50 Shades Of Grey: Beat The Market By 11% With Insider Trading?

By James Early, Chief Investment Officer of BBAE

"I have no problem with cheating. Whatever you can get away with."

-Joe Torre, chief baseball officer of Major League Baseball, 2011-2020

I hate to say it, but sometimes, cheating pays. 

Bill Gates stole Steve Jobs’ Graphical User Interface concept. (Steve didn’t even originate it, but he’d at least traded Xerox some Apple stock for it.) Steve Jobs cheated Steve Wozniak out of an Atari game bonus. Mark Zuckerburg cheated Tyler and Cameron Winklevoss when he lifted the Facebook concept from their ConnectU. 

Unfortunately, cheating can also pay in the stock market – for a special group I’m going to call the world’s best investors, because statistically, they probably are.

Everyone knows the market’s best investors individually: people like Jim Simons, whose fund returned 39% per year net of fees for 30 years, Warren Buffett, who returned 20% annually over 56 years, or Peter Lynch (29% annually over 13 years).

But the market’s best investors as a group are corporate insiders. 

In a paper called Estimating the Returns to Insider Trading: A Performance-Evaluation Perspective (1999), Leslie Jeng, Andrew Metrick, and Richard Zeckhauser, of Harvard, Harvard, and Yale, respectively, noted two findings: 

1. Corporate insider trading (far easier to measure than “outsider” insider trading, which is always illegal) earns corporate insiders 6 percentage points per year of “abnormal” profits (academic-speak for returns that are too good to be true on a risk-adjusted basis)

2. A strategy following insider trades beat the market by 11.3 percentage points per year. 

That’s 11.3% additional – per year.

If you started with $100,000 and earned a market-ish 9% per year for, say, 30 years, you’d have $1.3 million. But juicing your market-ish returns by 11.3 points would give you $25.6 million. 

Corporate insiders have superb investment skills, at least when investing “legally” in their own stock.

Keep reading for 5 names that insiders are trading (four they're buying and one they're selling) today.

Insider trading: No law against it

Weirdly, there’s no specific statutory law banning insider trading in the US. Insider trading does get prosecuted, but through roundabout charges like wire fraud or mail fraud, and using case law. The closest the US has to a ban is a 1948 SEC rule known as 10b-5, inspired by a case of a company president simultaneously bashing his company publicly while privately buying its stock, that piggybacks on the Securities Exchange Act of 1934 and bans “manipulative and deceptive practices.”

With no bright-line prohibition – and this idea is from Wharton Professor Dan Taylor, a world-leading expert in insider trading (Dan and I even made a video on insider trading last year) – only obvious, smoking-gun cases getting prosecuted.

CLEARLY OK: A CEO buying (her own company’s shares) because she feels optimistic about her company’s long-term prospects.

CLEARLY ILLEGAL: A CEO buying because she has specific knowledge that another company is about to announce that it will acquire hers at a nice premium. 

GRAY AREA: A CEO buying because she thinks there may be a chance her company may receive a buyout offer in the coming year or so, even if nothing specific is on the table.

Few insiders are stupid enough to trade based on obvious, discrete insider information like in the second case, but they don’t need to: They can take much less risk by trading on gray-area probabilities, like in the third.

"As society becomes more and more complex, cheating will in many ways become progressively easier and easier to do and harder to police and even understand."

-Vitalik Buterin, Ethereum founder

How to do insider trading in the US: Don’t be too obvious about it

If insiders are deliberately stopping short of the “egregious” line, but still cheating in spirit, their aggregate trading may reveal clues.

Knowing that: 

1. Corporate insider trading, or at least buying, can be legitimate and even good for demonstrating faith in the business and increases alignment with shareholders, and

2. Top managers are so “tainted” by access to material nonpublic information that a well-meaning insider wishing to avoid impropriety may struggle to find a clear line between trading on acceptable information (“I think the next five years will be bright because I’m smart and have a smart team”) and unacceptable or gray-area information (“I think the next five years will be bright because our team is smart – and because some twinkle-in-the-eye products/deals/partners/hires might be game changers.”)

The SEC created a safe haven via pre-arranged trading plans through something called Rule 10b5-1, a 2000 add-on to Rule 10b5.

The good news? Good insiders got a way to trade without looking like bad insiders.

The bad news?  Bad insiders got a way to trade without looking like bad insiders. 

10b5-1 trades: perfectly timed to the day

In 2004, my friend Alan Jagolinzer, then at Stanford and now head of the accounting faculty at Cambridge University, found that despite these “prearranged” plans, insiders, as a group and as if guided by clairvoyance, managed to sell at peaks and buy at dips.

