Insider trades and analyst recommendations — which is more informative? Hint: Which group has “skin in the game?”

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Both insider trades and analyst recommendations contain information which may be useful for investors researching stocks. However, of the two information sources, one is much more trustworthy than the other.

Everyday the financial media devotes major coverage to Wall Street analyst commentary on stocks. Goldman Sachs lowers it rating on stock XYZ to neutral, and the stock tanks. Or stock ABC receives an upgrade from Morgan Stanley analyst so and so and the stock jumps 15%. The assumption is that equity analysts are experts on the stocks they cover, and their opinions are significant and predictive. But in fact, the truth is generally otherwise.

Despite the constant attention paid to analyst ratings, studies have shown that the recommendations of sell-side analysts are of minimal value to investors. The fact is that sell-side analysts aren’t primarily interested in making accurate stock picks and earnings forecasts. That’s not really their job.

Analysts aren’t compensated for making accurate stock picks.

This 2014 study found that “accurate earnings forecasts and profitable stock recommendations have relatively little direct impact” on the compensation of sell-side stock analysts. Analysts in the survey were asked to rate aspects of their jobs most important to their compensation. “The profitability of your stock recommendations” was near the bottom for importance. Least important of all was “the accuracy and timeliness of your earnings forecasts.”

What was the primary criteria that determined analyst compensation? Industry knowledge and connections.

According to this WSJ article, many securities firms tally the number of times their analysts take company executives on the road to meet clients and use that number to help decide analysts’ annual bonuses. At some firms, as much as one-third of analysts’ yearly pay can be tied to corporate access. Current and former analysts say those forces can cause them to err on the side of producing rosy research reports rather than jeopardize lucrative relationships with investor clients. This explains why analysts typically rate at least 90 percent of stocks as “buys” or “holds,” while recommending investors sell only about five percent of stocks on average.

“When your compensation is in part based on how many meetings you set up in a given year, it’s really tough to stick to your guns,” one former analyst is quoted as saying.

In his book Skin in the Game, probability theorist Nassim Taleb suggests 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.

Wall Street sell-side analysts have little to no “skin in the game.”

Taleb believes that you should trust those who have skin in the game. Seek out advice givers who are exposed to both reward and risk. He warns to be wary of 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.

It’s obvious that Wall Street analysts have little or no skin in the game when it comes to their recommendations. They are not risking much by making bold predictions. That is unless the recommendation is a “sell.” So it’s not surprising that their recommendations are generally useless.

In contrast, some experts making “recommendations” have demonstrated skin in the game — corporate insiders. Insider trades and analyst recommendations have a key difference. Analysts take little or no risk when making recommendations. But insiders who buy their stock often stand to lose significantly if they’re wrong.

Corporate insiders, particularly “C-level” officers, have unmatched expertise in their industries. They also have access to information on their companies not available to the general public. Information that, if acted upon, could be highly profitable.

Pay attention to what financial experts do, and not what they say. Follow Form 4 filings.

The SEC defines an insider as any officer, director or 10%+ owner of a publicly traded company. Insiders must file Form 4 filings with the SEC within two business days of trading in their company’s stock. Insider Form 4 information is available at the SEC’s Edgar website or at services like WhaleWisdom.com that compile insider data.

Decades of academic research confirms that corporate insiders as a group achieve market-beating profits.

This 2005 study looked specifically at the relative informativeness of analyst recommendations vs insider trades. Analyst recommendations were informative only when conveying negative information. And this is a rare event.

“We show that the two activities often generate contradictory signals. Insiders in
aggregate buy more shares when their firm’s stock is unfavorably recommended or downgraded by analysts than when it is favorably recommended or upgraded…We find that analyst recommendations affect insider trading decisions, but not vice versa. Our further analysis shows that insider trading is informative when signaling positive information, and analyst recommendations are informative when conveying negative information. The overall results imply that corporate insiders and financial analysts do not substitute each other’s informational role in the financial market.”

The difference between insider trades and analyst recommendations. When an insider buys, he or she is putting skin in the game.

A highly informed insider buying stock in a company is not telling you to buy a stock. Rather the insider is “putting money where his or her mouth is.”

The trick of trading off the Form 4 filings of insiders is to decipher which buys (sells are usually not predictive) represent very high conviction. One wants to identify an insider putting significant skin in the game.

Of course, there is no guarantee that investing alongside an insider will be profitable. Corporate insiders are sometimes overly optimistic about their own companies. They’re often early, and they’re sometimes just plain wrong. Also, the most bullish insider signals — where insiders “back up the truck” and buy their own shares — are rare. But patiently watching and waiting for high conviction buys by corporate insiders is worth it.

When comparing the trustworthiness of insider trades and analyst information, it’s no contest. There is no better place to get investment ideas from experts with skin in the game than from corporate insiders.

You can follow insider buying at the SEC’s Edgar website or at sites like WhaleWisdom.com.

Contact Mark about investing based on SEC filings and smart money disclosures.

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