Getting Inside Insider Buying

Bob Gabele looks at some nonobvious reasons why insiders acquire their company's shares.
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Conventional wisdom holds that corporate insiders have many reasons to sell their company's shares, but they buy only because they expect the stock to head higher. At best, that's only half right. To be sure, insiders don't buy for diversification or estate-planning reasons, nor do they do so to satisfy personal needs and wants -- both common rationalizations for insider

sales

. There are, however, other reasons to buy, and for insider watchers, these can be every bit as distracting as the "other" reasons to sell.

That said, it's hard not to like the activity at

Cadence Design Systems

(CDN)

. You may recall that back in April, the stock collapsed quite suddenly to below 12 from around 25. Since the tumble -- largely a reaction to some cautious forward guidance and a slew of analyst downgrades -- seven insiders have acquired a total of 480,000 shares through a combination of options exercises and open-market purchases.

Director Carol Bartz exercised options to acquire 5,000 shares within a week of the stock's fall from grace. Much more impressive, however, is that insiders have continued to buy as the stock has consolidated and struggled to build a base in the low teens. In fact, the most recent purchase -- of 250,000 shares by John F. Olsen, president of the Design Realization Group and Corporate Development -- occurred on Aug. 25 at 13, well above the stock's Aug. 11 low of 9 1/8. And Chairman Donald Lucas, CFO William Porter, and President and CEO H. Raymond Bingham all were among the insiders acquiring stock in August.

Sounds simple, right? Well, not so fast. For every Cadence that looks to be the real deal, a dozen or so others fall short of the mark. The trick is to avoid being taken in. And although it's not easy -- we get burned ourselves from time to time -- a few simple rules may prove helpful.

For starters, be wary of sudden clusters of insider buys immediately after a dramatic price drop. Don't think for a moment that investors' renewed interest in insider activity has been lost on corporate investor relations departments, or that investor relations won't try to spin the situation to its own advantage. More than ever, on the morning after, top execs feel the heat of the investors' microscope, and a public show of confidence may be just what the doctor ordered.

For many of the same reasons, avoid reading too much into the large purchases of a high-profile insider, especially following a significant price drop. Purchases accompanied by company press releases or other corporate fanfare are particularly suspect. The same holds for cases in which insiders

sell

stock just before a considerable selloff and then reinvest only a small fraction of the capital taken out.

If there's an exception -- and invariably there is -- it's any individual or group with an exceptional track record for timing a company's stock. We've found it rarely pays to ignore the actions of a proven timer, regardless of the circumstances.

That covers the obvious attempts at grandstanding, tape-painting and promotional buying. But lurking in the background are more subtle, less insidious and even well-intentioned drivers of insider accumulation: company-secured loans that finance executive stock purchases and minimum stock-holdings requirements for executives. Conceived as a means of aligning the interests of executives and shareholders, they can have a profound influence on insider behavior. Ironically, because holdings requirements are often measured as a multiple of annual salary, even large holders can find that a suddenly lower stock price has knocked them out of compliance.

Finally, keep an eye out for signs of persistence in insider activity. Unlike sudden bursts of action, steady buys over time are far less likely to be corporate events and can provide some of the surest evidence of pure intentions. The ideal would be the case in which insiders continue to buy even as the stock begins to show signs of life. The move doesn't have to be dramatic, just palpable.

Which brings us back to Cadence Design. Here we have a large group of insiders quietly and persistently accumulating shares of what appears to be a consolidating stock. What's more, executives have most recently been accumulating shares in ever-larger numbers and at prices considerably higher than they had at the stock's recent lows. Could it all be for show, orchestrated for investors? Nothing is certain in this business, but at least we've done our homework. Let's hope it's enough.

Bob Gabele has been tracking and analyzing insider trading since 1978, most recently for First Call/Thomson Financial. This column is not meant as investment advice; it is instead meant to provide insight into the methods of insider trading. At time of publication, Gabele held no position in any of the companies discussed in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Gabele appreciates your feedback at

rgabele@thestreet.com.