Read Alan’s original paper via this link.

Rather than mostly being used as intended –  as a safe haven for legitimate trades made under a pre-set trading plan – Rule 10b5-1 appears to have mostly been used to mask illegitimate trades. 

10b5-1 plans not working as planned

On paper, insiders couldn’t employ material nonpublic information (MNPI) when they started or changed trading plans (wink wink) but, oddly, they could use MNPI when canceling them. In other words, if a CFO learns of good upcoming news, he could pause a 10b5-1 sales plan, and he could stop a buying plan once he becomes aware of bad upcoming news. 

And though the presumed intention of the 10b5-1 plan was that executives would create systematic trading plans that executed trades across a spectrum of market conditions, in practice, many 10b5-1 trades were one-and-dones. And rather than require electronic filing – which would create an appearance in the SEC’s (searchable) EDGAR database – the SEC allowed paper filing of 10b5-1 plans. Unsurprisingly, 99% of participants chose this more “clandestine” route (and when Dan Taylor wanted to research, he had to physically go to the SEC and review the paper filings). 

If you were an unethical insider looking to unethically trade on inside information while having the appearance of ethically following the rules, it was hard to envision a better gift than 10b5-1 plans.

Will things change?

Give the SEC a problem and two decades and you can consider it fixed.

Finally, 20 years after Alan’s research and following research by Dan Taylor and others, the SEC finally issued some news rules – even citing Alan’s study – making 10b5-1 plans harder to abuse: 

1. A 90-day cooling-off period between when an officer or director implements at 10b5-1 plan and when the first trade can commence, and a 30-day cooling-off period for people aside from officers and directors.

2. A restriction on single-trade 10b5-1 plans.

3. A restriction (though not a total ban) on overlapping 10b5-1 plans.

4. A requirement that directors and officers promise that they are not using their 10b5-1 plans for “bad” things like trading on material nonpublic information, or trying to evade the prohibitions of Rule 10b5, and a similar requirement that 10b5-1 users are implementing their plans in “good faith.” (Note: Maybe I’m jaded, but I’m not sure how effective making bad guys promise that they’re not going to be bad will be.)

5. Disclosures of 10b5-1 plans on 10-Ks and 10-Qs.

In other words, the SEC appears to have taken most of the 10b5-1 punchbowl away. Even Dan is now “basically happy” (mandating 8-K filings to accompany 10b5-1 plan changes would have made him even happier).  

Will corporate insiders lose their Midas Touch?

On one level, if you ban cheating, it becomes harder for cheaters to profit. This was why the SEC modified the 10b5-1 rules.

On another level, I’d surmise that much of the 10b5-1 cheating was relatively short-term in nature – executives profiting off of insider knowledge of near-term events. 

If that’s true, the new rules might remove a lot of noise from the insider signal from the perspective of long-term investors. If you see an executive buying a stock, it’s more likely to be because she believes that stock will have a good long-term future, and not because she’s planning to dump it after some good news and before some bad news.

Granted, insiders’ knowledge of things like a good long-term future is far less accurate than their knowledge of an upcoming deal, but at least they’re better aligned with shareholders now. 

“Insiders may sell for many reasons, but they only buy for one: they think the price will rise.”

-Peter Lynch 

The other way to look at it: Evidence showed that insiders were profiting hand over fist even before 10b5-1 came about, and during the easier-to-cheat days of 10b5-1, investors couldn’t easily follow insiders’ 10b5-1 trades in real time anyway, so there’s reason to believe that insider trades – buys in particular – could still convey valuable information to investors. 

The top stocks insiders are buying

With that in mind, let’s turn to Benzinga’s Insider Trades tab and see which stocks are most beloved of insiders. 

For this screen, I’ll set a market cap floor of $300 million and consider trades for more than $1 million and ideally represented 5% or more of the insider’s holdings. Trades were made between December 9, 2022 and March 9, 2023.

Company	Insider	Trade Type	Amount
Summit Therapeutics (SMMT)	Maky Zanganeh, Co-CEO	Buy	$24.7m
Grocery Outlet (GO)	Eric Ragatz, Director	Buy	$3.04m
DISH Network (DISH)	James Defranco, EVP	Buy	$8.84m
SLR Investment (SLRC)	Michael Gross, CEO	Buy	$2.38m
Quantumscape (QS)	Jagdeep Singh, CEO	Sell	$9.61m

James Early is Chief Investment Officer of BBAE, a digital investment platform. He has no financial interest in any shares mentioned.