"Insiders might sell their shares for any number of reasons, but they buy them for only one: They think the price will rise."
This quote comes from investing legend Peter Lynch. He averaged 29% annual returns from 1977 to 1990 when he ran the Fidelity Magellan Fund.
Obviously, he knows a thing or two about investing.
What was Lynch hinting at in his statement?
First, let’s define insiders. Lynch was referring to corporate insiders. This group includes top officers, directors, major shareholders and anyone else with access to key company information before it’s made available to the public.
Second, why is insider buying important? Corporate insiders have a natural edge over investors — and even top-notch financial analysts — because they know their businesses and industries better than anyone.
As an investor, no matter how much research you do … or how much financial news you consume … you’re always a step behind those "in the know."
What if you could peek through the keyhole at publicly traded company boardrooms, to see and hear what’s really going on behind the scenes?
Imagine if you were privy to closed-door conversations between CEOs, CFOs, boards of directors and other top officers. Wouldn’t you have a clear-cut information edge?
I know that is impractical …
You’d surely get a security escort out of the building if you made it to the boardroom door. And let’s not even talk about the consequences if you subsequently traded off that non-public information, which is punishable by the SEC.
Today, I have an investment that could serve as the next best thing. And it is perfectly legal!
I’m referring to the Direxion All Cap Insider Sentiment Shares ETF (KNOW).
While Direxion is famous for its 2-times and 3-times leveraged ETFs, this ETF is a different sort.
KNOW is a "smart beta" ETF. To refresh, smart beta products provide market exposure based on non-price-weighted factors. In other words, rules-based index construction instead of market-cap weighting.
KNOW tracks the Sabrient Multi-Cap Insider/Analyst Quant-Weighted Index.
That is a mouthful. To simplify it, the strategy follows "smart money" and "smart opinions."
Who possesses the real "smart money?"
Mutual fund portfolio managers
Many investors would cast votes for A, B or C. But I think D is just as deserving, if not more so.
If executives, directors or others with intimate knowledge of a public company are buying shares, investors should take notice. Following insider buying is a well-known strategy in the hedge fund space.
I spoke to Mike Eschmann, Direxion’s Managing Director of Capital Markets and Institutional ETF Strategist. Here’s what he said:
"Monitoring insider sentiment has been a tactic used by institutional investors for a long time. However, the time it takes to compile data, research and analyze individual stocks is a barrier for most. The majority of investors don’t have the time, technology and resources to do it."
Insiders, by law, are required to file a "Statement of Changes in Beneficial Ownership of Securities" (SEC Form 4) within two days of a completed transaction.
You can find this form online here.
Since this form is accessible to the public via the EDGAR system, anyone can see when corporate insiders are buying shares. KNOW’s strategy takes the hard work off your plate. Its insider buying playing field is the S&P Composite 1500 Index, which covers 90% of U.S. market capitalization.
But KNOW’s strategy dives deeper. In its review of insider buying, KNOW weeds out the non-speculative Form 4 filings (like option exercises, which are typically more related to liquidity events). This is a crucial distinction because KNOW pinpoints "open-market purchases." These types of buys require insiders to reach into their own pockets and purchase company stock on the open market.
With open-market purchases, insiders have true "skin in the game."
Smart opinions come from the "other insiders" — Wall Street analysts. In any given industry, there are a number of analysts who closely follow specific sectors, industries and companies.
It is their job to know their assigned companies inside and out.
KNOW’s strategy also looks for positive revisions on earnings estimates from analysts.
In this case, if several Wall Street analysts revise expectations to the upside for a particular stock, it is an added vote of confidence for investors.
There’s more to the strategy than just these two elements. Here’s how the index — that KNOW follows — works …
The Sabrient Multi-Cap Insider/Analyst Quant-Weighted Index Methodology Explained …
Starting with the 1,500 stocks with the largest market capitalization, the index eliminates stocks of companies with very aggressive accounting practices, as identified by Sabrient’s forensic accounting screening.
The following four factors used are used to narrow this 1,500 stock universe to 100 stocks. At least one of four factors must be positive for a stock to make the cut.
(1) Number of Purchasers: The number of insiders who have purchased company stock on the open market is very important. The more insiders purchasing shares on the open market, the greater the significance. The index assumes insiders are making informed purchase decisions. And it relies upon insiders’ collective intelligence to find interesting candidates.
(2) Percent Increase in Holdings: In addition to the number of insiders who purchase over a given time frame, the percentage gain in shares is considered significant. If an insider purchases just a tiny amount compared with their current holdings, then it is not a strong vote. On the other hand, if an insider doubles or triples their holdings, then it is considered significant.
(3) Number of Positive Analyst Revisions: A factor based on the number of Wall Street analysts who revise expectations positively, especially earnings estimates, is used to corroborate the insiders’ vote of confidence with their purchases. If both corporate insiders and Wall Street analysts agree that the stock is due for price appreciation, it is considered highly significant.
(4) Percent Increase in Analyst Expectations: As with the insider purchases, the amount that expectations are revised by analysts is important. If analysts increase their expectations of earnings per share by a large amount, it is of greater importance than a smaller amount.
The top 100 stocks from this second cut are used to populate the index.
A "defensive sentiment" overlay is used to rank the final 100 stocks. This overlay rewards stocks that historically have performed well in weak markets, have strong free cash flow yield, and strong dividend yield. The top 50 stocks are aggressively weighted in a range of 2.6% (for the highest ranked stock) to 0.96% for the 50th ranked stock. Each of the bottom 50 stocks is given a flat-weighting of 0.35%.
This strategy might sound gimmicky to you. I’ll admit: It did to me when I first heard about it years ago. But four years later, the performance is hard to dismiss …
The Proof is in the Pudding
Check out KNOW’s impressive showing since its 12/8/11 inception …
It has outperformed both the S&P 500 and S&P 1500 in all four calendar years of its existence.
And since its launch, KNOW has easily outpaced the S&P 500 and S&P 1500.
I also looked at the back-tested results of the index vs. the S&P 500 (both price change only). From April 2000 to July 2012, the S&P 500 Index recorded an annualized return of -0.6%. Meanwhile, the Sabrient Multi-Cap Insider/Analyst Quant-Weighted Index recorded an annualized return of 8%.
KNOW’s back-tested benchmark has whipped the S&P 500 by almost 9% per year!
So not only has KNOW given its investors impressive market-beating returns over its first four years in the ETF marketplace … but its index back-tests with marvelous results as well.
Eschmann also told me:
"For 65 basis points, KNOW follows a time-proven, repeatable, quantitative strategy. This ETF simplifies the strategy and may appeal to those who see value in following the so-called smart money."
Would you like to be "In the KNOW"?
To learn more about Direxion’s Insider Sentiment ETF, click here.
Or if you would like to learn more about this strategy and others that help you to follow fund flow and "inside" buyers, send me an e-mail here.