Of all the factors that investors consider when determining which stocks to own, the level of buying by company managers and directors in their own shares has long been one of the most important.
Insiders understand their companies' prospects better than anyone else. So if they're shelling out their personal funds to buy shares, they must feel pretty good about the outlook. And it would seem that investors who follow insiders into those stocks are bound to make money.
At least, that's the theory. Unfortunately, it doesn't always work out that way.
Increasingly these days, insiders are buying because their companies are forcing them to load up on shares. In other cases, companies offer managers sweetheart deals to buy stock.
Either situation may be a big red flag for investors scouting for clues about stocks: Insiders may be buying more because their jobs require it--or because they face little risk--than because they expect their stocks to rise dramatically. What's more, some firms use insider buying as way to boost their stocks. Aware that Wall Street pays attention to insider activity, firms may trumpet big buys in news releases.
"You really have to be careful when you're looking at insider buying," said Bob Gabele, president of Fort Lauderdale, Fla.-based CDA/Investnet, which tracks insider activity. "It's very important to determine to what extent corporate influence has come into play."
Some corporate mandates require that executives own a certain number of shares based on their salaries or job titles. Companies say such rules assure that managers think like shareholders.
At other companies, managers are given incentives to buy, such as company loans with favorable terms or protection from losses if stock prices drop. Those carrots are especially common at companies that encourage, but don't require, insiders to buy shares.
The special deals, companies say, simply make it possible for executives to afford large chunks of stock that sometimes total several times their annual salaries.
To be sure, there's nothing wrong with requiring heavy insider ownership or offering inducements to make it happen. In fact, the stocks of some companies with those programs have logged solid gains in the last couple of years.
The problem for investors, however, is that they can no longer assume that insiders are buying because they're bullish. Instead, investors must search for the reasons behind the purchases.
"It's getting murkier because of those programs," said Richard Cuneo, editor of Vickers Weekly Insider Report, published by Argus Group in New York. "It requires that people do additional analysis to find out from the companies how the programs work and if investors have anything at stake or if they're just being handed the shares."
There are no exact statistics on how many companies have either mandatory or assistedstock-purchase programs. But it's clear the number is growing. "It's like going out on a beach with a metal detector," Gabele said. "Every day, we find a few more rings."
Consider Darden Restaurants (ticker symbol: DRI), which owns the Red Lobster and Olive Garden chains. Last June, the Orlando, Fla.-based company set new rules requiring that its chief executive own stock worth four times his base salary within seven years. Other managers were now required to buy shares ranging from half to three times their salaries.
But here's the sweetheart part of the deal: The executives could borrow from the firm, at market interest rates, up to 75% of the values of the shares purchased. As an added incentive, Darden handed out two options for each share purchased, providing the potential for a windfall if the stock did well. Not surprisingly, 54 of 63 eligible managers took advantage of the program and scooped up 185,142 shares in late July. At the time, the stock traded at roughly $9 a share. It now changes hands at $16.44.
Though the stock has since fared well, Gabele said investors at the time could put little credence in Darden's insider activity. "That's an outside influence," he said. "They're getting some gimmes here."
Rick Van Warner, a company spokesman, counters that the program was risky for the executives because they had to pay back the loans and would have been on the hook had the stock gone down. "People ultimately are paying for this out of their own pockets," he said. "It wasn't a giveaway."
Another example: Baxter International Inc. (ticker symbol: BAX) executives who bought shares through a 1994 program and held on for at least three years were partly protected against any drop in the stock price.