Watch for SEC filings that reflect major "skin in the game" by corporate insiders

By Mark W. Gaffney

For WhaleWisdom.com

“Don’t tell me what you think, just tell me what’s in your portfolio.”

Nassim Taleb in Skin in the Game

 

In his most recent book Skin in the Game, Nassim Taleb asserts that if you offer an opinion, and someone follows it, you are morally obligated to share in the consequences. If you profit from giving advice, you should also share in the loss if your advice turns out to be bad.

The book is essentially about who to trust and who not to trust. Taleb thinks you should trust those who have skin in the game -- advice givers who are exposed to both reward and risk. Be wary of armchair experts who offer grand opinions but won’t suffer if they’re wrong: “Do not pay attention to what people say, only what they do, and to how much of their necks they are putting on the line,” Taleb writes.

What if everyone giving investment advice -- financial advisers, brokerage firm analysts, talking heads on CNBC -- were required to show their portfolios when making recommendations?

A rule requiring advice-givers to disclose their portfolios would definitely simplify the financial sales process: Skip the spiel Mr. Financial Salesman, just show us what you’ve been buying and selling. When the hedge fund expert appears on TV raving about a hot stock, a list of his personal holdings would be displayed on the screen below his face.

One of the best ways to profit from experts who have skin in the game is by following the public filings of corporate insiders -- legal insider trading.

If financial advice givers disclosed their portfolios, it would elevate our confidence in their recommendations.  There’s something else it would do: It would put out of business financial gurus, market prognosticators, and securities analysts that don’t follow their own advice, that don’t “eat their own cooking.” 

Unfortunately, such a law isn’t likely to happen.  Nonetheless, seeking out experts who have proven skin in the game makes good sense. But who among the various analysts and stock pickers we rely on for investment ideas are practicing what they preach?

One of the best ways to profit from the actions of experts with demonstrated skin in the game is by following the public disclosures of corporate insiders -- legal inside traders.

Any officer, director or 10%+ owner of a public company is considered an insider by the SEC. Any transaction by a corporate insider must be disclosed via a SEC Form 4 filing within two business days of the insider’s trade.

If you’d rather pay attention to what financial experts do, and not what they say, Form 4 filings are about as good as it gets.

Corporate insiders, particularly “C-level” officers, have access to information regarding their own companies not available to the general public. Information that, if acted upon, could be highly profitable.

Certainly, it is illegal to trade on non-public material information. For instance, if the CEO of company XYZ knows that 4th quarter earnings are going to be spectacular, she cannot buy XYZ stock immediately before the earnings announcement.

However, U.S. insider trading rules are unclear at best. There is so much ambiguity and complexity surrounding insider trading law that a book on the subject could be entitled “100 shades of grey.”

If you’d rather pay attention to what financial experts do, and not what they say, Form 4 filings are about as good as it gets.

Decades of academic research confirms that corporate insiders as a group achieve market-beating profits. Many individual insiders have stellar trading histories. How much of this outperformance is from being smart people who know their industries, and how much is from exploiting the grey areas of insider trading law? It’s difficult to say. Whatever the case, insiders consistently beat the market and few are charged with insider trading. In 2017, the SEC accused 41 people of insider trading; of those, only a small number were officers or directors of public companies. Meanwhile there were tens of thousands of Form 4s filed last year.

One of the best skin in the game trades to follow is when a long-term officer or director, or better yet the CEO/founder of a company, makes an unusually aggressive purchase of his or her company’s shares.

Here’s an example:

On February 26 of 2018, Bryan Sheffield, President, CEO and Founder of Parsley Energy (NYSE: PE) bought 189,500 of his company’s stock at $26.34. That’s a $5 million purchase. A review of Sheffield’s past Form 4 filings shows that since May of 2014, when PE began trading, Sheffield had never purchased a single share of his company’s stock on the open market.

Parsley Energy had traded between $11 and $40 since 2014. At no time did Sheffield feel inclined to buy PE shares -- his Form 4 filings reveal only granted shares, exercised stock options and stock sales. Why would he suddenly pony up $5 million to buy his own stock on the open market? There’s likely only one basic reason: He believed the stock was going higher and he’d make money.

The beauty of following insider trading and significant “skin in the game” trades is that you don’t really need to know why the insider is buying. The fact that the insider is risking a big chunk of his or her own capital speaks for itself. That’s not to say you shouldn’t do research after seeing a significant insider buy, you should. But an insider, an expert on his company, buying significant shares on the open market is a reason to get very interested. The insider is not telling you to buy his stock, but rather putting his money where his mouth is.

Now you might argue that Sheffield is a rich man, and $5 million to him isn’t necessarily that big of a deal. After all, the 189,500 shares purchased represents less than 1% of his total holdings. Maybe $5 million to him is like $5,000 to most of us. Possibly a lower level corporate officer buying $200,000 of her company’s stock -- the equivalent of her annual salary -- is a better sign of skin in the game.

The trick of trading off the Form 4 filings of insiders is to decipher which buys (sells are usually not predictive) represent an insider putting significant skin in the game, and which buys are insignificant or b.s. trades -- the insider giving the appearance of supporting his or her stock.

Of course, there is no guarantee that investing alongside an insider will be profitable. Corporate insiders are sometimes wrong, and they’re often early. And instances where insiders “back up the truck” and buy their own shares are rare. But watching and waiting for high conviction buys by corporate insiders is worth it. There is no better place to get investment ideas from experts with proven skin in the game.

 

Mark Gaffney