Insider Trading Is One Piece of the Puzzle

Contrary to Cramer's assertion, insider trading data can raise important flags.
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Did anybody happen to catch

Jim Cramer's invective on the evils of considering insider trading activity?

We did, and we wonder whether we were not at least partly at fault for his misconceptions. No, Jim, insider trading data aren't a perfect guide. But neither are charts or P/E ratios or any other piece of information that investors use to help them evaluate the prospects for a stock. But it can be an effective tool for making smarter trading decisions.

The biggest problem with analyzing insider trading is that, like everything on Wall Street, once the majority of the players figure out the key, someone changes the locks. Think of it as a chess game between investors and insiders: One side is always anticipating the moves of the other, and the winners are those who best anticipate and adjust.

The game first showed up on the buying side, when company insiders caught on to the public relations value of "cluster buying" back in the early part of the decade. This kind of collective insider behavior attracted so much press that insiders began orchestrating their buying when they wanted to signal that they considered their share price too low.

As the game has progressed, some companies have begun to require that their executives and directors own a minimum amount of their own stock. Some companies have even started loaning money to insiders to buy stock, thus making some of the purchases by their executives less risky. Other companies have found that by encouraging their executives to buy after big drops in their share prices, they can provide effective camouflage against class-action lawsuits. With the proliferation of these corporate orchestrations, we have become increasingly skeptical of any insider-buying analysis that overlooks their existence, and so should you.

Analyzing insider sales has always been much more difficult. With so many more companies now making stock options a bigger part of their employees' compensation packages than before, the sheer size of these holdings means that insiders will be regularly shedding their shares -- to buy a larger house, to pay taxes, etc. Such sales are often more about the insiders' lifestyles -- not necessarily a comment on the company's future -- and insider trading analysts must dig deeper to determine whether these kinds of sales contain real warnings about the company. That's why you should never take "unfiltered" insider selling information -- a straight list of insider buying and selling -- as a reason to avoid a stock.

How do we filter out the noise? We closely analyze insider options information, which we have been collecting since 1991, in order to help clarify the picture. First, we find out the of amount exercisable options available to the person at the time of the sale. We use this to ask: Are they holding onto large amounts of vested options or are they beginning to cash out of many long-held options?

Then, we look for mitigating circumstances: Are they merely selling to exercise expiring options or are they reducing their overall exposure to their company's stock price? If so, are any of the active insiders retiring or leaving the company?

We also compare their current activity to what they've done in the past. Do the options constitute the bulk of their compensation so that regular selling shouldn't be a red flag?

Finally, we look at other clues that might explain their behavior: Are they reacting to simple price movement in their stock or are they acting in the absence of movement? What news developments have there been in the stock in question? What are Wall Street analysts saying about it? Where are Street expectations? The list goes on and on ...

So often, these mitigating circumstances mean that even significant insider selling can be a false signal for the prospects of the stock.

That's why we spend so much time filtering out the noise that insider trading data sends us. This is particularly true at technology companies. These companies are the most aggressive with their use of options. In fact, the majority of insider positions in technology companies are in the form of options, not common stock. Because of this, it is important to understand that any analysis of insider confidence -- or lack thereof -- is especially complex in technology companies. That's why you won't see us commenting on insider selling -- in the majority of cases -- when it surfaces in these companies.

We have found ourselves saying over and over again through the years, "Use insider data as a tool for your analysis, not as your analysis itself." Nevertheless, when we discover some insider selling that carries significance, we are telling you that, after our analysis, we still want you to know about the activity. That's not a sell recommendation: What we are saying is that we feel there are elements in the insider picture that may be pointing to a potential for problems down the road.

Once armed with this information (and, hopefully, your own facts), it's up to you to determine your course of action. Perhaps it's time to revisit the reasons you bought the stock in the first place. Check to see if anything has changed in the picture since you last researched the issue, for instance.

In his attack, Cramer mentioned a slew of names where insider selling data would have kept you out of the stocks. The problem with his statement is that with the exception of

Sun Microsystems

(SUNW) - Get Report

-- whose insider sales we thought significant earlier this year -- the only other issues we had commented on were

Lycos

(LCOS)

(in a late January comment before the stock pulled back 50%) and

Xerox

(XRX) - Get Report

(where, in March, we commented on insider sales with the shares at $52.25). We had passed on the others. Don't get us wrong, we're not right all the time. But we do have a pretty good track

record.

In short, without presuming to speak for the "charlatans," or even the entire cottage industry that has grown up around insider trading data, we can assure you that we comment only on that small fraction of insider buys and sells that we consider investor-relevant -- once they've been sifted through our rigorous research process. In certain cases -- say, for instance, the incessant, loan-sponsored buying at

Conseco

(CNC) - Get Report

-- the activity is so suspect that we will go out of our way to warn investors to be wary.

As for the remainder -- for example, the fifty or so thousand shares of

TheStreet.com Inc.

(TSCM)

bought by James. J. Cramer himself in November -- we place a good deal of it on the back burner and wait to see what develops. After all, it may well be that the illustrious Mr. Cramer is -- in his own words -- simply "reacting to the same perennial low valuations that the stock market places on the mundane." Or maybe not. We don't think so, but to those who accept Cramer's view of insider activity as a contrary indicator, do what you must.

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.