisingly, top executives react to large option grants by exercising options and by selling vested shares out of their portfolios. Equally unsurprisingly, executives who hold large amounts of vested equity react to rising stock prices by selling some of their holdings in the firm. These diversifying transactions have essentially no predictive power for future stock returns.

Given that much of the inside selling by top executives is driven by equity compensation, outside investors should instead focus on purchase transactions, and outsiders should look for unexpected moves by top executives. Examples of unexpected transactions are top managers with small holdings who are selling (especially if they do so after prices have fallen), and managers with large holdings who are buying (especially if prices have risen). These are the transactions that are most likely to reflect a positive or negative opinion of the executive and not simply a desire to diversify.

Another useful strategy is to look simultaneously at executives' decisions in their own trades and at the decisions they make for the corporate equity account: equity issues and repurchases. By far the worst performance is experienced by firms that issue seasoned equity (non-IPO offerings) and, in the same year, have top executives selling significant amounts of equity.

The most intriguing finding coming out of my research is how systematic is the disagreement between executives and the equity market about valuations. Top executives tend to see very high valuations as excessively optimistic, and very low valuation levels as excessively pessimistic. Executives, as a group, have assessments of fundamental value that are less extreme than the market.

While one could simply dismiss this observation as irrelevant to outside investors, the historical record suggests that top executives may be on to something: over longer time periods, stocks with low price-earnings ratios and low market-to-book ratios have outperformed the more glamorous issues characterized by high valuation ratios.

So while executives are not using a lot of inside information in their trading decisions, their more cautious interpretation of publicly available fundamental information does contain an important message: if top executives don't believe the extremes of the market but actively go against them in their trading decisions, maybe individual investors should not believe them, either.

Dirk C. Jenter is Assistant Professor of Finance at the MIT Sloan School of Management in Cambridge, Mass. He can be reached at 617.258.8947.