Following Insider Purchases Can Be Dangerous

| August 2, 2011 | 0 Comments

Insider purchases are one of my favorite indicators…

There’s usually only one reason corporate insiders buy stock in their own company… they think the stock’s going higher!  So, when the CEO or any other exec is buying, it’s often a good idea to take a closer look at the stock.

After all, insiders should know more about the company than anyone.  And if they’re putting their money where their mouth is, it’s usually a good thing to pay attention to.  It’s not uncommon to see a well timed insider purchase launch a new rally or spur an existing rally onto new highs.

And the best part is insider purchases are public information.

Any time an insider buys shares on the open market, there’s a record of it.  You know exactly how many shares they bought and how much they paid.

The bottom line is insider purchases show us management is confident in the company’s future.

What’s more, insider purchases are often followed by a rally in the stock. So buying a stock at the same time as an insider is usually a good way to juice up your profits.

But be warned… don’t run out and buy every stock insiders are buying.

You see, nothing’s that easy.  No single indicator will tell you everything you need to know.  And blindly following insider purchases can easily backfire.

Take STEC (STEC) for example…

STEC is a small cap tech company that makes solid state drives (SSD). They’re computer hard drives without any moving parts.  And they’re fast becoming the high end data storage device of choice.

A few years ago, STEC was the dominant player in the high end SSD market.  However, competition amongst the SSD makers quickly heated up.  And despite management’s positive spin, they’ve consistently disappointed investors.

In fact, STEC recently reported weaker than expected first quarter earnings on May 10th.  And the management slashed their second quarter outlook as well.

Not surprisingly, the stock got hammered the next day.

But a week after the awful earnings report, CEO Manouch Moshayedi and COO/CTO Mark Moshayedi began buying shares of STEC on the open market.  All together they bought $6.5 million worth of stock when it was trading between $14.59 and $14.70.

Many investors took the insider purchases as a bullish indicator.  The stock immediately stopped falling.  And over the next two months, it even managed to rally more than 25% to more than $18.

But investors who held on eventually got burned.  Last week the company slashed their outlook for the third quarter earnings.  And the stock plummeted from $18 to under $10!  Ouch…

It begs the question… If the company’s future is so uncertain, why did the CEO and COO put $6.5 million of their own money at risk?

The easy answer is… They didn’t care about the $6.5 million!

You see, back in August of 2009, the Moshayedi brothers held a secondary offering to cash out a portion of their STEC holdings.  At the time, they sold 9 million shares for $31 apiece.  All told the brothers cashed in more than $279 million in STEC stock.

Oh, and by the way, the SEC recently announced they’re considering filing securities fraud charges against STEC and the Moshayedi brothers.  The SEC believes the Moshayedi’s manipulated STEC’s price higher in order to cash in with their 2009 secondary offering.

It certainly puts the $6.5 million worth of insider purchases in a different light!

These insider purchases weren’t the sign of executives who are confident in the company’s future.  More likely, these two threw $6.5 million worth of their ill gotten gains to temporarily stem the tide of their company’s floundering stock.

And the worst part is… it worked.

I just don’t see any other way to explain why the stock rallied 25% to the upside after the insider purchases.  Clearly, investors threw caution to the wind and blindly bought the stock after an insider purchase.  In the end, it ended up costing them big time.

Remember, an insider purchase is a great indicator.  It will tell you when to take a closer look at a stock.  But it won’t tell you by itself whether you should buy or sell…

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Category: Stocks

About the Author ()

Corey Williams is the editor of Sector ETF Trader, an investment advisory service focused on profiting from ETFs and the economic cycle. Under Corey’s leadership, the Sector ETF Trader has become one of the most popular and successful ETF advisories around. In addition to his groundbreaking service, Corey is the lead contributor to ETF Trading Research, where he shares his insights about ETFs and financial markets on a daily basis. He’s also a regular contributor to the Dynamic Wealth Report and the editor of one the hottest option trading services around – Elite Option Trader.

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