What Insiders Know About Future Earnings and How They Use it: Evidence from Insider Trades
Corporate insiders, including top-level executives, directors, and large shareholders, possess a significant informational advantage regarding their companies' future earnings and often leverage this private information through their trading activities . This extensive body of research highlights how insiders utilize their knowledge of upcoming financial performance, both positive and negative, to engage in strategic trading that can predict future stock returns and earnings surprises. Their ability to profit from this information is influenced by various factors, including the nature of the information, their intent (opportunistic versus routine), and the regulatory and social environment in which they operate.
Insiders' Knowledge of Future Earnings
Insiders are uniquely positioned to gain insights into a company's prospects that are not readily available to external investors. This "intimate knowledge" stems from their direct involvement in the firm's operations and strategic decision-making . This knowledge often translates into an ability to forecast earnings-related fundamentals .
One significant aspect of insiders' knowledge relates to disappointing future earnings. Research indicates that abnormally large stock option exercises by top-level executives can predict disappointing earnings performance in the post-exercise period . This pattern often comes as a surprise to even sophisticated market participants, such as financial analysts, suggesting that the executives are acting on private information not yet reflected in public expectations . Moreover, this disappointing performance in the post-exercise period can represent a reversal of inflated earnings in the pre-exercise period, implying that executives manage earnings to increase the cash payout from their option exercises .
Insiders also possess knowledge about future earnings innovations, both positive and negative. The likelihood of insider purchases is positively related to next year's earnings innovation . Conversely, insider selling and stock option exercises are negatively related to next year's earnings innovation . However, this relationship is not strictly linear; the expected costs associated with insider trading, such as litigation, political, and reputational risks, can attenuate these relationships, especially in cases of extreme positive or negative earnings innovations . This suggests that while insiders trade on future earnings news, there are thresholds where the potential costs of trading outweigh the expected gains from exploiting private information . Importantly, insiders tend to trade only on persistent earnings innovations, further indicating their discerning use of private information .
Beyond direct earnings forecasts, insiders also appear to know about future stock price crash risk. Insider sales are positively associated with future crash risk, indicating that managers trade on this risk for personal gain . This opportunistic behavior is more pronounced when information opacity is high, but it is constrained by financial limitations or regulations like SOX .
How Insiders Use Their Knowledge
Insiders utilize their knowledge of future earnings through various trading strategies, often differentiating between "routine" and "opportunistic" trades.
1. Opportunistic vs. Routine Trading: A crucial distinction in insider trading research is between routine and opportunistic trades. Routine trades are often uninformative about a firm's future, as insiders may trade for diversified personal reasons . In contrast, opportunistic trades are information-rich and contain significant predictive power for future news and events at a firm level . A portfolio strategy focusing solely on opportunistic insider trades can yield substantial abnormal returns, whereas returns associated with routine trades are essentially zero . This highlights that not all insider trading carries the same informational weight; identifying and isolating opportunistic trades is key to understanding how insiders leverage their private information .
2. Timing of Trades and Market Reactions: Insiders demonstrate an ability to time their trades strategically. They can engage in short-term market timing, with movements in returns around their trades consistent with this behavior . Some types of trades are more informative for short-term returns; for instance, medium-sized trades tend to be more predictive than large ones, aligning with the "stealth trading" hypothesis where informed traders avoid large blocks to evade detection .
Insider trades can also predict future stock return performance . Abnormally large option exercises, in particular, forecast future stock return performance, indicating that executives use private information about impending disappointing earnings to maximize their cash payouts .
3. Predicting Earnings Surprises and Post-Earnings Announcement Drift: Mutual fund managers, who are also considered "insiders" in a broader sense due to their professional information gathering, demonstrate stock-picking ability by forecasting earnings-related fundamentals . Their buys significantly outperform their sells around subsequent earnings announcements, and their trades forecast earnings surprises .
Corporate insiders' trades after an earnings announcement play a role in the post-earnings announcement drift (PEAD) anomaly . Contrarian trades by insiders can mitigate the market's under-reaction to earnings announcements, suggesting that insiders provide information that helps the market make appropriate inferences about the nature of the earnings surprise . Conversely, confirmatory trades allow for price discovery, with price movements continuing in the same direction as the earnings surprise . This implies that insider trading acts as a mechanism to convey relevant information about transitory or permanent changes to the earnings process .
