Monday, August 13, 2012

How to Avoid Insiders Trading Against you

With the Rajat Gupta case in full swing, it’s interesting to take note of the type of companies that he, allegedly, was involved in giving information on. The trial will focus on Goldman Sachs but Gupta also stands accused of giving information out on a Procter & Gamble acquisition.  His friend, Raj Rajaratnam, has already been convicted of insider trading in companies like IBM, Intel (NASDAQ: INTC), 3com and AMD (NYSE: AMD). Furthermore, in an unconnected case, former fund manager Reema Shah pleaded guilty to conspiracy to commit securities fraud involving companies such as Yahoo (NASDAQ: YHOO) and Microsoft (NASDAQ: MSFT). Everyone knows what happened with Martha Stewart and ImClone.

With Intel, a mid level executive, Rajiv Goel, was passing information to Rajaratnam, including upcoming earnings figures. With AMD, a top senior partner at a well known consultancy firm McKinsey & Company, Anil Kumar, was also passing information to Rajaratnam on the company. Altogether, Rajaratnam is believed to have made $24.5m profit from this information. In the seperate Reema Shah case, she was in contact with a Yahoo executive who leaked information about a possible deal between Yahoo and Microsoft. Unfortunately, it doesn't stop there. Rajaratnam was convicted of insider trading in other companies such as Clearwire, Akami, ATI and Ebay.

Now, before these companies’ lawyers start preparing letters, I should point out that I am in no way arguing that there is anything intrinsic in these companies that make them victims. And victims, they most certainly are, no company wants information on it to be disseminated in this manner. What I am arguing is that, it strikes me that there are certain types of companies that might get more targeted than others. If it isn’t a merger or an acquisition, it usually seems to involve technology companies and/or corporations that have volatile earnings prospects. Logically, this makes sense because they (insider traders) want their activities to count. In other words, they want more bang for their cheating buck.


Naturally Volatile Stocks

Frankly, it is very difficult to advocate protecting yourself by just not buying volatile stocks! However, investors can avoid chasing too many investments in companies that involve situations where insider information has more of an edge. I’m thinking of things like generally buying stocks with a diversified customer base. If you buy a stock with one major customer, in a competitive market, you can be sure that everyone will want to know what is happening in that relationship. I’d also urge caution with stocks exposed to a large one-off political risk. Retail investors are unlikely to be better informed.
Furthermore, I have never met an investor that consistently made money by trading stocks over earnings. This is a game that is likely to see you up against people like Rajaratnam who are using every means possible to get an edge.


Corporate Actions

If you are cynically disposed to the idea that ‘Chinese Walls’ are always full proof at investment banks, then you might be sympathetic to the notion that a lot of information gets leaked about corporate actions. I have no hard data to back this up, but I am frequently astounded by how often certain stocks seem to fall in a sustained manner only for the company to announce a rights issue and, then suddenly it starts rising again. Of course, the problem here is that how is a retail investor supposed to know when a company is about to launch a rights issue?

In truth he/she cannot, however what you can do is listen very carefully to what managements are saying and try to avoid companies that are burning cash and making noises about fund raising. Even if they are not saying it implicitly, if a company starts talking about aggressive expansion plans, but is not in a position to fund them, you can guess a fund raising is coming.

Another area is with hostile takeover bids. As soon as a bid is launched but not accepted, a host of corporate lawyers and, investment banking personnel will be all over the situation with a fine tooth comb. I always sell on the bid. You are possibly going to find yourself trading against others with better info. You will kick yourself later if the bid collapses after a sustained fall in the share price. I avoid such situations.


Glamour Stocks

As mentioned earlier, certain types of stock attract more media attention than others. I would argue that the kinds of high profile glamour stocks mentioned above, seem to be much more susceptible to insider trading than the more boring mundane type of stocks. Everyone in the media wants to know about the launch of the tech gadget or a new wonder drug, but are they really that interested in a change in demand for a certain type of food? Or an increase in margins generated by a cost saving program at a metal basher?

Peter Lynch was always keen to advocate boring stocks because they were often ignored by most analysts. He has a good point and, I think that investors could do well to avoid chasing too many stocks that have analysts and fund managers crawling all over them trying to trade the next set of results. The only stock that has risen in the S&P 500, every year, for the last 10 years is Wabtec (NYSE: WAB). Its primary activity is making brakes for rail cars. Boring stocks make money!


Avoiding Insider Trading?

In conclusion, I’ve mentioned a few areas in which retail investors can exercise a bit of caution. In truth, there is little that we can all do to fully evade being traded against in this manner. However, I think it is a useful practice to try and spot some tell tale signs of risk. There is no need for retail investors to chase glamour stocks, or trade over earnings, or keep buying volatile stocks exposed to a lot of headline risk. In fact, the beauty of being a private investor is that you can walk away from such situations and selectively pick your way through the market. Something that professional fund managers can’t always do.