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Following insider trading isn't a sure thing

/ Source: The Associated Press

When an executive like Michael Dell buys about $70 million worth of his company's stock in one of the largest individual share purchases of its kind in recent history, that gets people talking. But it shouldn't necessarily get people buying.

Insider transactions are something that many stock-market watchers like to monitor. The thinking goes: If people in the know are scooping up or selling stocks, then maybe other investors would be smart to follow their lead.

That strategy may look great on paper, but in practice it's not as reliable as one might think. In some industries the performance of stocks following big insiders' moves fall short of the broader market, according to a new study from Morgan Stanley.

With Wall Street plagued lately by mounting concerns over rising inflation and slowing economic growth, investors are doing what they can to navigate a choppy market. Since mid-May alone, the Standard & Poor's 500 index has fallen more than 5 percent, erasing much of the gains tallied in 2006.

As a result, stock picking has become increasingly important. When investors can't count on the broader market to give them much in the way of return, they search for individual stocks that could potentially have something to offer.

Maybe that's what Michael Dell is thinking, too. Shares in his namesake company, Dell Computer Corp., where he now serves as chairman, have taken a beating over the last year, plunging from a 52-week high above $41 a share to now trade around $25 a piece. According to Thomson Financial, its forward price-earnings ratio is now 37 percent below its five-year average and is 44 percent below its major competitors in the computer business.

Apparently, Dell believes this as an attractive time to buy, and did just that with his purchase last month of more than 2.9 million shares of Dell common stock for an average price of $23.99 a piece — his first purchase of common stock since 2001. Dell Computer declined to comment on Michael Dell's purchase, saying it was a private investment.

But investors interested in Dell or any other company with big insider activity might want to take note of the Morgan Stanley study. It judged the probability of success from using insider trading as a buy signal at 52 percent, meaning it would make you money only about half the time.

That's even though the study found that investors who bought stocks that registered an insider buy signal since 2003 have outperformed the S&P 500 by 6.3 percent over the next year. In particular, the best performance comes from following trades by the highest-ranking insiders _ chairman, vice chairman, CEO, CFO or president. Total return is 7 percent above what was seen in the S&P 500 over that three year period.

But as Morgan Stanley's chief investment officer Henry McVey points out, while "aggregate levels of purchases are good signaling mechanisms, the devil is in the details ... certain insiders are poor buyers of their stock."

One would be better off buying an S&P 500 exchange-traded fund than following the insider buying of auto company executives. After insider purchases, those stocks underperformed the S&P 500 on average by 19.2 percent. Pharmaceutical or biotechnology stocks underperformed the S&P 500 by 18.6 percent on average a year after insiders bought, while media companies underperformed by 15.6 percent and technology hardware and equipment firms by 7.6 percent.

Those that fared best: energy companies, where insider buying was followed by an average positive relative return over a 12-month period of 45.8 percent.

"Not all management is 'smart money,' " McVey said in a recent report to clients. "Our best guess is that these insiders may have been attempting to bolster confidence by buying their own stock, even if they knew the fundamentals were lackluster."

Insider selling, meantime, also often isn't predictive of a market downturn. That's because some stock sales may just be routine or may be executives wanting to free up money to cover personal expenses or to help pay the taxes on shares they buy after exercising options.

It's too soon to tell whether Michael Dell made the right bet or not. But just blindly following his money might not provide investors with a guaranteed payout.