Are Orthopedic Insiders Buying or Selling?

In the U.S. stock market, all players are supposed to be buying and selling securities based on equal access to material information.

In 2002, ImClone CEO Samuel D. Waksal passed along some key information to his friends and family about his company’s FDA progress. His daughter, Aliza Waksal, sold $2.5 million of her shares in ImClone stock on December 27. Waksal’s father sold $8.1 million worth of ImClone shares. Even ImClones general counsel, John B. Landes, sold $2.5 million of ImClone shares. Waksal pleaded guilty to illegal insider trading and received a seven-year prison sentence.

Martha Stewart, who knew Waksal and owned ImClone stock also sold, lied about it and was also sentenced to prison.

By definition, company executives or “insiders” have information about a company’s prospects that outsiders do not have. They know, for example, what new products are in the pipeline, how FDA applications are progressing (or not), how product demand is developing, what the competition is doing and so forth.

In one form, as was demonstrated in the Waksal/Stewart case, trading on specific, non-public information is a quick path to prison.

But…there is another, LEGAL way for executives at public companies buy or sell stock in their own company even if they have material non-public information.

Under SEC and other rules and precedents, insiders are able to purchase or sell shares in their company’s stock at certain times of the year, by filing with the SEC that they plan to buy or sell shares, by disclosing how many shares and for how much or if these transactions are the exercise of their stock options.

In those cases, insiders can and do buy and sell—despite having insider knowledge of the most sensitive kind. Furthermore, these insiders are perfectly within their rights to make these buying and selling decisions based on that information and for their own benefit.

They just have to be transparent about the transactions.

The good news is that non-insiders can watch what the insiders buy or sell and, even though they may not know the precise reason for those actions, they can reasonably infer that insiders are acting in their own self interest.

As it happens, there are many studies that support the idea that insider trading is, in fact, based on insider information.

Former University of Illinois finance Professors Josef Lakonishok and Inmoo Lee, who now work for the private sector, calculated insider trading returns from 1975 to 1995 and found that they were 7.7% higher and 4.8% higher on a risk adjusted basis to either standard returns or naïve returns.

In 1986 University of Michigan Professor Nejat Seyhun found that insiders had received abnormally positive returns of 4.3% for the first 300 days for firms with more insider purchases than sales and a negative 2.2% over the first 300 days for firms with more insider sales than purchases.

Two years after Seyhun’s study, Harvard University’s Leslie Jeng and Richard Zeckhauser and Yale University’s Andrew Metrick studied insider purchases and sales and discovered that, without any sort of screening for size of transaction nor risk adjusting transactions, that insider purchases beat market returns by 11.2% per year.

More recently, there was a fascinating study published last year in the Journal for The Society for Financial Studies which found a strong inverse relationship between insider trading and institutional demand. Turns out institutions provide the liquidity necessary for insiders to buy or sell stock. Second, insiders are more likely to buy shares in their companies at times of low valuations and low lag returns while institutional investors are likely to do the opposite (i.e., buy high and sell low).

The authors' conclusions? Insiders are more likely to view their stocks are overvalued (or undervalued) following a period when institutions are net buyers (or sellers).

In short, insiders know exactly what they are doing.

Which brings us to insiders at 19 public manufacturers/suppliers of orthopedic products. Over the last six months insiders at public orthopedic companies have purchased in either open market purchases or through stock option programs 3.357 million shares of their own company’s stocks while selling a much smaller 1.969 million shares.

Orthopedic company insiders bought 70% more shares than they sold over the past six months.

The following table shows which orthopedic companies have had the strongest insider buying:

Source:  Yahoo!/RRY Publications, LLC

Of those companies whose insiders are net buyers, the ratio of buys to sell is a whopping 5 to 1.

The following table shows which orthopedic companies have had the strongest insider selling of their stock;

Source:  Yahoo!/RRY Publications, LLC

There are, of course, many reasons for buying and selling shares of one’s own company. In Stryker’s case, for example, the vast majority of those sales were by Ronda Stryker who is, no doubt, adjusting her estate and as a percent of the roughly 16 million shares the Stryker family holds, these sales are a small percentage.

The aggregate buy/sell pattern is crystal clear. Orthopedic insiders are buying orthopedic stocks. Last week, the average P/E for an orthopedic company was 12.93. The average price to sales was 2.66. And the ratio of P/E to expected growth was just 1.17. In short, insiders know bargains when they see them. And they are voting with their pocket book.