What Do Insiders Know?

Peter Cziraki is Assistant Professor of Economics at the University of Toronto. This post is based on an article authored by Professor Cziraki; Evgeny Lyandres, Associate Professor of Finance at Boston University; and Roni Michaely, Professor of Finance at Cornell University.

The evidence that share repurchases and seasoned equity offers (SEOs) contain value-relevant information is extensive in the corporate finance literature. In addition, we also know that insider trading is informative about future firm value. What is less clear is how trading by firms’ insiders prior to corporate events interacts with firms’ actions and whether this interaction contains additional value-relevant information. In our paper, What Do Insiders Know? Evidence from Insider Trading Around Share Repurchases and SEOs, which was recently made publicly available on SSRN, we examine the information contained in insider trades prior to open market share repurchases and seasoned equity offerings using a comprehensive sample of over 4,300 repurchase and nearly 1,800 SEO announcements.

We find that insiders tend to “put their money where their mouth is.” They buy more before repurchases and sell more before SEOs. In particular, there is a sizable increase in insiders’ net buying in the months before a repurchase announcement, equal to 13% of the standard deviation of a measure of net insider trading. There is a similarly large decrease in insiders’ net buying in the months before an SEO announcement, equal to 40% of the standard deviation of the same measure of net insider trading.

Next, we show that insiders’ actions prior to announcements of repurchases and SEOs influence the market’s perception of these events. More insider buying and less insider selling prior to share repurchases is associated with larger positive announcement returns. Similarly, more net buying by insiders before SEOs is associated with less negative announcement returns. A one-standard-deviation increase in pre-event abnormal net insider purchases is associated with an increase of around 80 basis points in abnormal returns measured over the three-day period around repurchase announcements. Similarly, a one-standard-deviation increase in abnormal net insider purchases prior to SEOs is associated with abnormal announcement returns that are 45 basis points higher. These numbers are substantial relative to the average announcement returns of 2.1% in the case of repurchases and -2.6% in the case of SEOs.

Our results also indicate that the market does not immediately absorb all the information in insider trading prior to repurchase announcements. For repurchases, the tercile of firms with the highest insider net purchases prior to the event outperforms firms with the lowest insider net purchases by six percentage points in following one year. On the other hand, the market seems to incorporate the information contained in pre-SEO insider trading fast—there is no evidence of a positive association between pre-SEO insider trading and post-SEO long-term returns.

We design our empirical analysis to ensure that these results can be attributed to the joint signal in insider trading and event announcements. In particular, we examine announcement returns relative to returns of firms that have similar characteristics and exhibit comparable insider trading patterns, but do not engage in share repurchase or SEO. This matched-firm evidence demonstrates that there are complementarities between value-relevant information contained in insider trading prior to SEOs and repurchases on one hand and the information in these event announcements on the other hand. We find that the relation between insider trading and future returns is twice as strong around repurchases as it is at other times.

Finally, we analyze why insider trading around repurchases and SEOs is informative for future returns; or what do insiders know that outside investors do not know? We investigate the types of information that insiders seem to possess and convey to the market. Insiders buy more (sell less) prior to repurchases (SEOs) when expected future operating performance is better. For example, the average change in the return on assets in the three years following repurchase announcements is 1.5-1.6 percentage points higher for repurchases belonging to the top tercile of insider net buying than for those belonging to the bottom tercile. The respective figures are 1.0-1.4 percentage points for the case of pre-SEO insider net buying. We also find highly statistically and economically significant differences in changes in risk and cost of capital following repurchases between firms characterized by relatively high net insider purchases and those with low net insider purchases. Using the Fama-French (1997) model as the benchmark, the reduction in post-repurchase cost of capital is 1.1-1.2 percentage points larger within the tercile of repurchases with the most insider net buying than within the tercile with the least insider net buying. This is not the case for SEOs: pre-SEO insider trading does not seem to be negatively associated with post-SEO risk and cost of capital.

In addition, our results suggest that large part of the information contained in insider trading is not about investor sentiment and insiders’ desire to trade against it. In most cases, the information contained in pre-event insider trading does not differ significantly between subsamples of firms sorted by a measure of relative misvaluation.

Overall, our findings suggest that corporate insiders’ personal investment decisions tend to be consistent with their firms’ actions: Insiders sell more on average prior to SEOs and they sell less on average prior to open market repurchases. Investors seem to incorporate the information in insider trading prior to corporate events when forming reactions to event announcements, although the speed with which the market incorporates the information in pre-event insider trading varies across events. The information that insiders trade on prior to corporate events seems to be about future changes in operating performance and, in the case of repurchases, about future changes in the cost of capital. Altogether, it seems that insiders use their superior information about their firm’s fundamentals (about operating performance and changes in risk) to optimize their trades before corporate events.

The full paper is available for download here.

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