4. Manipulation and Self-Serving Behavior: The evidence suggests that insiders, particularly top executives, can use their private information in ways that serve their personal financial interests. For example, the timing of abnormally large option exercises is linked to earnings management aimed at increasing the cash payout of exercises . This involves inflating earnings in the pre-exercise period, which subsequently reverses into disappointing performance in the post-exercise period .
Furthermore, political connections can facilitate opportunistic behavior by corporate insiders . During the 2007-2009 financial crisis, politically connected insiders at financial institutions engaged in abnormal trading, anticipating market reactions to Troubled Asset Relief Program (TARP) infusions . This demonstrates that connections can provide access to privileged information that insiders exploit for personal gain .
Factors Influencing Insider Trading on Future Earnings Information
Several factors modulate how insiders use their knowledge of future earnings:
1. Costs and Benefits of Trading: Insiders weigh the expected gains from trading on private information against potential costs such as litigation, reputational damage, and political scrutiny . These costs can lead to non-linear relationships between insider trading decisions and future earnings innovations, as insiders might curtail trading when earnings innovations are extreme to avoid drawing attention . The expected costs associated with insider selling appear economically larger than those for insider buying, leading to a more pronounced non-linearity in sales related to negative future earnings news .
2. Transparency and Market Efficiency: The predictive content of aggregate insider trades can be mitigated by country-level institutions that promote transparency, especially when markets are prone to deviating from fundamentals (e.g., during market fads) or when stock prices exhibit greater co-movement . Financial information transparency, as well as robust governance and investor protection, play complementary roles in reducing the informational frictions that give rise to the predictive power of insider trades .
Insider trading laws also influence stock price informativeness . Better transparency can lead to lower profitability from insider trading. However, a study on insider trades on the London Stock Exchange, after adjusting for microstructure (spread) transaction costs, found that abnormal returns largely disappear on a net basis . This suggests that while gross abnormal returns may exist, after accounting for trading costs, the net profitability might be limited in certain well-regulated markets .
3. Corporate Governance and External Monitoring: Effective corporate governance mechanisms can influence earnings management and, consequently, insider trading behavior. In Latin American markets, for instance, boards that meet more frequently tend to adopt a more active monitoring role, leading to a lower use of manipulative practices . A non-linear relationship between insider ownership and discretionary accruals suggests that ownership concentration can constrain manipulative practices, but only when the ownership of main shareholders is moderate . Stronger governmental controls aimed at reducing corruption, strengthening the rule of law, or improving government effectiveness also lead to a reduction in firm earnings management .
4. Social Norms and Religiosity: Local social norms, particularly religiosity, can influence the profitability and opportunism of insider trading . Insiders in firms located in more religious areas tend to have lower profits from their trades, are less likely to trade on future earnings news, and their trades are less likely to be opportunistic . This effect holds across different disclosure environments and is more pronounced in firms with poor corporate governance, suggesting that religiosity acts as a social norm curbing self-interested behavior .
5. Analyst Forecasts and Biases: Financial analysts' earnings forecasts can exhibit biases that insiders might exploit or react to. Analysts' conditional expectations are often upward-biased, especially with longer forecast horizons . These biases are associated with negative cross-sectional return predictability, and managers of companies with the most upward-biased earnings forecasts are more likely to issue stocks . This interplay between analyst expectations and actual earnings information known by insiders can create opportunities for informed trading.
Data and Methodology Research on insider trading extensively uses datasets capturing insider trading activity, often derived from regulatory filings made available by bodies like the Securities and Exchange Commission (SEC) . While proprietary commercial databases are common in academic papers, direct use of original regulatory filings, which are updated daily and include all reported information without alteration, is advocated to enhance replication and data integrity .
In conclusion, insiders possess valuable private information about future earnings, which they strategically leverage through their trading decisions. This knowledge spans impending positive and negative earnings innovations, potential earnings manipulations, and even future stock price crash risks. Their ability to profit is shaped by a complex interplay of personal incentives, regulatory environments, corporate governance structures, and broader social norms, leading to identifiable patterns of opportunistic trading that can predict market movements and earnings surprises.